LLC Tax Deductions andBusiness Tax Loopholes
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This roadmap is designed to provide entrepreneurs with information about the legal, tax, and accounting aspects of forming and managing a company.
Listed below are a few important highlights from this Tax and Legal Tips roadmap. Click on the [Learn More] links to read more about these points (in later sections of this page), or scroll down to learn about other tax tips.
- A Limited Liability Company (LLC) is taxed as a partnership or sole proprietorship, unless the owners elect to be taxed as a Corporation.
- The unit owners of an LLC or stockholders of a “C” Corporation may be Corporations or foreign citizens.
- “C” Corporations can deduct 100% of health insurance premiums and can adopt a Medical Expense Reimbursement Plan (MERP) for its officers and employees.
- “C” Corporations (i.e., general Corporations without “S” Elections or LLCs that elect “C” Corporation tax status) pay a 15% federal tax rate on the first $50,000 of taxable income.
- Consultants can avoid the personal service Corporation tax status by issuing 6% of stock or LLC units stock to a person (including a spouse) that is not employed by the Corporation or LLC.
- A general Corporation making a Subchapter “S” Election pays no federal tax on its taxable income and no employment taxes on its distributions to stockholders.
- Choosing Between an LLC and a Corporation
The “Limited Liability” of Both Entities
The owners of a sole proprietorship or general partners of a partnership are not protected from the judgments against and liabilities of the business or from the acts of their business partners.
The stockholders of Corporations and members owning units in Limited Liability Companies (LLCs), on the other hand, benefit from “limited liability.” In other words, their liability is limited to their investment in the stock of the Corporation or in the units of the LLC.
Why Choose an LLC? – Simple LLC Tax & Legal Explanations
An LLC gives the greatest tax flexibility. The LLC operating agreement includes management provisions and buy-sell provisions, making the LLC a popular entity to own real estate, boats, and airplanes and a popular entity for foreign citizens to render services or sell products.
A one-member LLC starts out being taxed as a sole proprietorship. All income and expenses “pass through” to be reported on schedule C of the individual tax return of the member. No EIN (Employer Identification Number) is necessary.
A multi-member LLC starts out being taxed as a partnership that needs to apply for an EIN on Form SS-4. Each year, a Form 1065 Partnership Return needs to be filed with a Form K-1 for each member listing the income or losses to be reported by each member.
The main disadvantage for owners of an LLC that is taxed as a sole proprietorship or partnership is that all taxable income, which passes through to the owners, is treated as “earned income” and is subject to employment taxes. Therefore, the 15.3% Social Security-Medicare rate applies to the first $90,000 of earned income and the 2.9% Medicare rate applies to all earned income over $90,000.
To avoid this disadvantage, an LLC can make a Subchapter “S” Election by applying for an EIN on Form SS-4 and filing a Form 2553 within 75 days after the date of formation or beginning of a tax year. (Note: only U.S. citizens and U.S. permanent residents can make this election). After deducting reasonable compensation and other business expenses, the LLC taxable income is then reported by the member(s) as passive income rather than earned income subject to Social Security and Medicare contributions. After making the election, the LLC would need to file a Form 1120S Corporation Income Tax Return each year.
An LLC may elect to be taxed as a Corporation (a.k.a. “C” Corporation) by applying for an EIN and then filing a Form 8832 within 75 days after the date of formation or beginning of a tax year. After deducting reasonable compensation and other business expenses, the LLC taxable income is taxed at the Corporation tax rates on a Form 1120 Corporation Tax Return to be filed each year. The U.S. tax rate on Corporations is 15% on the first $50,000 of taxable income each year. This low rate is only available to LLC’s through which personal services are rendered if a person who is not employed by the LLC owns at least 6% of the units (ownership interest). Otherwise, the top personal tax rate would apply to the taxable income from personal services in the LLC that elected to be taxed as a Corporation (“C” Corporation).
Why Choose a Corporations? Simple Corporation Tax & Legal Explanation
A Corporation is controlled by a majority of its stockholders. A Corporation needs to obtain an Employer Identification Number (EIN) and file a U.S. Corporation Income Tax Return each year.
A Corporation starts out as a “C” Corporation for tax purposes. This means that the taxable income (after deductions for salary, business expenses, and depreciation on furniture and equipment) is taxable to the Corporation. The Corporation would only be taxed on income “effectively connected with the United States.” The beginning corporate tax rate of 15% applies to the first $50,000 of Corporation taxable income each year.
