Chapter 13
IN THIS CHAPTER
Understanding how your LLC is taxed
Finding out what to file based on the tax status
Saving on taxes with your LLC
Just the thought of taxes probably makes you want to throw this book across the room, but don’t do it. This chapter isn’t the most entertaining one you’ll read, but it’s quick and painless. I promise. Although taxes can be a pain in the butt, by educating yourself about them, you gain the upper hand and can end up paying less. Just think, after reading this chapter, you’ll be able to stride into your accountant’s office with your head held high, with no problem discussing the tax basis of assets, tax reporting requirements for LLCs, and how you can avoid sending a chunk of change to the IRS.
LLCs can be taxed in a multitude of ways, but most LLCs just stick with the default partnership taxation. And why not? It’s a great way to be taxed! In Chapter 7, I go through all the various forms of taxation you can choose. At this point, I assume you’ve already elected your company’s tax structure and are now ready to deal with the ins and outs of managing it — maintaining books, filing your federal returns, and so on — and avoiding any potential hiccups you may encounter along the way.
Although I touch on all types of taxation in this chapter, I spend the most time discussing partnership taxation because it’s the most common to LLCs and, in my opinion, the least understood form of taxation.
Because LLCs can elect pretty much any tax status that suits them, the federal returns, information statements, and/or notices they must file each year vary accordingly. To review, an LLC can choose disregarded entity, partnership, corporation, or S corporation taxation. Check out Chapter 7 for help on which form of taxation to choose.
Disregarded entity isn’t so much an election as a default tax status for single-member LLCs. Single-member LLCs don’t qualify for partnership taxation because no partners exist, so they’re automatically subject to disregarded entity status unless they elect corporation or S corporation tax status.
Disregarded entity taxation can actually be beneficial for some real estate and investment transactions. When considered a disregarded entity by the IRS, your company is treated as if it doesn’t exist, and you’re taxed simply as an individual (or as a sole proprietorship, to be exact). This setup can be beneficial when executing tax credits, deductions (like those awesome mortgage interest deductions!), and strategies that only apply to individuals (see Chapter 17 for some real-estate-specific tax strategies).
Partnership taxation is the default tax status for limited liability companies with more than one member. It’s a form of pass-through taxation (where the business profits pass through to the owners to be reported on their individual income tax returns) — though, don’t let that fool you. There are some key differences between the other two primary forms of partnership taxation: disregarded entity taxation (for single-member LLCs and sole proprietorships) and S corporation taxation. The primary benefit of partnership taxation over other forms of pass-through taxation is that you can vary the profit and loss allocations to the partners.
The corporate tax status differs dramatically from all others. It’s the only non-pass-through form of taxation an LLC can elect. A company’s revenues and expenses — and thus the profits and losses — don’t pass through to the members. Instead, they are retained in the company and taxed at the applicable corporate income tax rate. Because the corporation tax rate is generally lower than what an individual pays, this status can often be beneficial.
Additionally, when a member sells their interests in the company, the profit from that sale is subject to a very favorable long-term capital gains rate, which can result in substantial tax savings. However, the major drawback of corporate taxation occurs when the members remove ordinary profits (called dividends), causing a double-taxation scenario where the amount is taxed both as corporation profit and then as owner income.
The corporation’s answer to pass-through taxation, S corporation tax status, came about when small, closely held businesses (such as independent contractors) needed the ability to operate under the liability protection of a corporation but without the heavy tax and regulatory burden that comes with the standard corporation. Note that S corporation isn’t an entity type; instead, it’s simply a tax election that can be made by either a corporation or an LLC.
The S corporation’s claim to fame is the members’ ability to hire and pay themselves a salary. The resulting tax burden ultimately equals the income and self-employment taxes they’d pay with partnership taxation. However, the members pay income tax only on amounts over their salaries (as opposed to members subject to partnership taxation, who have to pay income tax and self-employment tax on all profits over their salaries). Obviously, you can’t just pay yourself $1 and be done with it. The IRS stipulates that your salary must be consistent with others in your industry and your position.
Although you’ll most likely delegate the filing of your federal tax returns to a competent accountant, I still recommend that you have a good, basic knowledge of what your LLC needs to do at tax time. You’ll have more-educated conversations with your accountant and also be able to review their work. After all, you sign those filings; don’t you want to know what you’re signing exactly?
If you have a single-member LLC, the IRS classifies it as a disregarded entity by default and taxes it as a sole proprietorship. This designation means that the company doesn’t have to file an information statement with the IRS as an LLC does, and you don’t have to issue yourself a K-1. You simply report your company’s income and expenses on a Schedule C, Profit or Loss from a Business, and attach it to your personal income tax return (your Form 1040) as with any other side income you have. If you have rental property, the profit and loss information is instead listed on a Schedule E, Supplemental Income and Loss.
With partnership taxation, you don’t file an actual tax return for your LLC. Instead, you file only an information statement — IRS Form 1065, U.S. Return of Partnership Income. On this statement, you report the company’s income, deductions, gains, losses, and the allocations made to the partners. After this statement has been filed, the company then issues a Schedule K-1 to each member, showing them the income and deductions allocated to them. The member then reports the allocations made to them (individually) in Part 2 of a Schedule E attached to their personal tax return.
