Disregarded entity taxation

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, and strategies that only apply to individuals (see Chapter 18).

Partnership taxation

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 profits of the business pass through to the owners to be reported on their individual income tax returns). 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.

Corporation taxation

The corporate tax status differs dramatically from all others. It’s the only non-pass-through form of taxation an LLC can elect. The revenues and expenses, and thus the profits and losses, of the company don’t pass through to the members but instead 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 his 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. The major drawback of corporate taxation, though, occurs when ordinary profits (called dividends) are removed by the members, causing a double-taxation scenario where the amount is taxed both as corporation profit and then owner income.

S corporation taxation

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, but instead 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 themselves and pay themselves a salary. Although the resulting tax burden is ultimately equal to the income tax and self-employment tax they’d pay with partnership taxation, the members pay income tax on only amounts over the salaries they pay themselves (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.

Sucking it up with sole-proprietorship status

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 like 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) like you do for 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.

Keep in mind that as a sole proprietor, you can’t pay yourself a salary. Therefore, all your income is subject to self-employment tax, which you report on a Schedule SE, Self-Employment Tax, that you attach to your Form 1040. You can, however, deduct other employees’ salaries as an allowable business expense.

If you have less than $5,000 in expenses for the year, you should be allowed to file the short form of the Schedule C, the Schedule C-EZ. Double-check with your accountant to make sure that this is the case.

Ponying up with partnership taxation

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 that are being made to the partners. After this statement has been filed, the company then issues a Schedule K-1 to each member that shows what income and deductions have been allocated to her. The member then reports the allocations made to her (individually) on Part 2 of a Schedule E, which she attaches to her personal tax return.

Before you can file your IRS Form 1065, or any return for that matter, you need to obtain a tax identification number for your LLC. You can do that by submitting a Form SS-4, Application for Employer Identification Number, to the Internal Revenue Service or applying online at www.irs.gov (enter the phrase SS4 apply online in the search box). I recommend that you apply online so that you can get your number immediately (and I explain how to do so in Chapter 8).

Coughing up cash with corporation tax status

When you decide to be taxed as a corporation, you’re subject to the same type of taxation that corporations are — with no exceptions. If you aren’t used to corporate taxation, just think of your company in terms of being an official person that’s separate from yourself. You don’t pay taxes on behalf of your company. All taxes are paid by the corporation on the profits that are left in the business at the end of the year.

You report all of 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.

Shelling it out with S corporation tax status

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 he can use the information when preparing his personal tax returns. You then submit one copy to the IRS with your Form 1120S.

With the K-1, you must also send to each member a copy of the Form 1065 tax classification election and Form 2553, S-Corporation Tax Election. Not only is this step an IRS requirement, but it also explains to your fellow members why their LLC is filing taxes as an S corporation. For someone who isn’t hip on all the tax flexibility inherent in LLCs, getting a K-1 for an S corporation can be pretty confusing without an explanation attached.

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.

Transferring assets into your LLC

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 his 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 his tax basis. (I describe tax basis in greater detail in Chapter 8.)

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 he was reducing his debt by $40,000 and that 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 he 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.

Dealing with phantom income

When a partner is allocated a sizeable company profit that she has to pay tax on but she 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 a creditor 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, he’ll be running for the hills and eager to settle the lawsuit in the member’s favor. (Chapter 17 covers this strategy in more depth.)

You can add a provision in your operating agreement that can force the company to distribute enough cash for the members to be able to pay the taxes on their allocations. You can figure out a percentage that works for all members and also includes a percentage for state taxes. However, by doing so, you completely undermine the strategy that gets rid of creditors who have obtained charging orders.

Minimizing self-employment taxes

Even though LLCs aren’t imposed the same double layer of taxation on profits like corporations are, you can still end up paying more in taxes if you aren’t careful. And aren’t you’re supposed to be saving on taxes, not paying 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 that you have to 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 reach retirement (I hope), and 2.9 percent goes to Medicare, which is a form of hospital insurance. You use Schedule SE, Self-Employment Taxes, to determine the self-employment tax that’s owed, and file it with your personal Form 1040 tax return.

You have to pay self-employment taxes if

• Your LLC offers licensed services to the public, including accounting, actuarial science, architecture, consulting, engineering, health, and law.
• Your LLC is actively engaged in business. If your LLC engages in only passive activities, such as holding rental properties with the rent the only profit distributed to the members, then it’s passive income and not subject to self-employment taxes.
• You work more than 501 hours during the LLC’s tax year. That is, on average, about ten hours per week.
• You have the authority to execute contracts on behalf of your LLC.

If you’re an investor or partner in the business, you aren’t required to pay self-employment tax on the money you earn.

Luckily, a cap limits the amount of earnings subject to self-employment taxes per year. Unluckily, that amount is $117,000, which is way over the national average — and that only applies to Social Security. Anything over that amount is still subject to the 2.9 percent Medicare tax. This increases to 3.8 percent if you are married (filing jointly) and make in excess of $250,000, or if you are single and make $200,000 or more.

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.