The low 15% tax rate is only available to a Corporation rendering personal services if a person who is not employed by the Corporation owns at least 6% of the issued stock of the Corporation. Otherwise the top personal tax rate would apply to the taxable income from personal services in the Corporation.
A Corporation owned by one or more U.S. citizens or permanent residents may file a Subchapter “S” Election with the Internal Revenue Service on Form 2553 within 75 days after either the date of incorporation or the beginning of a year. The “S” Election will cause the taxable income of the Corporation to be passed through to be taxed to the Corporation’s stockholders in proportion to their stock ownership.
The advantage of the “S” Election for Corporations which render personal services is that the profits distributed as “S” Corporation dividends are treated as passive income not subject to employment taxes. After reasonable salaries are paid for the personal services, the 12.4% Social Security Tax and 2.9% Medicare Tax would not have to be paid on the “S” Corporation’s dividends.
The disadvantage of the “S” Election is that deductions for health insurance, disability insurance, automobile, and medical, drug and dental plan reimbursements would be taxable to the “S” Corporation stockholders for whom they are paid.
Lowering the Tax Rate
- The Tax Shelter Benefit
The Corporation or LLC which elects to be taxed as a Corporation can be a tax shelter. The first $50,000 of taxable income is taxed at 15%. A Corporation or taxable-LLC can retain up to $250,000 without having to justify (and pay a higher tax rate on) its accumulated earnings. If the Corporation or LLC is part of a controlled group, the low tax rate bracket and retained earnings exemption would have to be shared equally or as otherwise agreed upon in the controlled group.
- Avoiding the Personal Service Corporation Classification
A “C” Corporation or taxable-LLC which provides consulting or personal services other than professional services can avoid the 39.6% highest personal tax rate on its taxable income by issuing at least 6% of the stock in the Corporation or units in the taxable-LLC to a person not employed by the Corporation or taxable-LLC. This exception to the Personal Service Classification will apply even if the 6% of the stock of the Corporation or units of the taxable-LLC are issued to a spouse or relative of the 94% stockholder or unit owner (with the spouse/relative not being employed by the Corporation or LLC).
Allowable Tax Deductions
- Charitable Deductions
Since a Corporation or taxable-LLC can only deduct charitable contributions up to a value of 10% of its taxable income, it is usually advisable for the owner to make personal charitable contributions. (Note: Any excess Corporation or LLC charitable deductions not currently deductible can be carried over for 5 years).
- Health Insurance
A “C” Corporation or taxable-LLC can deduct all of the premiums paid on health insurance for its owners who are employed, along with their spouses and dependents. The cost of the premiums is not taxable to the employee owner. Subject to the rules of the health insurance company, health insurance might not be provided to other employees or might be limited to single coverage. If family health insurance coverage costs $5,000 per year, the owner might have to earn twice that amount (in pre-tax dollars) to net enough to pay the premium out of his or her personal funds (in after-tax dollars). An individual can only deduct the premiums if the total of premiums and other medical deductions does not exceed 7.5% of the individual’s adjusted gross income.
- Medical, Dental, and Drug Expense Reimbursement Plan
A “C” Corporation or taxable-LLC may adopt an MERP (Medical, Dental, and Drug Expense Reimbursement Plan) at any time during a fiscal year, which can be made effective retroactive to the beginning of the fiscal year. The MERP is one of the least publicized yet one of the most tax-effective and appreciated benefits for officers and other employees. The advantage of the MERP is that the Corporation or taxable-LLC can deduct the cost of medical, dental, and drug (prescription and non-prescription) expenses not covered by health insurance up to the stipulated limit without the employee having to include the benefit in his or her income. Otherwise, the employee would have to pay for these benefits with after-tax dollars and could only deduct them personally if they exceeded 7.5% of adjusted gross income.
- Disability Insurance
A “C” Corporation or taxable-LLC can purchase disability insurance for one or more of its executives or other employees and deduct the premium without the cost being taxable to the executive or employee. The drawback is that the benefits will be taxable when they are received by the disabled executive or employee. In order to avoid taxation on the benefits, the executive or employee should purchase and pay the premiums on the disability insurance. After the disability contract year, the “C” Corporation or taxable-LLC could reimburse the executive or employee for the premium and take a deduction for the reimbursement.