All partnerships, including LLCs, must file a Form 1065 by April 15 of each year. The 1065 isn’t a tax return; it’s a summary and information statement that lets the IRS know who pays which percentage of the company’s tax burden for the year. It’s five pages long and contains six different schedules. (Some other schedules and disclosures can be filed with the 1065 if your accountant deems them necessary.)
The company also must make some tax decisions called elections. Elections can include decisions concerning the research credit, for example, and also the depreciation of assets. These decisions can affect all the members and can have huge tax consequences. Therefore, whoever prepares and files the Form 1065 must look to the operating agreement for guidance on how tax elections are to be decided. If the operating agreement doesn’t address them, then all members should come together for a vote.
After Form 1065 is completed, only one member needs to review and sign it; however, that member must answer to all the other members if they have a question or problem with the filing.
After filling in your LLC’s Form 1065, your accountant creates a Schedule K-1 for each LLC member. The K-1 contains the allocation information for each partner, including how much and what type of company income is allocated to the member and what sort of deductions they can write off. It also provides an updated analysis of each partner’s tax basis. See Chapter 7 for more about tax bases.
Remember that one of the benefits of an LLC is that the company profits and losses don’t have to be allocated to the members according to their ownership percentages. LLCs allow for special allocations, which means you can own 10 percent of the company and feasibly receive 100 percent of the profits and losses for a specific year. Granted, you can’t make these decisions without having a good reason (specifically, one that isn’t purely for tax avoidance); however, if your accountant determines that your situation is sufficient, special allocations are easy to do.
When your accountant creates the Schedule K-1s, they file the originals and Form 1065 with the IRS. You’ll get a photocopy of your Schedule K-1 that you can use when filing your individual tax return.
If you’re a United States citizen, you pay your personal taxes on IRS Form 1040. But your 1040 tax return doesn’t include a line that specifies LLC income. If you take a look at Form 1040, you see that line 17 mentions business income. So, here, you list the total income stated on your Schedule E, Supplemental Income and Loss, which you submit with your Form 1040.
You use a Schedule E to report all income and losses from business activities that don’t constitute your primary source of income. If you’re managing the day-to-day business of the LLC, you should be on the company payroll, and your regular paycheck is what’s considered your primary source of income. The company’s yearly allocations are considered secondary income. In other words, if all you do is sit at home and collect profits from businesses that you don’t actually operate, and you don’t have any “job” per se, that income is still reflected on a Schedule E.
When filling out your Schedule E, you report all the business income and deductions in Part 2.
Because the Schedule E isn’t as simple as copying and pasting the information from your K-1 (a few other schedules are involved), I recommend leaving the preparation of this form to your accountant. I include the basic how-to here only so you can familiarize yourself with it. Armed with this information, you can check your accountant’s accuracy and have intelligent discussions with your accountant about the documents they prepare.
When you decide to be taxed as a corporation, you’re subject to the same type of taxation as corporations — with no exceptions. If you aren’t used to corporate taxation, just think of your company as an official person separate from you. You don’t pay taxes on behalf of your company. All taxes are paid by the corporation on the profits left in the business at year’s end.
You report all your business’s income and deductions on IRS Form 1120, U.S. Corporation Income Tax Return — a separate tax return. (You send a signed copy of Form 8832, Entity Classification Election, to the IRS with your corporate tax return.) Your profits are subject to the federal corporate tax rate, which averages around 15 percent (for profits under $50,000). Then, if you distribute them to the members, those same profits will be taxed again as dividend income to the members. This situation is called double taxation.
If you elect to be taxed as an S corporation, you file an IRS Form 1120S, U.S. Income Tax Return for an S Corporation, rather than the traditional partnership returns. The 1120S is more of an information statement than anything else because S corporations don’t really pay taxes; they just pass the profits on to the owners for them to handle the burden.
When filing a Form 1120S, you prepare a Schedule K-1 for each member (referred to as shareholders on this form) and give a copy of the K-1 to each member so they can use the information when preparing their personal tax returns. You then submit one copy to the IRS with your Form 1120S.
If you’re taxed as an S corporation, you’re required to file Form 1120S by March 15 of the following year; if you’re on a fiscal year that isn’t the calendar year, the deadline is the 15th day of the third month after the close of the fiscal year. Depending on your state, you may also have to send a copy of Form 1120S and the corresponding K-1s to your state tax board. Or, they may have a similar form that you need to file. Your accountant can assist you in pulling together all of the required filings for your LLC.
Business is business, and the unwary can easily fall into quagmires. Every entity has its tax traps, and LLCs are no different. As long as you plan around them, you’ll be fine.
For the most part, when your LLC elects partnership taxation, transferring assets into your company in exchange for membership is a nontaxable event. This term means that, for income tax purposes, the IRS recognizes no gain or loss. Problems arise only when debt or liability is involved.
