You have four LLC taxation options; a partnership, disregarded entity, or an S or C corporation. It is important to keep in mind that there is a big difference between an LLC managed by managers or members when you form an LLC. It is possible for an LLC that is managed by managers to have one manager and still be taxed as a partnership. How? It may have one manager and more than one member.
A business entity with only one owner is classified as a corporation or is disregarded; if the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner. A business entity with two or more members may elect to be classified, for federal tax purposes, as either a corporation or a partnership, beginning January 1, 1997.
What are the LLC taxation options default rules? A newly formed domestic entity will automatically be classified as a partnership for tax purposes if it has two or more members unless an election (form 8832 as a regular corporation or 2553 to be taxed as an S corporation) is filed to classify the entity as an association (and thus taxable as a corporation).
If the entity has a single member, it will not be treated as an entity separate from its owners for federal tax purposes, unless an election is filed to classify that organization as an association.
Conclusion: if you have two partners, the LLC will be taxed as a partnership. If you have two members and you want the LLC to be taxed as an S corporation, you must file form 2553 to make the Federal S election. If you have a single-member LLC, the default rule is to be taxed as a disregarded entity, like a sole proprietorship. If you want the single-member LLC to be taxed like an S corporation, then you would file form 2553.
It is common for a single owner business to start with an LLC disregarded for tax purposes with all the profits and losses flowing to schedule C, and as the business becomes more profitable, consider filing the 2553 election with the IRS to help save on self-employment taxes on profits.
Foreign entrepreneurs will often form a US single-member LLC disregarded owned by themselves as a foreign individual or a foreign entity. The mistake is assuming no US tax return is required in this situation. Typically, a 1040NR or 1120F protect return along with the IRS form 8833 is required.
Distributions from an LLC
After your LLC is formed and your business is up and running and revenue is flowing in it will come to that important point where you will distribute money to the partners. That may be just you, your spouse or other outside partners.
Most simply think about writing a check from the LLC to themselves as the owner and really do not consider the tax ramifications of their actions. This is especially important when you have a partner, whether a spouse, outside partner, or separate legal entity.
Let’s address some basic fundamentals first then get into more details
The first step is to be aware of how your LLC is taxed. Are you a single-member LLC taxed as an S corporation, or disregarded for tax purposes? If you have earned income and a single-member LLC that will flow through to schedule C (basically you are operating as a sole proprietorship, but have the liability protection of an LLC). Test question: Is there any payroll for a single-member LLC? The answer: depends. If the LLC is disregarded for tax purposes there is NO payroll to the owner. Is it possible for a single-member LLC to have employees? Yes. If the single-member LLC is taxed as an S corporation, the active member (owner) would have payroll and distributions. If you have a single-member LLC taxed as an S corporation, of course, the only member is active. If you have a two-member LLC taxed as an S corporation, it is possible that the second member could be passive (this could be a spouse or silent partner). Would the passive member be the manager of an LLC managed by managers? No. By definition, if passive they would not be running day to day operations. Keep that in mind.
A single-member LLC taxed as a C Corporation; there would be at some point some type of payroll to the owner of the C Corporation. Is it possible that there was only enough revenue in the LLC taxed as a Corporation to pay business expenses only and not enough profits left over for any type of payroll? That is possible. You may take dividends from the LLC taxed as a C Corporation, but keep in mind that dividends are NOT deductible to the LLC taxed as a C Corporation’s profits.
An LLC taxed as a partnership is a very common structure. The big mistake you want to avoid is doing payroll for partners. There is NO payroll to partners in an LLC taxed as a partnership. There is something called, “guaranteed payments” to the manager of the LLC for their role in the day-to-day operations of the LLC which is subject to employment taxes, but it is not payroll. The members (or partners) of the LLC will receive distributions in profits. If the member or partner is actively involved in operating the business those distributions will be subject to employment taxes.
Let’s get into more detail about when an LLC can make distributions to members. Absent any agreements with third parties restricting distributions, LLCs generally can distribute cash or property. Here is an important point (a reason to have great accounting records from the beginning); most LLC acts prohibit to members if, following a distribution, the LLC’s liabilities (other than liabilities to members) would exceed the value of the LLC’s assets. Most LLC statutes hold members liable to creditors for wrongful distributions under their fraudulent conveyance statute.
Is compensation considered a distribution to a member? In some states, the answer is yes. Compensation to a member when the LLC is insolvent may be considered a wrongful distribution that is subject to recovery. Some states see that differently. Most state LLC statutes provide that distributions are shared in proportion to each member’s contribution to the LLC. If you and a partner own an LLC 50/50, typically that is the percentage of profits that are distributed. If you have $5K to distribute, the LLC would distribute $2500 to each member. Some (very few) LLCs have a situation where there is a disproportionate distribution between ownership percentage and profits percentage. It is possible to have a situation where two partners own the LLC 50/50 and the profits are split 80/20.
It is very important to note that the LLC is not obligated to distribute profits at all. Unless otherwise written into the operating agreement to distribute enough profits to cover the tax bill of each member. That seems to make sense on the surface but there are other issues with having that written into the operating agreement. You may be a member of an LLC, with no profits distributed and you receive a K-1 for $40,000 of profits from the LLC and if you did not receive any distributions you will have to come out of pocket for the amount to pay the taxes due on that $40K. Be careful in that situation.
Finally, most forget that an LLC has requirements for formalities just as a corporation protecting the entity veil. Don’t just form articles at the state, but have a complete LLC record book with an operating agreement that matches your entity’s number of members and taxation type.