Taxes for LLCs
The Limited Liability Company (or LLC) is a popular form of organization for new businesses in the United States. LLCs generally provide the same personal liability protection as a corporation, but without the additional layer of taxation or burensome administrative requirements. These requirements, commonly referred to collectively as “the corporate formalities,” generally include naming a board, holding an annual meeting, and keeping written minutes of the board, at a minimum. A corporation may also be limited by law in the amount of stock it can issue or the minimum amount of capital it must maintain. By contrast, an LLC has very few administrative requirements, allows a flexible management structure consisting of either members or outside managers, and may select its own tax treatment.
Taxed as a Disregarded Entity
There is no federal tax classification called “LLC.” By default, a single-member LLC is treated as a sole proprietorship by the IRS. A multi-member LLC is treated as a partnership. This means that the LLC’s tax attributes (income, deductions, credits) will be reported on the owners’ individual tax returns (on Schedule C of Form 1040 or Schedule K-1 of Form 1065). LLC owners must pay income tax and self-employment tax on their share of the LLC’s net income and may be required to make quarterly tax payments during the year. The self-employment tax is meant to replace Federal Insurance Contributions Act (FICA) tax withholding (for Social Security and Medicare) on normal wages and is assessed at the same rate.
Taxed as an S Corporation
An LLC that qualifies may elect to be taxed as a subchapter S corporation by timely notifying the IRS. Though S corporation taxation results in additional filing requirements, some small business owners may pay less tax overall by electing S corporation treatment.
S corporation shareholder employees must pay themselves a reasonable salary. The IRS has not provided guidance as to what would be considered a reasonable salary in any particular scenario, but the following factors have been relevant in prior cases where an IRS audit of an S corporation resulted in additional tax:
- Training and experience of the shareholder employee
- Duties and responsibilities of the shareholder employee
- Time and effort devoted to the business by the shareholder employee
- Dividend history
- Payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements
- The use of a formula to determine compensation
Salary payments are subject to standard FICA tax withholding as in typical employment arrangements. However, profits in addition to salary payments may be distributed free of FICA taxes. This is the major value proposition for companies electing S corp. treatment.
Taxed as a C Corporation
An LLC may also elect to be taxed as a traditional corporation (commonly called a “C corporation”). Though this has long been a disfavored option due to the resulting double taxation effect, it may be worth another look under current law. Subsequent to tax year 2017, changes in the tax code create the possibility that some entrepreneurs may pay less tax overall by electing C corporation treatment. This is because the federal corporate tax rate is a flat 21%, whereas the highest marginal individual tax rate is 37%. As with an S corp., C corp. shareholders who are also employees must be paid a reasonable salary with regular income and FICA tax withholding. Additionally, any distributions made to shareholders would be taxed as dividends on their personal returns.
Get Professional Help for LLC Taxes
Regardless of your company’s tax treatment, it is important to follow a clear system for paying yourself and keep accurate records. If you need assistance understanding the unique characteristics of your LLC and what you are required to do as an LLC member, do not hesitate to contact us. Our team of experienced tax and legal professionals can help you understand your options and help you choose the best method for your business.