LLCs have a tax pitfall known as a deemed cash distribution. It occurs only when one of the members reduces the amount of their liability. The IRS considers the reduction in liability to be a cash distribution, and like a cash distribution, the member must pay taxes on any of this amount that goes over their tax basis. (I describe the tax basis in greater detail in Chapter 7.)
A good example of a deemed cash distribution is a member who transfers a piece of property into the LLC. Say that the property has a mortgage on it for $80,000. When the property is transferred into the LLC, the two members decide to refinance the property to include the other member as a personal guarantor. Unfortunately, the partner who transferred the property didn’t realize that by refinancing it, they were reducing their debt by $40,000, and the IRS would consider that $40,000 a cash distribution. So, at the end of the year, the contributing member has to pay taxes on $40,000 that they never actually received.
Had the members talked to a professional early in the game and chosen to obligate the member in some other way than refinancing the property, the contributing member could’ve avoided a big tax surprise.
When a partner is allocated a sizeable company profit on which they must pay tax but isn’t actually distributed any profits, that allocation is called phantom income. Phantom income can be dangerous because a partner in the LLC can end up with a pretty hefty tax bill but no cash to pay it with.
Members often experience some phantom income — especially in your LLC’s beginning stages, when you need to keep the profits in the business to help it grow. However, you can feel pinched in the pocket if the business doesn’t even distribute enough cash to the members to help cover the tax burden. You’ll have to scrounge up the dough on your own. Garage sale, anyone?
Phantom income has a good and a bad side. The bad side is that it can happen to you. The good side is that you can force it on a creditor who obtains a charging order on a member’s interest. A charging order is all that a creditor can go after if a member is liable personally, and it gives creditors access to only the allocations and distributions that a membership interest can receive. If you allocate only profits to the members (who include the creditor with a charging order) and don’t give any cash distributions to pay the taxes on those profits, how happy do you think the creditor will be? Needless to say, they’ll be running for the hills and eager to settle the lawsuit in the member’s favor. (Chapter 16 covers this strategy in more depth.)
Even though LLCs aren’t imposed the same double layer of taxation on profits as corporations, you can still end up paying more in taxes if you aren’t careful. And aren’t you supposed to save on taxes and not pay more?
The IRS hits LLCs and sole proprietorships the hardest with self-employment taxes. Self-employment (SE) taxes are Social Security and Medicare taxes, and they’re imposed in addition to the federal income taxes you must pay. These taxes amount to about 15.3 percent of the total income allocated to you. About 12.4 percent goes to Social Security, which will be paid out to you when you retire (I hope), and 2.9 percent goes to Medicare, a form of hospital insurance. You use Schedule SE, Self-Employment Taxes, to determine the self-employment tax owed and file it with your personal Form 1040 tax return.
You have to pay self-employment taxes if
If you’re an investor or partner in the business, you aren’t required to pay self-employment tax on the money you earn.
Currently, you can only deduct half of what you paid in self-employment tax when calculating your adjusted gross income — the amount you have to pay income tax on.
Not everyone is required to pay self-employment tax. SE tax is for wage earners, not necessarily big fish. So if you’re a silent partner who doesn’t deal with the day-to-day matters of the business, you may be able to find a way around the mandatory self-employment tax.
First, make sure your LLC is manager-managed. If it’s member-managed, it’s hard to attest that you, as a member, aren’t managing the day-to-day affairs! Then find someone trustworthy who can act as manager and will be able to enter into contracts with your and the company’s best interests in mind. Finally, make sure that you work no more than 500 hours per year for that particular company.
Obviously, this workaround isn’t possible if you’re one of the operating partners. But if you’re simply an investor, you may be able to eliminate the required self-employment taxes and keep a hefty chunk of change in return. Since you’ll effectively structure your specific membership akin to a “limited partner,” you must account for this in your LLC’s operating agreement. Before you commit to this, it would really benefit you to speak with a tax professional to make sure that any tax savings you generate would be worth the potential headaches.
Unlike partnerships, the owners of S corporations can hire themselves. In fact, they’re expected to hire themselves; an S corporation without any owners on the payroll is a sure path to an audit. The main benefit of hiring yourself is that you’re paid as a regular employee, as you’d be if you had any regular job. This setup means that the income you receive isn’t subject to self-employment taxes. You still have to pay regular payroll taxes, but this amount is often much less.
Of course, you must hire yourself for a standard wage in your industry. If your company hits a windfall, you can’t necessarily take all the cash out as a bonus because you’re limited to having a believable salary for an executive of your rank, in a company your size, in your industry. For instance, if everyone else in similar positions is pulling around $100,000 per year, you can’t take home $10,000 and not expect to raise some red flags with the IRS.
Keep in mind that if you’re an owner who is active in the business’s day-to-day operations, the IRS considers you to be an employee. Therefore, you must include yourself on the company payroll and pay payroll taxes on that income. Make sure to take enough of a salary to align with the standard for your position in your industry. After that, the remaining income you take is classified as company profit, which you don’t have to pay self-employment taxes on. You’re only subject to personal income tax on this profit. That’s a 15.3 percent savings!