LLC Taxes Explained (2022) - YouTube

What’s up guys Taylor Mathis here, the KEYTLaw girl, marketing director, and legal assistant

at KEYTLaw, today I’m going to explain to you all 4 ways LLCs can be taxed.

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And one other quick tip!

All of the forms mentioned this video are linked in the show more section below the

video!

So, one of the advantages to forming an LLC is that it allows maximum flexibility for

choosing a method of federal taxation.

So, for example, if an individual formed a limited partnership, the limited partnership

must be taxed as a partnership.

Whereas, an individual who forms a corporation must be taxed as either a C Corporation or

S Corporation.

But the person who forms an LLC, can choose their federal tax option.

You can elect to be taxed as a partnership, a C Corporation, S Corporation, or a sole

proprietorship.

So Here are 4 ways your LLC can be taxed and some of the pros and cons to each.

The First way: Sole Proprietorship Method A sole proprietorship is the default classification

for a single member LLC.

Only a single member LLC may be taxed as a sole proprietorship.

A sole proprietorship doesn’t have to file any separate tax returns and is a disregarded

entity for federal income tax purposes.

The member of the LLC reports all the economic activity of the LLC on their personal income

tax return on Schedule C. The taxpayer then pays any tax associated with the LLC on their

personal income tax return.

A major advantage to having an LLC taxed as a sole proprietorship is the ease of reporting

the income or loss of the LLC.

And with sole proprietorship you don’t need to file an additional tax return unlike the

rest.

This is a big advantage because the LLC doesn’t have to prepare a balance sheet and other

schedules which may be required on the tax returns for the other methods.

This allows many small business owners to focus more time and money on their business,

rather, than having to pay an accountant or prepare the additional tax forms themselves.

But there are two major cons to sole proprietorship.

The first disadvantage is that taxpayer’s who file Schedule C tend to get audited at

a higher rate than taxpayers who don’t.

This means members must be especially diligent in maintaining documentation supporting any

deductions they claim associated with the LLC, so keeping receipts and other supporting

items for at least 3 years after the return has been filed.

If the member fails to do this, the IRS may disallow many deductions during an audit and

the taxpayer may be faced with a substantial tax bill.

The second major disadvantage associated with sole proprietorship taxation is that the member

must pay self-employment tax.

An employee pays 6.2% for social security on the first $106,800 of wages and 1.45% for

Medicare on all wages.

Self-employment tax is similar to payroll taxes paid by employees.

The key difference is that the member of the LLC must also pay the employer’s portion

of social security and Medicare.

Generally, self-employment tax is calculated by taking the sole proprietor’s net earnings

from self-employment which includes any allowable business deductions.

The LLC member pays 12.4% for social security on the first $106,800 of net self-employment

earnings and 2.9% for Medicare on all net self-employment earnings.

With self-employment tax, the member must pay both the employee and employers share

of the payroll taxes on self-employment income.

So, they are paying double the amount of payroll taxes they would have to pay if they were

an employee.

But, the member does receive a tax deduction for one half of the self-employment taxes

paid for the tax year.

So, the next way is the C-Corporation Method So, the default classification for a LLC will

never be a C-Corporation.

Therefore, the LLC must file Form 8832 to elect to be taxed as a C-Corporation.

This form can be filed any time after the LLC has been formed, but the time the LLC

will begin to be taxed as a C-Corporation can’t be more than 75 days before the date

of filing with the IRS.

A C-Corporation is considered a separate entity for federal tax apart from its shareholders.

The C-Corporation must file its own tax return and pay whatever tax is owed.

The C-Corporation files a Form 1120.

This is becoming increasingly less relevant as an effective method of paying reduced taxes,

because individual income tax rates have dropped.

The decrease in individual income tax rates has brought the individual rates roughly equal

to the corporate tax rates.

Because the rates are now roughly equal which prevents shareholders from using the C Corporation

to shelter income, more people use partnerships or S-Corporations to take advantage of the

tax saving opportunities that those two forms offer over the C-Corporation.

The major problem with the C-Corporation is the concept of “double taxation.”

The government taxes corporate earnings as the corporation earns the income and taxes

the earnings again when the corporation distributes the money to shareholders.

A shareholder of a C-Corporation might try to avoid paying taxes on dividends by not

making any dividend distributions and keeping all earnings within the C-Corporation.

To prevent people from utilizing this strategy, Congress enacted the accumulated earnings

tax (“AET”).