- Business Automobile
The “C” Corporation or taxable-LLC could reimburse an executive or employee the current mileage rate permitted by the Internal Revenue Service for the business use of an automobile owned by the executive or employee. Another alternative would be for the “C” Corporation or taxable-LLC to purchase or lease a business automobile and include in the Form W-2 of the executive or employee a percentage of personal use of the automobile which includes trips to and from the office. As a third alternative, the executive or employee could purchase the automobile, take depreciation on it up to the business percentage use and lease it to the business. The advantage of this approach is that you don’t have the valuation question if the executive or employee wants to get the automobile out of the Corporation or taxable-LLC for personal use when it is to be replaced by a new business automobile.
- Business Insurance
You should consult with your insurance agent to determine the various types of insurance coverage you will need for your Corporation or LLC. The Corporation or LLC should be listed as the name insured on all of the insurance policies. You should make certain that Workmen’s Compensation Insurance covers all individuals who are employed by the Corporation or LLC. If you are a consultant, the Corporation or LLC may want to purchase professional liability insurance. The individual owners who are employed by the Corporation or LLC should consider purchasing an umbrella liability insurance policy with coverage of no less than $1 million to raise the coverage limits of their automobile and homeowner’s policies. The premiums for the foregoing insurance are deductible by the Corporation or taxable-LLC.
- Office at Home
The Internal Revenue Code has been liberalized to allow a Corporation or taxable-LLC to reimburse its employees for their office at home expense as long as the office at home is used regularly and exclusively for administrative and management activities of the business, and/or for storing records, inventory, or product supplies. The reimbursement could be paid on a monthly or yearly basis, is deductible by the Corporation or taxable-LLC, and is not included in the income of the employee. The items which can be included in the office at home calculation are homeowners insurance, cleaning, maintenance, utilities, and telephone. The reimbursement is based on the percentage of office at home space in relation to the overall space in the home. Although depreciation could be taken on the office at home space, it would be recaptured upon the sale of the home. In order not to lose any of the long term capital gain exclusion ($500,000 for married couples and $250,000 for single tax payers), it is advisable to not take the office at home reimbursement during the last three years before your home is sold.
- Tangible Property (Section 179)
Section 179 of the Internal Revenue Code permits the deduction of up to $25,000 (in the year of purchase) of the cost of tangible personal property to be used in the business. Computers, off-the-shelf computer software, and office furnishings all qualify as Section 179 property. If the total cost of all the business’ tangible property bought and put into use by the business exceeds $200,000 in one year, the excess cost reduces the Section 179 deduction dollar by dollar. Since there is an advantage to offset the cost of Section 179 tangible property against income in the year of purchase, you could plan to stagger your purchases in different tax years of the business.
- Retirement Plans
A Corporation or LLC can deduct contributions to qualified retirement plans. There are a lot of choices of qualified plans with different deduction limits which can be adopted. Plans can be adopted that provide for immediate vesting or provide for staggered vesting of the participant’s account. The contributions to the qualified plans accumulate tax free in the plan until distribution to the employees upon death, disability, or retirement (when it is then subject to income tax). If an employee changes jobs, he or she can do an income-tax-free rollover of his or her vested interest to the plan of another employer or to a Rollover IRA account.
- Children as Tax Shelters
The minor children of business owners can be paid for working for the business after school or during vacations. In effect, they can earn tax-free allowances or save for education. A child for whom a dependency exemption is allowed to another taxpayer may earn up to $6,200 without having to file a tax return. Even though Social Security contributions have to be made while children are employed by a Corporation or LLC, a Form W4E exemption from withholding tax can be filed. The child can also contribute up to $5,500 of his or her earned income to an IRA or Roth IRA.
- Business Entertainment and Meals
A Corporation or LLC can deduct up to 50% of the cost of meals consumed during times of business entertainment or professional development. The cost of meals with employees is 100% deductible.
- Education Expense
A Corporation or LLC can deduct education expenses (currently limited to $5,250) of its employees for them to maintain or improve their skills. The reimbursement for education expense under the employer’s education assistance program is not included in the income of the employee.
- Longevity or Productivity Awards
A Corporation or taxable-LLC can deduct up to $400 of the cost of tangible property given to an employee by declaring it a longevity or productivity award. The award can be made every 5 years on a selective basis, with possible recipients including the owners who are employed by the business. The cost of the award is not included in the income of the recipient.
- Dues and Subscriptions
A Corporation or taxable-LLC can deduct the cost of dues for business or professional organizations and/or the cost of newspapers and subscriptions related to the business. The cost is not included in the income of the employees who benefit from them. A sole proprietor could only deduct his or her expenses to the extent that the cost exceeds 2% of the sole proprietor’s adjusted gross income.
