Chapter 8
IN THIS CHAPTER
Knowing which tax classification is right for you
Watching out for tax traps
Electing a tax designation with the IRS
In 1997, the United States Treasury established the current entity classification laws (which you may hear referred to as the check-the-box regulations because the corresponding IRS form is comprised of a series of check boxes). This profound move established LLCs as one of the few entity types whose owners can dictate to the IRS how they want their company to be treated for tax purposes. LLCs can be taxed in four main ways — partnership taxation, disregarded entity taxation (if you’re a single-member LLC), corporation taxation, and S corporation taxation — and in this chapter I discuss them at length.
The chosen taxation has no bearing on the actual integrity and structure of the LLC; for instance, an LLC that elects to be taxed as a corporation is still considered an LLC by state law in every sense of the word. The key benefits of an LLC — dual liability protection, flexible management and ownership, and so on — are all still in full effect. The LLC simply pays taxes like a corporation does.
The default taxation for multiple-member LLCs is partnership taxation. If you file no Form 8832, Entity Classification Election with the IRS, you’ll be subject to partnership taxation at the end of the year. This rule applies to all LLCs except those with only one member (commonly referred to as single-member LLCs). I go into all this information in this chapter.
The IRS recognizes only the following four tax types:
As an LLC, you have the option of being taxed like any of these entities. The only exception: If you want to be taxed as a disregarded entity (think sole-proprietorship), then you must be a single-member LLC.
But with great power comes great responsibility; make sure you fully understand all your options and make an educated choice on which form of taxation to choose. The following sections detail each of these four taxation types.
All LLCs are created with a default tax status. It’s like hair color; you’re born with one color, but as you get older you can choose to change it if you want. If your LLC has at least two partners and the LLC doesn’t make any tax classification election with the IRS, then your LLC is automatically assigned the default, which is partnership taxation — a favorable form of pass-through taxation. I actually really like partnership taxation. In most cases, this arrangement isn’t such a bad deal.
Unfortunately, if you’re a single-member LLC, you can’t elect partnership taxation. Your default status is disregarded entity unless you elect corporation or S corporation taxation, all of which I describe later in this chapter.
To understand partnership taxation, you need to understand two concepts: allocations and distributions. At the end of the year, your company generates either a profit or a loss, which passes through to the owners on their personal tax returns. This number is referred to as the allocation, and each owner pays individual taxes on this amount. A distribution, on the other hand, is the actual cash you get from your LLC (or, sometimes, hard assets). It’s usually what you’re able to deposit into your personal bank account and spend as you please.
More often than not, the amount of profit you’re allocated at the end of the year and pay taxes on isn’t the amount of hard cash that drops into your pocket. Why not? Well, you’ll most likely decide at some point that you want to retain some money in the company to pay for growth or to keep as a buffer. Or perhaps you or your partners will make a company expense or two that isn’t deductible. When this situation happens, you have to pay taxes on these profits, yet you don’t actually get to cash the check and go hit up Vegas for a nice little shopping spree.
One of the coolest features of an LLC that has elected partnership taxation is that it has the ability to vary its allocations and distributions. This designation means that the company profits and/or losses don’t have to be allocated or distributed according to the percentage of ownership.
An example of how you can use varied allocations and distributions to your advantage: Say you really need some last-minute capital to grow your business, and you’re even willing to give up a 30 percent stake in your LLC in exchange. As an enticement for an investor to give you an infusion of capital, you offer to structure the deal so that she receives 100 percent of all company profits until she is paid back. After that point, the profits will be distributed according to ownership percentage, with the investor receiving 30 percent and you receiving the remaining 70 percent. This scenario is just one of thousands of ways you can use this flexibility to your advantage. Don’t underestimate how powerful this concept is!
If you have sources of income other than your LLC, you may be able to deduct your LLC’s losses from that other income to pay less in taxes. The IRS recognizes three types of income:
Assuming your LLC has elected partnership taxation, you can use your share of the business’s losses to offset any additional passive income that you may have received from other sources.
