Wednesday, December 4th, 2019
One of the best benefits of forming an LLC is the flexibility on choosing how to be taxed. As default, a one-member LLC is treated as “sole proprietorship” and more than one-member LLC as a “partnership”. What does it mean?
Sole proprietorship: although legally the LLC is considered a separated entity with limited liability, to the IRS the entity “does not exist” and any profit made by the member should be declared in his/her tax return in schedule C.
Partnership: A partnership is a pass-through entity, that means each member from the LLC taxed as partnership shall include the LLCs gains, losses, income, deductions, and credits in their own tax return in schedule K1. The LLC will only file an information return (IRS Form 1065) to inform each member’s distributive share and issue Form K-1 to each member. Then the member generally should treat, in his/her own tax return, each LLC item in a manner consistent with the treatment given on the forms 1065 and K-1.
What both classifications have in common are that the member(s) are not subjected to double-taxation and do not need to pay taxes on the entity level, however when they declare the LLC’s income on their tax return, they are subjected to the high self-employment tax. Thus, some LLCs may opt to be taxed as a corporation.
S-Corporation: An LLC may opt to be taxed as an S-Corporation by filing Form 2553 with the IRS. On this structure, the members are treated as “employees” of the LLC and shall be paid reasonable salary. While in the “sole proprietorship” structure any distribution from the LLC was subjected to self-employment taxes, here only the salary is. However, there are additional expenses. Under this structure the LLC will have to file a separate tax return (Form 1120-S), will incur in additional payroll processing expenses, bookkeeping, among others. It is always wise to consult with an accountant, but generally an LLC that has less than $50,000 annual income would not benefit by this choice.
C-Corporation: This option is generally only beneficial to large and sophisticated LLCs that can benefit from “income splitting” which allows some members to stay in a lower tax-bracket by paying themselves lower salaries and leaving profit in the business. However, most LLCs would not benefit by this structure given the taxation on the entity and personal level (double taxation) increasing its tax liabilities. If an LLC considers that option, it should consult with an accountant to avoid the Accumulated Earnings Tax for leaving profits in the company for too long.
There is no “LLC taxation” and although the IRS provides for default rules based on the number of members, an LLC may choose to be taxed as any of the entities provided above. If chosen correctly that can create substantial savings in taxes.
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