LLC Tax Classifications
There are four main ways that an LLC can be taxed in the United States:
- As a sole proprietorship
- As a partnership
- As a C corporation
- As an S corporation
This article provides information and examples of the four ways that the limited liability company is taxed. The article ends with a summary of why one might choose one method of taxation over another.
LLC Taxed as a Sole Proprietorship or Partnership
By default if an LLC has one member (“owner”) it will be taxed as a sole proprietorship. Likewise, if it has two or more members it will be automatically taxed as a partnership unless you elect otherwise. When taxed as a sole proprietorship or partnership, income and deductions flow through to the members of the company. Such flow-through taxation is the preferential tax treatment for real estate investors according to many tax advisors because taxes will be minimized. This is because the real estate tax deductions and other tax benefits flow through to the owners of the LLC. Plus, there will be no federal income tax on the company itself.
It is important to note that how an LLC is taxed and how it protects you legally are separate issues. An LLC taxed as a sole proprietorship or partnership can still offer substantial legal protection. Whereas, sole proprietorships and partnerships themselves, (such businesses that are not corporations or LLC’s) offer little, if any, liability protection to business owners.
Here is an example. John is a real estate investor. He establishes one LLC for each property, or group of properties. Therefore, when there is a lawsuit stemming from one property, the lawsuit does not attach properties in John’s other LLCs. Additionally, when John is sued personally, such as a car crash where John is sued for more than his insurance limits, there are asset protection provisions in the statutes such that assets inside John’s company are protected from being taken from him.
John also enjoys tax benefits offered by his legal entities. The real estate depreciation deduction on John’s properties flows through to his personal tax returns, reducing his personal income taxes. John does not have to pay Social Security (12.4%) or Medicare (2.9%) on his rental income, saving him 15.3% in taxes. John can use his company to participate in 1031 tax deferred exchanges where the profit produced on the sale of one property can be rolled into one or more other properties without paying income taxes. So, the tax benefits remain intact and John enjoys the added benefits of lawsuit protection stemming from liability on his properties.
John also enjoys asset protection. His properties are owned by properly structured limited liability companies. The statutes provide that when John is sued personally, the assets inside the companies are protected from being taken from a member of the companies. So, when legal liability strikes his personal life, the properties he worked so hard to acquire can be protected from seizure.
LLC Taxed as a “C” Corporation
An LLC can be taxed as a “C” corporation by filling out the IRS form 8832, titled the “Entity Classification Election,” and electing corporation taxation status. The election says, “A domestic eligible entity electing to be classified as an association taxable as a corporation.” The LLC will then be taxed as a C Corporation separately from the owners. Profit remaining in the LLC after the end of its tax year will be taxed at corporate tax rates, which, incidentally, are often lower than personal tax rates. This is often chosen when a client desires asset protection and financial privacy. Since the company is taxed separately from the individual, the income need not appear on one’s personal tax returns, giving the members additional privacy. Plus, there are provisions in LLC law that protect company assets from being taken when a member is sued.
Additionally, with C corp. taxation you can choose a fiscal year rather than a calendar year. When you choose a month on which to end your tax year, the tax year will end on the last day of the month you have chosen. For example, if you choose March as your tax year end, the tax year will end on March 31 of each year. Many professionals suggest choosing a calendar quarter, which corresponds with quarterly filings; March, June or September, for example. The benefit of choosing a fiscal rather than a calendar year is that this allows you to move money from one tax year to another.
For example, Ben ordered an LLC to be formed. He elected C corporation taxation status on the 8832 form and chose a March tax year end. He had a customer who placed a sizable order in June that resulted in profit of $100,000 more than his business usually earns. Next year, he does not expect the additional $100,000 in income. He does not want to bump himself into a higher tax bracket this year by paying himself the entire amount as a salary or bonus in one calendar year.
So, Ben writes a check to himself out of the corporate checkbook $50,000 before December of that year and adds that amount to his personal income taxes. The $50,000 salary he has paid himself is taxable income to him and is a tax-deductible expense to the corporation. The remaining $50,000 of extra profit remains in the company.