If you aren’t an active participant in your LLC, you can’t deduct your LLC’s regular business losses from your personal portfolio or active income, such as the income from your day job. In other words, under the passive income rule, if you’re not active in the business and your LLC passes on $50,000 in losses to you, you can’t use it to offset the $50,000 you made when you made a good trade on Wall Street (portfolio income). So you can sound like a smarty-pants when talking to your accountant, this situation is called a passive loss limitation.
All forms of pass-through taxation — not just partnership taxation — are subject to the passive loss limitation. However, as a member of an LLC that has elected partnership taxation, you get a wicked bonus those other guys with S corporations and sole proprietorships don’t get. Say you’ve shunned the slacker lifestyle and are regularly (and on a continuing basis) engaged in the day-to-day operations of the LLC, making you an active participant in the eyes of the IRS. Never underestimate the value (literally!) of hard work, because you now get to deduct your portion of the LLC’s losses from all other income, including wages and stock dividends, without limitation. Starting a small business and not yet ready to quit your day job? This incredible tax deduction is reason alone to form an LLC and elect partnership taxation.
To help clarify the ins and outs of what partnership taxation allows you to do, check out Table 8-1.
TABLE 8-1 Offsets Allowed by Partnership Taxation
Can Offset Portfolio Income with LLC Losses |
Can Offset Active Income with LLC Losses |
Can Offset Passive Income with LLC Losses |
|
Active in LLC |
Yes |
Yes |
Yes |
Passive in LLC |
No |
No |
Yes |
If you elect partnership taxation, you’re assessed a 15.3 percent self-employment tax in addition to the personal income taxes you’re required to pay on the profit that’s allocated to you. In addition, even if you’re an active member of your LLC, you aren’t allowed to hire yourself and use payroll taxes as a way to get around the hefty self-employment tax bill each year. This taxation is one of the only drawbacks of LLCs when compared to S corporations, which only assess self-employment taxes on the amount of salary you choose to pay yourself, assuming it’s within the norm for your industry.
One caveat, however, lands this guideline in the LLC’s favor. Although you may not be able to officially hire yourself (and thereby avoid self-employment tax), you can slack off a bit, to the point where you’re no longer considered an active participant but rather a passive participant. In the case of an LLC electing partnership taxation, only active participants are required to pay self-employment tax, whereas inactive participants aren’t. The income itself is considered passive, which, as far as income goes, is about as favorable as the IRS gets. However, depending on your industry and specific situation, the rules can be murky. I strongly suggest you let your CPA help guide you in this area.
The disregarded entity tax status is the default for single-member LLCs. Essentially, it’s the same tax status you’d pay as a sole-proprietorship (as if you haven’t filed your LLC at all). It’s the one form of tax status that LLCs with multiple members can’t elect.
Similar to partnership taxation, disregarded entity tax status is a form of pass-through taxation, and in this case the sole member pays personal income taxes and self-employment taxes on the company’s profits and/or losses on his personal tax return. The LLC is treated as a separate entity for the purpose of paying employment and excise taxes only.
Whether you’re a single-member LLC or you have multiple members, you can always elect to be taxed like a corporation. Corporate taxation is completely different from partnership taxation. First and foremost, the IRS considers a corporation (or an LLC electing corporation tax status) to be an entity completely separate from its owners and treats it as if it were an individual. Instead of passing through profits and losses to the members, the corporation files its own tax returns. All a member must report on his personal tax return is the actual cash the company decides to distribute to him, whether in the form of dividends or salary. The member can’t report the LLC’s losses and therefore can’t deduct them against other personal income. You don’t have to worry about allocations, tax bases, phantom income (allocations that you have to pay taxes on, but don’t actually get the cash to cover the tax bill), and deemed cash distributions because they aren’t relevant to corporations.
When it comes to the corporation tax structure, many people worry about something called double taxation. It’s understandable; who wouldn’t balk at a term that implies paying double the amount of tax? Double taxation occurs when the owners of the corporation take the profit out of the company and the profits are taxed on the individual owner level. This scenario means that the same profits are taxed once at the corporate level and then again at your (the member’s) level when they’re paid out. As horrific as this situation sounds in theory, it’s usually not so bad in practice. Check out the following section to find out why.
