May 19, 2017
First of all – congratulations on your new enterprise! Dealing with the red tape and administrative burden of starting a business can be overwhelming, and dealing with federal, state, and local tax systems adds to this burden.
LLC’s have become a very popular choice when forming a new entity for many reasons. The most significant reason to choose an LLC is the incredible flexibility that you are offered. The “operating agreement” of the LLC can dictate very flexible profit & loss sharing between the owners that can be specifically tailored to your needs. Also very significantly, an LLC has tax characteristics that you can pick and choose based on your needs. LLC’s also generally avoid some of the corporate documentation formalities (shareholder meetings, minutes, stock certificates, etc.) that can add complexity.
Getting technical for a second, an LLC is termed a “check-the-box” entity by the IRS. This means that an LLC has certain default tax treatments, but elections can be made for alternative tax treatments (i.e. checking the ‘box”), as long as they are made in a timely manner, generally within 75 days of the desired effective date of the tax treatment.
You have four basic tax treatments of your LLC depending on your ownership structure:
Default Treatment
One Owner - The LLC is treated as a “disregarded entity”, IRS lingo for a tax “nothing”. In other words, whatever the LLC does, you are treated as doing yourself as the sole owner. For most businesses, this means that your income will be reported directly on your individual tax form 1040, on Schedule C – just the same as if you didn’t have the LLC. If you are conducting a rental activity, it will typically be reported on Schedule E.
Multiple Owners – The LLC is treated as a tax partnership. For tax purposes, a partnership is a “pass-through” entity, with the partners essentially paying tax on their share of the partnership’s income.
C Corporation – you can elect to tax the LLC as a C corporation. The C corporation can make sense in certain situations, but it is not very popular for closely-held businesses, since its income is subject to tax, and then any shareholder dividends or gains on sale of stock are subject to another layer of tax. There are other potential benefits to a C corporation however, including enhanced deductibility of fringe benefits, favorable structuring options when foreign businesses are involved as owners or subsidiaries, and flexible ownership options with multiple ownership “classes”.
S Corporation – you can file an S corporation election with the IRS, which taxes your LLC as a corporation that has made an “S” election. In short, an S corporation is a pass-through entity somewhat like a partnership, which means that owners pay tax in proportion to their ownership. S corporations do have strict limits on shareholders, including the types of owners permitted, number of shareholders, and type of ownership (generally only one class of ownership is permitted).
In the majority of cases, the default treatment makes sense for the business, as disregarded entity status is very simple from a reporting standpoint, and partnership status is very flexible with few downsides. This is certainly the case for the vast majority of entities that are focused on the ownership of real estate, which generally should be held in disregarded entities or tax partnerships.
However, it is imperative to consider your options, as S corporation or C corporation status may make the most sense depending on your facts. For example, your business, financial, and ownership structure may allow you to consider the use of S corporation treatment to minimize self-employment/FICA/medicare taxes. Alternatively, perhaps you have foreign business subsidiaries that cause you to opt for C corporation treatment to permit certain tax-advantaged deferral of income earned overseas.
Unfortunately, given the complexity of our tax system, something as simple as starting a new business entity has many nuances to consider. However, this complexity does bring opportunities to minimize your tax obligations – make sure you take advantage of every possible opportunity!
There are many nuances to this issue, so please consult your tax advisor. This article is intended to serve as general guidance, and should not be construed as specific tax advice for your situation.
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