"Check the Box" taxation
We've learned in other articles about the flexibility in the management structure of LLCs. This article is about the wonderful flexibility in the federal taxation of LLCs. First we'll list the choices available to the LLCs and explain in general some pros and cons of the taxation schemes. However, your CPA or tax attorney is the right person to help pick the entity taxation type.
Typically, the biggest question will be whether or not to make an S-Corporation election. If unknown at time of formation I typically recommend to form under the default taxation option but strongly encourage the client to visit their CPA with sufficient time to file the S-Corporation election before the deadline passes. But, it's crucial to remember that any entity that opts for more than one class of ownership is disqualified from making the S-Corporation election! Sometimes the extra protection afforded by multiple classes of ownership outweighs the tax benefits of an S-Corporation.
Single Member LLCs, and some LLCs owned solely by spouses in community property states
The default taxation for a single member LLC is to be taxed as a sole proprietor. This means the IRS doesn't recognize that the LLC exists for personal income tax purposes (however be careful about local, state, sales, and excise taxes; if you're in an industry with excise taxes, you need to consult with your tax professional). This status is called a "disregarded entity". You file and pay your taxes as part of your personal tax return just the same as if you were running a sole proprietorship business without the LLC.
Because Texas is a community property state, the IRS will recognize a husband and wife owned LLC as a sole proprietorship (instead of a partnership) if specific conditions are met, thus making the LLC a disregarded entity for tax purposes. Please discuss with your tax professional. Most of my clients (and their tax professionals) elect the disregarded taxation or S-Corp taxation for husband and wife entities to more separate the LLC from their personal taxes. Michigan is not a community property state so disregarded status for spouses-owned LLCs is not available.
Single Member LLCs may also elect to be taxed as either an S-Corporation or as a C-Corporation. C-Corporations are the taxation scheme that publicly traded companies use (think Apple or Microsoft) and typically aren't appropriate for the small-business investor until a very substantial yearly revenue is reached and there are multiple owners.
C-Corporations are also subject to "double taxation"; this means that the C-Corporations pay income tax at the entity level, and then any distributions to the owners are taxed again at the owner level as dividends. C-Corporations are so rarely appropriate for small-business investors that I will not discuss them further in this article.
S-Corporations are often used in small-business entities. The "S" stands for "small business". Unlike the C-Corporation, they offer flow-through taxation meaning the entity pays no income tax at the entity level. Also, an S-Corporation has the potential to reduce payroll taxation for owners who are also employees which is one of the main reasons to consider an S-Corporation. Another consideration for a single member LLC is to get the LLC tax return into a separate tax return instead of going on the owner's personal tax return.
But, they have some disadvantages. First, there are restrictions to qualify for S-Corporation status.
The entity must meet the following requirements:
- Be a domestic entity (i.e. USA company)
- Shareholders may only be individuals, certain qualifying trusts, and estates, and may not be partnerships, corporations, or non-resident aliens
- have no more than 100 shareholders
- have only one class of owners
- not be in a list of prohibited business types such as certain financial institutions and insurance companies
- cannot have more than 25% of their gross revenue be from passive sources for more than 3 years (rental income sometimes counts as passive)
Don't get excited about 100 members; small business run into Federal and State securities regulation issues way before 100 members. And really don't get excited having only one class of owners as that removes some powerful asset protection strategies to employ.
S-Corporations are also typically poor entities to hold real estate, particularly appreciated real estate, due to some complicated tax reasons beyond the scope of this article, as well as the simple fact that holding companies may have significant passive income, which may disqualify their S-Corporation status after three years and may even subject them to higher taxes during those three years.
Multi-Member LLCs
Multi member LLCs may elect S-Corporation status, C-Corporation status, and Partnership status. They may not elect sole proprietor status. As discussed above, C-Corporation status rarely makes sense for the revenues brought in by small businesses, so we will disregard them here. So, the real choice comes down to S-Corporation versus Partnership taxation. Since I've already discussed S-Corporation status, I will discuss Partnership taxation.
Like S-Corporation status, Partnership status is a flow-through taxation choice. This means the LLC would pay no income tax at the entity level and the members will be taxed at the owner level. There are substantial advantages to holding real estate and for borrowing with personal liability for real estate mortgages. They have more options with 1031 exchanges. There are also more opportunities for tax deferred distributions as well as more favorable distribution in kind rules than S-Corporations. They also have vastly more favorable basis rules for members if the members personally guarantee any loans of the LLC. (Which is really important for real estate investors.)
However, your income and losses will be subject to SECA, otherwise known as self-employment tax, unless your membership interest can take advantage of the exclusion in 26 USC Section 1402(a)(13) to have a non-manager member qualify as if they were a limited partner in a partnership structure. This means manager-managed forms may be more tax efficient assuming they pass securities regulation muster. Unfortunately though, it's not guaranteed that passive members in an LLC will be able to avoid paying SECA in the future because the IRS has yet to promulgate official rules on this treatment (the debate has been raging since the '90s; talk about indecision!). There were proposed regulations seeking to make passive LLC members the same as limited partners for purposes of SECA, but they were not officially implemented at the time of this writing. We'll have to wait and see what the IRS does; so, make sure to verify with your CPA as the SECA tax may be substantial. However, real estate rental income is typically not subject to SECA tax either, regardless of the above passive member distinction. However, personal property rentals are.
But, it's not the end of the world if you have to pay SECA tax. You only pay SECA on a portion of your total net self employment income (92.35% in 2014). You also get to deduct from income half of the SECA tax you pay. This reduces your adjusted gross income for tax purposes. So, it's not the end of the world; but, it is a tax you have to consider.
Further, if you're the most active member of an LLC or the manager of an LLC, you likely can't qualify for the 'limited partner' exclusion. Depending on your expected revenues and ownership structure, it may make sense to consider the extra expense of a Limited Partnership in order to know for certain that limited partners' income will not be subject to SECA except for guaranteed payments. For example, you'd form a Limited Partnership with you personally as 99% limited partner and an LLC you control as the 1% General Partner. The General Partner's share is subject to SECA, but the limited partner's share is typically not, assuming you satisfy some complex rules about participation and activity that you'd need to verify with your CPA. However, you'll now have multiple tax returns, increased compliance, more paperwork, etc.. Sometimes, it's best to pay the SECA, and sometimes it's best to form the more complicated structure.
Summary
We've learned that single member LLCs must make the choice between being taxed as a sole proprietorship or an S-Corporation. We've also learned that multi-member LLCs must make the choice between S-Corporation taxation and partnership taxation. We've also learned that S-Corporations can be good for owners who are active employees of the company and we've learned that partnerships are preferred for holding title real estate. Please note, however, that this article is not a substitute for the advice of tax counsel. Rather, it is intended for informational purposes and to help you discuss these issues with your tax counsel.
I hope I've helped you learn about LLC taxation choices. It will help you understand and discuss your options pre-formation with your attorney and your CPA.