A limited liability company (LLC) is a very popular business entity for small and mid-sized businesses. The reason is primarily based upon the versatility of the business entity. The LLC formation can take on characteristics similar to the general partnership or the corporation. The general partnership or S-Corp designation of an LLC formation generally refers to its tax election; however, there are other structural and operational considerations affected by this tax election.
LLC Formation & Maintenance
An LLC is formed by filing articles of organization with the state secretary of state’s office. Whatever state you choose to organize your LLC formation will have its own filing forms and fees associated with filing. To maintain the business entity, the state will require annual updates.
Ownerships and Control
The owners of the LLC are known as members. The LLC formation may choose to be managed b Zy its members, a (“member-managed LLC”) or managed by appointed managers, a (“manager-managed LLC”). A member-managed LLC is more akin in management structure to a partnership. A manager-managed LLC structure is more akin to the management structure of a corporation. While these ownership and control status are not unique to entity’s tax classification, it is more likely that an LLC taxed as an S-Corp will be a manager-managed LLC than one taxed as a partnership.
One important aspect about setting up the LLC is that the owners can choose its form of taxation. That is, the owners, upon formation, will contact the IRS to establish as Federal Employer Identification Number (FEIN). At the same time, the LLC will determine its fiscal year and under what section of the Internal Revenue Code it will be taxed. Generally, the options are to be taxed as a partnership or taxation as a corporation. If the entity chooses corporate tax status, it will then choose whether to be taxed under Subsection S (S-Corp designation) or Subsection C (C-Corp).
Being taxed as a partnership versus a corporation has numerous differences. The major difference are as follows:
Company Taxation – Generally, the LLC formation does not pay income taxes if it is organized as a partnership of LLC. Any business profits or losses flow through to the owners. If the business is organized as an S-Corp designation, 20% of the S-Corp income is simply not recognized as income for tax purposes. That is, subtract 20% from profits before calculating what flows through to the owners. If the business is taxed as a C-Corp, the business entity pays taxes at a 20% rate. Any profits that are distributed to members are taxed to the members at the dividend rate of taxation.
Owner Compensation – Owners of a partnership-taxed entity cannot receive a salary for their work for the company. They must receive a draw on company profits or earnings. Of course, members working for the company may receive a special allocation of profits that does not match their ownership percentage in order to compensate them for their work. The special allocation must be justified based upon economic realities. If the company is organized as a corporation, any owner working for the company may receive a salary. The salary is an expense to the company and is handled separately from the distribution of profits.
Federal Insurance Contribution Act (FICA) taxes – All of the profits received as a partnership draw or distribution are taxed as earned income – meaning that the payment is subject to self-employment taxes (FICA taxes). What this means is, instead of the business paying 1/2 of the Medicare and Social Security, the employee pays the full share. If the entity is organized as a corporation, any distributions of profits above the owner’s salary is treated differently with regard to FICA. If the company is organized as an S-Corp designation, any profits in the company are deemed to be distributed to the owners based upon their ownership percentage. Importantly, any distributions are not subject to FICA taxes. This generally yields a considerable tax savings. If the company is taxed as a C-Corp, any dividends paid are also not subject to FICA taxes.
Basis – If the company is organized as an LLC partnership, it has serious implications for contributions of property (other than cash) to the company. The company must now track an inside basis and outside basis. If the company is taxed as a corporation (S or C), there is no inside and outside basis for the owner. The basis of her ownership of the LLC formation is simply the value of her property contributed.
Qualification for Taxation as an S-Corp
The default type of taxation for an LLC is partnership status. The owners must affirmatively elect to be taxed as a corporation. Generally, the members must vote unanimously to approve election of corporate tax status. Further, to qualify for taxation as an S-Corp, the LLC formation must meet the following requirements:
Less than 100 members
All members are real people – not entities (with a few exceptions)
All members are United States citizens (with a few exceptions)
Only one class of LLC ownership interest
Failure to meet any of these characteristics will cause the LLC formation to lose the S-Corp tax treatment.
LawTrades Knows Business Entities
The various options and tax considerations associated with forming a business entity are complex. It is always in your best interest to consult a professional when making these decisions and elections. The legal professionals at LawTrades are experts in tax law and business entities. They can help you form and organize a business entity that meets your operational needs.