To explain why corporation taxation may result in less tax than any of the forms of pass-through taxation (such as sole-proprietorship, partnership, and S corporation taxation), I’ll use an example from my own life. As an entrepreneur, I often use loans from my established businesses to help cover the cost of establishing new businesses (instead of paying double taxation by taking the money as personal income before investing it into the new business). All of my companies are owned by me, so approval for this practice doesn’t present much of a problem.
After the company is established, I may pay myself a salary (which is taxable to me, but deductible by the corporation); however, I rarely issue dividends. Instead of taking a lot of money from the business, I reinvest it and use it to help propel growth, which is the only way a business can achieve exponential growth. If you reinvest those profits into further building your company — a tax-free endeavor — instead of just buying yourself a fancy car, you’re compounding your resources, and the results you can achieve are much greater.
By following this plan, you manage to grow your company while maintaining a nominal — almost nonexistent — tax burden. And when the company reaches its peak, you can sell it. I keep my stock for over one year, so any income from the sale of my ownership of the company is considered long-term capital gains, which are only subjected to a 20 percent long-term capital gains tax. The government is happy because creating new companies creates new jobs and helps stimulate the economy, and you’re happy because now you can get the fancy car you’ve been wanting!
With an LLC, you don’t have to make this tax election right away. If you’re going to be putting a lot of money into the company and want to be able to deduct the losses of your initial, formative years, you can maintain default partnership taxation for a few years and then make the tax election to switch to corporation tax status. However, this change may have other tax implications that aren’t obvious at first glance, so run any strategies like this one by a qualified accountant before committing.
In a few instances, you should never elect corporation taxation for your LLC — namely, if your LLC holds real estate. In today’s litigious America, the idea of putting your personal assets in another name to protect them is a generally accepted practice; using an LLC to hold real estate is a good move, but you’re going to find yourself in a world of hurt at tax time if you elect corporate taxation in this scenario.
In addition, myriad other tax problems can pop up if you subject your rental property to corporation taxation. You can spend time and money getting a second opinion from a CPA, but I think you’ll find it’s a universally accepted rule: Never elect corporation tax status for an LLC that’s being used to hold passive investments such as real estate. An LLC with partnership taxation is a better option. (Flip to the earlier section “Partnership taxation” for details on this election.)
S corporation taxation is the corporation’s answer to a pass-through tax status. Just like a corporation can elect S corporation tax status, so can a limited liability company that has elected corporation taxation. You may think this move is a waste of time considering LLCs already have a pass-through tax status by default, but S corporation taxation differs from partnership taxation on some pretty big issues — namely, in what taxes you pay when you take money out of the company.
If you’re a single-member LLC and therefore not allowed to choose partnership taxation, you’re allowed to elect corporation taxation and then elect to be taxed as an S corporation. This method provides favorable pass-through taxation without the need to take on a partner. Just be aware that S corporation taxation differs substantially from partnership taxation and, should you take on a partner sometime in the future, you may be restricted in your ability to change back.
S corporations get a pretty big advantage when it comes to taxation, though at first glance the situation looks comparable to partnership taxation status. If you’re a member of an LLC electing partnership taxation, you’re required to pay personal income tax on all company profits that are allocated to you. In addition to personal income tax, you’re also required to pay a 15.3 percent self-employment tax, which is simply both the employer’s and employee’s shares of Social Security and Medicare taxes. But with an S corporation, you’re allowed to pay yourself a salary, which is a deductible expense for the company, and any amount over that isn’t subject to self-employment tax. You simply pay personal income tax on those profits and nothing more after they’re allocated to you. This setup differs substantially from LLCs (which have elected partnership taxation) because all profits you derive from the company in that scenario are subject to the 15.3 percent self-employment tax.
In other words, if you’re taxed as an S corporation, the amount of Medicare and Social Security you pay is limited to the amount you take as a salary. As long as your salary is comparable with others in your position and your industry, any profits the company takes above that amount aren’t subject to extra taxes.