- Conventions and Continuing Education
A Corporation or LLC can deduct the cost of travel, lodging, meals, and program fees for employees attending conventions and continuing education. This includes one or more owners employed by the business. The reimbursement is not included in the income of the employee.
- Independent Contractor Agreement
If a consultant or manufacturer’s representative forms a Corporation or LLC through which to receive his or her income, it is important for the Corporation or LLC to execute an agreement with the client or manufacturer stipulating that the Corporation or LLC is an independent contractor providing the services of the consultant and is to be paid directly without any employment taxes or withholding. It is not unusual for a retired executive to form a Corporation or LLC to consult for the former employer on special projects or other clients in order to get the tax advantages of a Corporation or taxable-LLC.
Other Financial Considerations
- Electing a Fiscal Year
A “C” Corporation or taxable-LLC can elect a fiscal year that will straddle the individual income tax year of December 31. Therefore, the income of a Corporation or taxable-LLC before December 31 can be deducted when it is paid as compensation after December 31 but before the end of the fiscal year of the Corporation or taxable-LLC. A fiscal year can end at the end of any month within twelve months after the month in which the Corporation or LLC was formed. The fiscal year election is made on the Corporation tax return, which is due to be filed within 2.5 months after the end of the first fiscal year. (Note: The fiscal year of an “S” Corporation or an LLC that does not elect to be taxed as a Corporation will end December 31 each year after it is formed).
- Interest-Free or Low-Interest Loans
The accumulated earnings of a “C” Corporation or taxable-LLC can be lent to the owners of the Corporation or Limited Liability Company. A loan of up to $10,000 can be made without interest to each owner. Minimum interest, such as 6%, should be paid on the entire loan if the loan exceeds $10,000. If the borrower secures the loan with a mortgage on his house, the interest can be deducted as a home equity loan on the first $100,000 of the loan. If a “C” Corporation or taxable-LLC needs working capital, the owner could make loans to the Corporation or taxable-LLC after the initial capital contribution. (Note: Under Delaware, Florida, and Nevada laws, there is no minimum capital contribution to a Corporation or Limited Liability Company). The advantage is that the loans can be repaid out of Corporation or taxable-LLC earnings accumulated at the low corporate or LLC tax rate. This avoids the money being locked in the Corporation or LLC as a capital contribution until the Corporation or LLC is liquidated. In order for the repayment of a loan from owners to not be considered a dividend by the Internal Revenue Service, it should not exceed 5 to 10 times the amount of capital contributed by the owners (i.e. debt to equity ratio). Loans should always be documented with Promissory Notes.
Other Operating Considerations
- Accounts Receivable and Accounts Payable
A Corporation or LLC cannot be used until it is formed. However, Section 351 of the Internal Revenue Code permits the assignment of all the accounts receivable and accounts payable of a business to a newly formed Corporation or LLC so that they can be collected and paid through the Corporation or LLC.
- Signature Block
In order to preserve the limited liability of the Corporation/LLC owner, all business documents and contracts should be executed in the name of the Corporation or LLC using the following form of signature block:
Corporation or LLC Name
Corporation President or LLC Managing Member Name
A Corporation or LLC should apply for and maintain the required business licenses in the City, County, and/or State where it does business.
- Qualification in Other States or Countries
If a Delaware, Florida, or Nevada Corporation or LLC does business, has an office, or hires employees in other states or countries, it may have to qualify to do business in those other states or countries. Usually, a Certificate of Good Standing is required by the state or an Apostille is required by some foreign countries. (Incnow can provide these documents).
- Preservation of Name or Trademark
The availability of a name in Delaware, Florida, or Nevada for a Corporation or LLC does not mean it is available for use in other states. It also does not mean that it has not been trademarked or reserved as a domain name in Internet commerce. Separate searches would have to be done to determine any conflicts.
- Address and Bank or Merchant Accounts
A Delaware, Florida, or Nevada Corporation or LLC does not have to use a Delaware, Florida, or Nevada business address or a Delaware, Florida, or Nevada bank account. If you want a Delaware, Florida, or Nevada mailing address for mail forwarding or want to open a Bank or Merchant account, please call Incnow for a recommendation.
- Annual Meeting
A Delaware, Florida, or Nevada Corporation is supposed to have on Annual Meeting of its Directors and Stockholders. This meeting can be held outside of Delaware, Florida, or Nevada. By unanimous consent, the minutes can be signed without a meeting. The main purpose of the meeting is to elect or re-elect the Officers and Directors.
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