Before March of the next year, he pays himself the remaining $50,000 of excess profit by writing another check from the corporate checkbook. This is also tax deducible to the company Thus, he clams the $50,000 on the following year’s personal tax returns. If he had claimed the entire $100,000 of extra income on his personal income tax returns in one tax year it would have bumped him up to a higher personal tax bracket.
So, Ben used his entity taxed as a C corporation to move part of the money from one personal tax year to another. He has made the same amount of money. But he has used the offset tax year between himself and his company to pay less of that money in taxes by keeping himself in a lower personal income tax bracket. He has saved himself thousands of dollars in income tax.
Finally, when an entity taxed as a C corporation the company can write off 100% of medical insurance and related medical expenses for all employees and their dependants. Medical insurance, insurance deductions, prescriptions, aspirin, bandages can all be deducted through the C corporation.
As an example, Nick and Betty Johnson have a son with diabetes. The disease has resulted in substantial medical expense for the family. Personally, the IRS only lets you deduct medical costs if they are more than 7.5 percent of your adjusted gross income. So, first chunk of medical expenses are not deductible. Medical expenses must reach a great threshold before deductibility kicks in on one’s individual tax return. Then there are great limitations on the deductibility of those expenses. That is, there are substantial limitations as to what can and cannot be deducted.
Knowing this, Nick and Betty elected C corporation status for their business and have adopted a corporate medical plan. Now, all medical expenses for all family members are deductible, starting with the first dollar. In addition to other tax benefits, the Johnson’s save several thousand dollars each year on the medical deductions alone with their C corporation.
LLC Taxed as an “S” Corporation
An LLC can be taxed as an “S” corporation when, after choosing the corporation election on the 8832 form, the IRS tax form 2553 “Election by a Small Business Corporation” is subsequently filed with the IRS. All owners of a limited liability company taxed as an S corporation must be US citizens or resident aliens. With rare exception the tax year-end must be December.
The S corporation election is considered by many to be favorable for active businesses (as opposed to passive investment businesses) when the owner wants to spend all or most of the profit generated by the business. This is because, in addition to a “reasonable” salary that is paid to the owner of the company, the shareholders can receive income in the form of “distributions” to shareholders. Distributions to shareholders are free from Social Security (12.4%) or Medicare (2.9%) taxation. So by paying oneself a small but reasonable salary and paying the rest of the corporate profits as a distribution to shareholders, one can save 15.3% in taxes. That is an extra $1530 that the owner can keep in his or her pocket for every $10,000 paid in this fashion.
Bill has a lawn care business with several employees. He has formed a company and elected the S status by filing an IRS form 2553. His business earns him $100,000 per year. He pays half of the $100,000 as a salary and the other half as a distribution to himself as a shareholder of the company. So, he pays himself what the IRS would consider to be a reasonable salary, let’s say $50,000 per year. He pays himself $2083 on the 15th and the 30th of each month. He pulls out his corporate checkbook and writes a check payable to himself. On the memo section of the check he writes the word “Salary.” He or a payroll service he hires calculates and deducts the required taxes and he writes the check to himself for the rest.
Then he pays the remaining $50,000 to himself as a distribution to shareholders. As income allows he writes checks from his corporate checkbook to himself throughout the year. He pays this to himself several time a month as income allows. He writes “distribution” on the memo section of the check. He does not have to pay the 15.3% self employment tax on this income (which consist of the 12.4% Social Security and the 2.9% Medicare tax). So he saves $50,000 X 15.3% = $ 7650 in taxes by choosing the S election.
So, there are four ways that an LLC is taxed. Here are the common reasons why one would choose each type of taxation:
- As a sole proprietorship – when the business has one owner.
- To own real estate rental property
- For a business that has passive investment income such as stocks, bonds and mutual funds.
- As a partnership – when the business has two or more owners.
- To own real estate rental property
- For a business has passive investment income such as stocks, bonds and mutual funds.
- As a C corporation
- For financial privacy to keep business income from appearing on one’s personal tax returns.
- For an individual or family with high medical expenses
- As an S corporation
- To operate an active business.
- To save the 15.3% self employment tax (consisting of Social Security and Medicare) on distributions to the shareholders.
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