Pass-Through Taxation, Self-Employment Taxes, and Other Key Tax Considerations for LLC Members

Owning a small business can be quite exciting and rewarding. Many people find, however, that it can also be quite stressful and confusing when it comes to making sure taxes are handled properly. A limited liability company, or LLC, is very commonly used as the vehicle for a new small business, so it is a good idea to understand the tax rules that apply to an LLC and its owners.

In concept, an LLC is almost mindlessly simple.  An LLC can be formed under state law by filing a simple form and paying a nominal filing fee.  But as we have learned from prior blogs, complexity is lurking everywhere when the tax law takes hold of a simple concept.  I will note some of these “cliffs of complexity” further on in this blog, and try to provide some ways to keep us from toppling over.

Non-Tax Considerations

There are very good non-tax reasons to use an LLC.  As the name connotes, the owner(s) of an LLC (also interchangeably referred to here as “members”) will not be held personally liable for some (but not all) of the LLC’s liabilities.  (For example, if a lawyer or accountant conducts his or her practice through an LLC, he or she would still be personally responsible for any professional liabilities.)  If you are particularly interested in the limited liability aspects of an LLC, I can refer you to a terrific business attorney.

Pass-Through Taxation

A conventional corporation, or “C corporation” (the “C” refers to Subchapter C of the Internal Revenue Code, not “conventional”) and its shareholders are said to be subject to “double taxation” – the corporation will be taxed on its taxable income and its shareholders will be taxed on any dividend distributions from the corporation.  To the contrary, an LLC is a “pass through” for income tax purposes.  This simply means that any profits or losses will “pass through” the LLC, and be reported on the tax returns of the LLC’s owner(s). (I will just note in passing that the pass through of losses is sometimes a very complicated matter, due to any number of rules including the “at risk” rules and the “passive activity loss” rules, that limit the amount and timing of allowable deductions for losses.)  Since the LLC is not subject to Federal income taxation (unless it elects out of pass-through treatment – see discussion below), there is no double taxation.  

The Federal income tax reporting requirements for a “single member” LLC are very simple – there literally are none.  A single member LLC is a “disregarded entity” for Federal income tax purposes.  The LLC is even required to use the Employer Identification (or Social Security) Number of its single member for any tax reporting it is required to do (see discussion below).  If the single member is an individual filing a Federal Form 1040, the tax results of the LLC will be reported on the individual’s Schedule C.  If the single member is another entity, we are tripping along any number of cliffs of complexity, and you really must consult with a tax professional before proceeding.

If the LLC has more than one owner, the LLC will be treated as a partnership for Federal income tax purposes.  In this case, the LLC will be required to obtain its own Employer Identification Number, and it will be required to file an annual Form 1065, the partnership return.  This will be the case even when the LLC has two members who are spouses, unless they are residents of a community property state, such as Louisiana.  In the latter case, the LLC will be treated as having a single member and will be disregarded.

Self-Employment Taxes

An LLC may pay salaries and wages to its employees, and in this case, the LLC, even a single member LLC, is subject to the withholding and reporting rules that apply to any other employer.  For this purpose, and for purposes of certain Federal excise taxes, a single member LLC is not treated as a disregarded entity.

Typically, particularly in a service business, the LLC’s owner(s) will not bother to have the LLC pay them salaries and thus will not have to bother with the withholding and reporting rules.  In this case, the owners will have to be mindful of making quarterly installments of self-employment taxes (Social Security and Medicare).  