The AET gives the IRS the ability to assess taxes against a C-Corporation for failing

to pay dividends to their shareholders.

If the IRS believes a corporation has accumulated excess earnings, it can assess this penalty

tax against the corporation.

The tax rate of the penalty coincides with the tax rate shareholders pay on dividends.

Another disadvantage of C-Corporation taxation, is that capital gains aren’t subject to

a preferential rate.

Most individuals receive the benefit of paying a lower rate on capital gain income.

Capital gain income is typically the income associated with selling stocks, bonds, or

from other capital assets.

With a C-Corporation, capital gain income will be taxed at whatever the corporate tax

rate is.

Compared to an S Corporation or Partnership whose capital gain income would flow through

to the individual where it would be subject to the special rate.

So capital losses would be kept inside the C-Corporation and could only be utilized by

the corporation; whereas, with the S Corporation or Partnership, the capital losses could be

used to offset any capital gains the individual taxpayer might have.

Third way S Corporation Method So, S-Corporations are a pass-through entity

taxed under subchapter S of the Internal Revenue Code.

A pass-through entity does not pay tax; rather, the S-Corporation passes earnings and losses

through to the shareholders.

The shareholders then report the earnings or losses of the S-Corporation on their personal

income tax return.

There are a few unusual situations under which a S-Corporation might pay tax.

One situation occurs when converting a C-Corporation into an S-Corporation.

If you have a LLC taxed as a C-Corporation and want to change the method of taxation

to a S-Corporation, then any assets of the C-Corporation which have appreciated in value

could be subject to the built-in gains tax.

So, a LLC must elect to be taxed as an S-Corporation.

This is done by filing a Form 2553.

And The filing of the form is time sensitive.

See the instructions to Form 2553 linked in the video description.

In order to be eligible for S-Corp taxation, the members of the LLC must meet certain eligibility

requirements.

The limited liability company must be a domestic LLC meaning it is formed within the United

States.

The LLC cannot have any members who are partnerships, corporations, or non-resident aliens.

Also, certain types of trusts may not be members of the LLC.

The LLC can’t have more than 100 members.

and certain types of businesses such as financial institutions, insurance companies, and domestic

international sales corporations are prohibited from being taxed as a S-Corporations.

Keep in mind the that the prohibitions against different types of LLC members are very important.

If the LLC admits a new member, who is of the prohibited type or another member disposes

of their interest to a prohibited type of member, the S-election will be terminated

leading to major tax consequences.

The S Corporation does offers many tax benefits.

S-Corporations don’t suffer the sting of double taxation associated with C-Corporations,

because the S-Corporation passes through all the economic activity to the shareholders.

Shareholders, generally, don’t have to pay tax on distributions they receive from the

S-Corporation unless the distribution exceeds their stock basis in the S-Corporation.

Owners of entities taxed as S-Corporations calculate their stock or membership interest

basis using this formula.

The owner adds any contributions of either cash or property which the owner made to the

S-Corporation and deducts any distributions that the owner receives from the entity.

at the end of the tax year if the entity made a net profit, the owner would add the owner’s

share of the entity’s profits to the owner’s stock or membership interest basis.

But if at the end of the year the entity has a net loss, the owner will decrease the owner’s

stock membership interest basis by the amount of the net loss.

So, its Contributions of Money/Property + Corporate Earnings – Distributions of Money/Property

– Corporate Losses equals Stock or Membership Interest Basis

The ability of an owner of an entity taxed as an S-Corporation to deduct losses on the

owner’s personal income tax return depends upon the owner’s stock / membership interest

basis.

An owner may only deduct a loss to the extent of the owner’s stock / membership interest

basis.

For instance, assume the entity taxed as an S-Corporation has a $100 net loss for the

year, and the owner has stock / membership interest basis of $50 at year end.

The owner can deduct $50 of the loss on the owner’s personal income tax return.

The remaining loss is suspended and may be deducted when the owner has sufficient basis

in their stock / membership interest to take the loss.

Entities taxed as S-Corporations can minimize the sting of the self-employment tax.

An owner of an entity taxed as an S-Corporation can be treated as an employee.

The entity pays the owner a reasonable salary for the services which the owner performs

on for the entity.

The entity pays the payroll taxes with respect to the owner’s wages.

The entity may deduct the owner’s wages and corresponding payroll taxes associated

with those wages in computing the entity’s net income.

The owner reports the wages as ordinary income on the owner’s personal tax return.

The owner may also report the owner’s share of the entity’s net profits on the owner’s

personal income tax return.

