By Lucas Rihely
Starting a business can be an exciting and, at times, nerve-wracking endeavor. In the midst of establishing the operations of the business and striving towards a commercial success, the tax decisions are sometimes pushed aside even though choosing a disadvantageous entity type could result in business owners paying significantly more in taxes than would otherwise be necessary.
In recent years, the limited liability company (LLC) has become a very common legal entity for new businesses. In addition to the benefits unrelated to taxation, such as ease of set up and limited liability for its members, LLCs are afforded the opportunity to elect how it is to be treated for federal income tax purposes. For LLCs that consist of one member, referred to as single member LLCs (SMLLCs), the default classification is for the LLC to be considered disregarded as an entity separate from its owner. This treatment results in the business activities being reported on the members Schedule C as if the member was a sole proprietor. For LLCs that consist of more than one member, the default classification for the LLC is a partnership. The LLC is not required to maintain the default classification, however, as the LLC has the ability to elect to be treated as an S Corporation or a C Corporation, assuming that the LLC entity meets the applicable eligibility requirements for the respective entity types. Below are four different tax treatments that are common for LLCs:
1. Sole Proprietor – The default classification for single member LLCs. This entity type results in simpler tax compliance as it does not require a separate entity income tax return. The member may take draws from the business cash flow and the taxable income from the business, regardless of whether drawn or maintained with the business accounts, is subject to both ordinary income taxes and self-employment taxes and is calculated and reported on the member’s Form 1040. This default treatment is a common entity type for single owner consulting or personal service businesses.
2. Partnership – The default classification for LLCs with more than one member. This entity type requires a tax filing specific to the entity – an added layer of compliance cost but one that is common for any multi-member LLC. In this case, the entity files Form 1065 which reports the business activities and also allocates the tax results of such activities to its members. Each members’ allocable share of partnership tax items are reported on the members’ Form 1040 and are subject to each members’ respective ordinary income tax rates and, generally, self-employment taxes. Because the taxable income is reported on the members’ individual returns, partnerships are a “pass-through entity”. Similar to sole proprietorship entities, partnership treatment is a common entity type for consulting or other personal service businesses.
3. S Corporation – a common entity type for small businesses if all eligibility requirements are met. To elect to be treated as an S Corporation, the LLC must generally notify the IRS within two and a half months of the beginning of the year in which the election is to be effective. An LLC taxed as an S Corporation will file a Form 1120S to report its activity for income tax purposes. Similar to a partnership, an S Corporation does not pay income taxes; rather, S Corporations are “pass-through entities” and so taxable income and other tax attributes are allocated to the members on a pro rata basis based on ownership. One of the more popular tax benefits of S Corporations is that the taxable income passed through to the members is not subject to self-employment taxes, often resulting in an overall tax savings. Members and officers of the LLC are considered employees of the entity and the IRS expects each to be paid compensation commensurate with the services provided to the entity. This entity type is very common amongst small businesses and is favorable in particular scenarios of businesses with anticipated losses in the early years of operations or in mature businesses with steady earnings.
4. C Corporations – LLCs have the ability to elect to be taxed as a C Corporation. Unlike partnerships and S Corporations, a C Corporation is not a “pass-through entity” as it reports and calculates its taxable income and resulting tax at the corporate level. Similar to S Corporations, members and officers who perform services for the entity are expected by the IRS to receive compensation for their services. To the extent that the entity has accumulated earnings, the entity may distribute a dividend to its members. The dividend is taxable to its members on their individual return but is not deductible by the corporation. This presents a layer of double taxation that may make a C Corporation election undesirable for certain businesses. One of the benefits of a C Corporation is that it has many more options compared to other entities as it pertains to equity financing. Multiple classes of stock, stock options, stock warrants, convertible notes, etc. are generally permissible for C Corporations which provide the opportunity to raise equity capital and align such financing with a strategic direction. C Corporation elections are common for businesses that have the need to raise outside capital or are rapidly growing in expanding markets which are likely to need earnings-generated cash to remain invested in the business.
This is a brief overview of entity types available for your LLC business. Please consult with a tax advisor as to which type is best for your LLC as recommendations may vary based upon the facts and circumstances surrounding your business.
Contact us today to schedule a consultation to discuss which entity type is right for your small business.