The matter of self-employment taxes as applied to LLCs is very interesting because, even though LLCs have been able to be formed as long ago as 1977, the IRS still does not have an entirely unified and consistent theory of how self-employment income earned by an owner of a pass through entity, like an LLC, should be treated.  In the case of a partnership, a partner’s share of the partnership’s income is generally considered to be self-employment income, unless the partner is a limited partner, in which case the limited partner’s share of the partnership’s income is generally considered not to be self-employment income.  An LLC with multiple owners is treated as a partnership for Federal income tax purposes, and all of its members have limited liability, like limited partners.  So, one would logically conclude that the limited partner rule would apply, and none of the LLC’s income would be self-employment income in the hands of the members.  And one would be dead wrong!  The IRS’s position, supported by at least some court cases, is that a member’s share of the LLC’s income is self-employment income unless the member is purely passive, like an investor, and has no managerial authority.

The matter is even more complicated when one considers the way a Subchapter S corporation (another pass through for Federal income tax purposes) is treated for self-employment income tax purposes.  In general, if an S corporation shareholder performs services for the corporation and is paid a “reasonable” salary (subject to employment tax withholding and reporting by the S corporation) the shareholder’s share of the S corporation’s income is generally not considered to be self-employment income.  So why not, then, have the LLC pay its members a “reasonable” salary and borrow the S corporation rule, that anything more is not self-employment income?  For any number of reasons, some tripping dangerously close to multiple cliffs of complexity, it just ain’t as simple as that.

Why does it matter?  Wages and salaries, and self-employment income, are subject to hefty taxes in addition to regular income taxes – for 2016, 15.3% on the first $118,500 of income subject to tax, and 2.9% on all excess amounts without limit.  There is a huge incentive for taxpayers to attempt to structure their income so as to avoid characterization as self-employment income, and just as strong an incentive on the part of the IRS to thwart taxpayers’ attempts.  Suffice it to say, if one of your goals is to limit the portion of the LLC’s income that will be considered self-employment income in the hands of an owner, you must consult with a tax professional before proceeding.    

Electing Corporate Tax Rates

At this point you can forget everything I have said about the disregarded entity and pass through tax rules.  An LLC can simply elect to be taxed as if the company were a corporation, by filing . IRS Form 8832 (known by tax geeks as “checking the box”).  While the corporate tax rates are lower than the individual rates for certain ranges of income, most cases of checking the box will occur in response to state tax or foreign tax considerations.  There are even cases where an LLC (a presumed pass through) checked the box (to be treated as a corporation, a non-pass through), and then elected to be treated as an S corporation (a pass through, albeit with some special rules and limitations).  Obviously, this kind of planning is the very essence of cliffs of complexity, and should be undertaken, always, with the assistance of a tax professional.

State Tax Considerations

You will have noted that I have very carefully referred to “Federal income tax purposes” in this blog up until now.  The reason is simple – there are 50 states, and there are no universally applicable rules for how LLCs and their owners are taxed.  In Pennsylvania for example, an LLC is a pass through for income tax purposes, but is subject to the Capital Stock/Franchise Tax.  An LLC doing business in more than one state may routinely be subject to multiple sets of rules for taxation of the entity and its owners.  Needless to say, if state tax planning is any part of your decision as to whether to use an LLC (and it should be) you should be consulting with a tax professional.  

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While the tax rules that apply to an LLC and its owners aren’t necessarily as complicated as many people think, a seemingly simple situation can quickly become very complicated.  It is best to proceed with eyes wide open, rather than learn the rules after the fact once the IRS has started to ask questions.  Whether you are trying to determine how you want your business structured, or you need help with the taxes on an existing business, please contact Morgan Maxwell to schedule a consultation today.

Written by E. Morgan Maxwell

E. Morgan Maxwell

Since beginning his own firm, Mr. Maxwell has continued a tax-law oriented practice encompassing a wide range of transactions, planning and dispute resolution. His dispute resolution experience includes involvement at all levels of the Internal Revenue Service (Examinations, Appeals, Collections, Office of Professional Responsibility, the U.S. Tax Court), the Pennsylvania Department of Revenue, the Tax Litigation Section of the Pennsylvania Attorney General’s Office, Pennsylvania Commonwealth Court, Common Pleas Court and local taxing jurisdictions in southeastern Pennsylvania.

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