However, the owner does not have to pay any self-employment taxes on the entity’s profits.

Under the sole proprietorship method of federal income taxation, all the net profits are subject

to the self-employment tax.

One key difference between the S-Corporation and partnership methods of taxation concerns

the allocation of profits and losses.

With a partnership, the partners can choose to allocate income and losses any way they

choose if those allocations comport with “substantial economic effect” requirements of Internal

Revenue Code Section 704(b).

The entity taxed as an S-Corporation must allocate all profits and losses pro-rata based

on the owner’s ownership interest in the entity.

If there were two shareholders of an entity taxed as an S-Corporation with owner A owning

10% and owner B owning 90%, owner B must be allocated 90% of any profit and loss, and

owner A must be allocated the remaining 10%.

Further, distributions made by the entity to the owners must be made pro-rata.

If the entity fails to follow these rules regarding profit and loss allocations and

distributions, then the IRS can terminate the entity’s Selection.

Way 4 Partnership Method of Federal Income Taxation

The other way an LLC can be taxed is as a partnership.

The IRS default classification for a multi-member LLC is partnership taxation.

A LLC with only husband and wife as members may elect to have the LLC treated as a partnership

all they have to do is file the Form 8832 . The partnership must file a tax return on

Form 1065.

The return is only for informational purposes.

The partnership is like the S-Corporation method of income taxation in that the entity

is considered a pass-through entity.

The owners of an entity taxed as a partnership must report all the economic activity of the

entity on the owner’s personal income tax returns.

Owners have a tax basis in their partnership / membership interest, but partnership basis

rules are much more complex than the basis rules that apply to entities taxed as S-Corporations

and are beyond the scope of this article.

Entities taxed as partnerships, unlike entities taxed as S-Corporations, can specially allocate

income and losses to the owners.

However, the Internal Revenue Code requires that allocations of income and losses must

have substantial economic effect.

The IRS briefly summarizes substantial economic effect as:

If the IRS does not view the entity’s allocations of profits and losses as having substantial

economic effect, then the IRS will reallocate the items based on the owner’s percentage

interest in the entity.

Thus, an owner of an entity taxed as a partnership cannot receive wages for services performed

on behalf of the entity.

The amount of money the owner would have received in wages is treated as a guaranteed payment.

The guaranteed payment will be subject to self-employment taxes on the owner’s individual

tax return.

The self-employment tax issue has created controversy within the context of LLCs taxed

as partnerships.

Before the advent of the LLC, the general rule was that limited partners of limited

partnerships didn’t have to pay self-employment tax on their distributive share of partnership

income, but general partners were required to pay self-employment tax on their distributive

share of partnership income.

Because the legal structure of the LLC differs from that of partnership, the rule is not

easy to apply to LLCs.

An LLC doesn’t have the equivalent of a general partner.

Members of a LLC all have limited liability, so it appears it would be easy to apply the

limited partner rule to the LLC.

The IRS has taken a different position examining the facts and circumstances surrounding each

situation to determine whether LLC members must pay self-employment tax.

So, for example if the LLC is manager-managed and the member doesn’t serve in the role

as a manager, then the member probably wouldn’t have to pay self-employment tax.

So, the bottom line is that you should consult with your tax adviser to determine the correct

reporting requirements for your situation.

Entities taxed as a partnership are not subject to the double taxation problem that plaques

entities taxed as C-Corporations.

But one of the drawbacks of the partnership method of taxation is that the reporting requirements

can be much more complex than that of the other entities.

The instructions to Form 1065 alone estimate that one should spend 35 hours on keeping

and maintaining partnership records, 24 hours on learning about the law and form, 35 hours

preparing the form, and 3 hours copying and assembling the form to send to the IRS.

That’s 97 hours spent on completing your partnership informational tax return.

The LLC offers its owners the most flexibility and choice (the four methods described above)

as to the type of federal income taxation that will be best for the owners’ situation.

The good news is that when you form an LLC, you have 75 days to consult with your tax

advisor, determine which of the four tax methods is best for your company and make an election

to change the default method of income taxation by filing either an IRS Form 8832 to elect

to be taxed as a C -Corporation or an IRS Form 2553 to be taxed as an S-Corporation.

All the forms talked about in this video are in the description below!

So hopefully you guys found that helpful!

The four different ways your LLC can be taxed along with some of the benefits and downfalls

to each.

Be sure to like this video and comment with any questions you have, also subscribe to

our channel for more videos!