In a nutshell, this designation means you save 15.3 percent in taxes on all profits above an appropriate salary. So if you have a business from which you intend to remove a substantial amount of profits — more than the reasonable salary you’re taking — you’ll probably see some pretty hefty tax savings by electing S corporation taxation.
Unfortunately, even if S corporation status is the best choice for you, you may not be able to elect it. When the IRS created the S corporation election, it wanted to make sure that the status was employed by genuinely small businesses and not exploited by large enterprises strictly as a tax-saving strategy. Therefore, you must meet quite a few restrictions in order to take advantage of S corporation taxation:
In addition to these ownership restrictions, you may want to take into consideration a few other downsides before committing:
These rules (plus many more) make S corporations a bad choice for holding real estate. Even though S corporation status lets you get around the double-taxation nightmare that comes with a regular corporation, you’re still limiting yourself by not being able to personally deduct the mortgage.
Making a tax election for your LLC is as simple as filling out a single form: IRS Form 8832, one of the simplest tax forms you’ll ever complete. They don’t call them check-the-box regulations for nothing — all you have to do is check a box! In this section, I walk you through the process of making your tax election, starting with the necessary background work.
All businesses must obtain an employer identification number (EIN for short, but also called a tax identification number or tax ID) from the Internal Revenue Service. The IRS uses this number to identify your LLC when the LLC pays its taxes. Over the years, the EIN has become an important number for the government, financial institutions, and other businesses to identify different entities. After all, an LLC in Georgia can have the same name as your LLC in California; how would Uncle Sam be able to tell them apart? Think of it as a Social Security number for your enterprise.
Obtaining credit, paying taxes, and even opening a company bank account are virtually impossible without a tax identification number, so don’t delay! Some attorneys, accountants, and incorporating companies may charge you an arm and a leg to obtain this number for you, but you’re smarter than that. With a few little tips, you can have your tax ID within an hour.
You can obtain a tax ID immediately online by going to www.irs.gov
and doing a search for EIN online application. This should pull up the page that you need to get your application started. When you’re asked for your Type of Entity, you’ll notice that there is no LLC option. Here’s what to select:
If you can, file your Form SS-4 online; you’ll likely receive your tax identification number instantly. Otherwise, you should be able to find the most recent IRS Form SS-4 at www.irs.gov/pub/irs-pdf/fss4.pdf
.
The best time to file Form 8832, Entity Classification Election is when you form your LLC; otherwise you’re automatically assigned your default tax status (disregarded entity taxation if you’re a single-member LLC or partnership taxation if your LLC has more than one member). After you file Form 8832, you don’t need to continue to file it each year; the taxation election automatically lasts until you file another Form 8832, electing a different form of taxation.
Note that this entity classification is for income tax purposes only and has no bearing on how you’re treated by the state, especially for liability purposes. For instance, if your LLC elects corporation taxation, you still have the protection of the dual-layer liability protection that’s unique to LLCs.
Form 8832 itself is pretty straightforward. I provide a current one with instructions at www.irs.gov/pub/irs-pdf/f8832.pdf
. The first section (lines 1 to 3) asks you a series of questions to determine your eligibility.
When you choose a tax classification, you’re stuck with it for 60 months (5 years). The IRS does this to keep you honest. It figures a business process needs a few years to work the kinks out. It doesn’t want shady tax avoiders to exploit the classifications for their personal benefit.
Under line 6 of Form 8832, you’re required to select your type of entity. If your LLC is formed within the continental U.S. (and I’m assuming it is), only the first three options apply to you. You notice that none of these options allows for S corporation taxation, and that’s because you need another form, Form 2553, to make that election. Select Corporation taxation on Form 8832; then attach a completed Form 2553 and file them both together.
Your LLC’s tax election should also be indicated in your LLC’s operating agreement. Your operating agreement is an internal document and isn’t publicly accessible, so by recognizing the tax classification in the operating agreement, you show that all members agree on it. You should also document any further tax classification changes by special resolution of the members of the LLC (I show you how to draft resolutions in Chapter 13).