Limited Liability Company Taxation and Costly Mistakes to Avoid
Discover all about the LLC and how it is taxed and the different options for your situation! Will it be taxed as a disregarded entity, corporation or partnership?
How is an LLC taxed?
An LLC may be taxed with one of four options, a partnership, disregarded entity or an S or C corporation. An LLC is treated as a partnership for tax purposes if it has two members by default.
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 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) 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. In all these cases please consult a tax professional.
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2.If an LLC is taxed as a partnership are the distributions subject to Employment taxes?
According to an IRS official and a national issue specialist in its Examination Specialization Program, until the Service issues further guidance, it will not challenge limited liability company (LLC) members on self-employment (SE) tax if the member and the LLC conform to the most recent (1997) proposed regulations (REG-209824-96). These regulations, however, need clarification now on the definition of limited partner (LP).
Under Prop. Regs. Sec. 1.1402(a. 2(h)(5), if substantially all of a partnership's trade or business activities involving the performance of services (i.e., consulting), any individual who provide such services as part of that trade C business will be a general partner (gross income for self employment tax purposes).
In a "non-service" partnership, Prop Regs. Sec. 1.1402(a)-2(h)(2) treats partner as a Limited Partner for self employment tax purposes unless he or she:
1. Has personal liability for the partnership's debts by reason of being a partner;
2. Has the authority to contract on the partnership's behalf-, or
3. Participates in the partnership's business for more than 500 hours during the entity's tax year.
Even if a member does not meet the hours test or is not personally liable for a partnership's debts, an individual serving as a manager in a member-managed LLC would be subject to self employment (SE) tax. If the LLC agreement does not precisely give the managing rights to a specific individual, all members would be subject to SE tax.
In general, under Sec. 1402(a),"net earnings from" self employment include the gross income derived from any trade or business carried on by an individual, less any allowable deductions attributable to such trade or business, plus his or her distributive share of income or loss from any trade or business carried on by a partnership of which he or she is a member.
Under Regs. Sec. 1.1402(a)-2(f), a "partnership" includes a syndicate, group, pool, joint venture or other unincorporated organization that carries on a trade or business, but is not a trust, estate or corporation.
For this purpose, gross income includes payments received by a partner from the partnership for services rendered to the partnership or for the use of capital by the partnership (guaranteed payments). However, Sec. 1402(a) provides a number of specific exceptions from self employment earnings, such as (1) rental income or loss from real and personal property, (2) interest and dividend income, (3) gains or losses from sales or exchanges of capital assets and (4) payments received from a partnership not engaged in a trade or business within the meaning of Sec. 1402(c) and Regs.Sec.1.1402(c)-1.
Sec.1402(a)(13) excludes a Limited Partner's distributive share of any item of income or loss received is remuneration (other than guaranteed payments described in Sec. 707(c) for services rendered to the partnership or on its behalf). However, further clarification is needed in applying this exception to LLC members.
In December 1994, proposed regulations were issued, specifically addressing which LLC members were to be included in the definition of Limited Partner (LP). Under those rules, an individual owning an LLC interest was treated as an LP if (1) he or she lacked the authority to make management decisions needed to conduct the LLC's business and (2) the LLC could have been formed as a limited partnership rather than an LLC in the same jurisdiction, and the member could have qualified as a LP in that partnership under applicable law. Because such an assessment would have been difficult to make with certainty, and because this rule could have led to inconsistent LLC-member treatment, the Service withdrew the proposed regulations.
Revised proposed regulations were issued in 1997, defining which partners were to be considered LPs for Sec. 1402(a)(13) purposes. These regulations intended to exclude from self employment (SE) tax an individual's net earnings that were demonstrably returns on a capital investment in the partnership. However, if these rules are applied literally, numerous partners would be reclassified as General Partners (even though they might not function as such), subjecting their investment income to SE taxes.
Because of criticism on this matter, Congress added Section 935 to the Taxpayer Relief Act of 1997, preventing the IRS from finalizing these regulations before July 1, 1995 . However, to date, the Service has not finalized, withdrawn or modified them. Although the proposed regulations do not have the same judicial weight as final regulations, they represent Treasury's position on this matter.
A taxpayer has other options in dealing with the self employment tax, rather than following the proposed regulations, but these have various risks. One alternative is to adopt the position that all the LLC members are Limited Partners (LP). This would eliminate the self employment tax for all of them. Unfortunately, this position has limited legal support. Letter Ruling 9452024 held that even though members were not classified as LPs per se, they could be treated as such for some Code purposes. However, for a member who participates in the daily operations of an LLC's business, this argument would be fairly weak. Further, under- the Revised Uniform Limited Partnership Act, a LP who participates in a partnership's activities of the partnership risks losing his or her limited liability protection and effectively reverting to General Partner status if he or she "participates in the control" of the partnership.
An LLC member could take the position that his or her portion of earnings is a return on capital invested in the LLC, which arguably matches the 1997 proposed regulations' intent. A percentage could be determined by paralleling a similar investment (such as a return on small publicly traded stocks), with an adjustment for the increased risk of a non-publicly held company. However, there is neither Code nor IRS guidance on this position; thus, if taken, it should be disclosed on the member's return to avoid a penalty.
A variation would be for the LLC member to adopt a position that only "reasonable compensation" is subject to the self employment tax. However, this would most likely be even riskier, resulting in an ever-larger exclusion. Again, this position lacks Code and IRS guidance and, so, should be properly disclosed.
Proper planning can minimize self employment tax on LLC members. An LLC manager can be a one percent member, which could eliminate the tax on the remaining ninety-nine percent of income. An S corporation can be the manager, which could potentially remove all members from the tax.
The proposed regulations represent the Treasury's position on this matter. Taxpayers can rely on them until further notice. SE Issue from SHARON L. COOK., CPA, SOUTH BEND, IN, The Tax Adviser , September 2003.
LLC Terms and Definitions
It is important to understand the basic LLC terms and what they mean. You will notice many sound similar to corporate terms but keep in mind they are different. Many times in business situations people will use the inappropriate terms when referring to an LLC. You will come across as more organized and professional when you know the difference.
Articles of Organization: The Articles of Organization are filed with the Secretary of State in order to form the LLC. This document is similar to the Articles of Incorporation for corporations and the Certificate of Limited Partnership for Limited Partnerships.
Certificate of Formation: Some states, such as Delaware, refer to the Articles of Organization as the Certificate of Formation. Most will use the term, Articles of Organization.
Economic interest: An economic interest is the right of a member or nonmember to receive an allocable share of income, gain, loss, deductions, and credits in the LLCs. An economic interest does not include the right to vote or participate in management. Hence the benefit of a "charging order". Normally, a member may transfer an economic interest in an LLC without the consent of the other members unless the organizational documents otherwise provide. However, transfer of the economic interest normally transfers only the member's right to share in distributions and profit and loss allocations. It does not transfer the member's voting and management rights without the consent of the other members (as specified in the Operating Agreement).
Managers: Managers are the persons designated by the members to manage the LLC. Most state laws allow members to designate managers. If there are no designated managers, all members normally manage the LLC in accordance with their proportionate interests in the LLC. Managers are similar to the officers and directors in a corporation and the general partners in a Limited Partnership. Managers manage most LLCs because it provides more flexibility than to limit management to all members only; i.e., to be able to use one or a portion of the members or even non-members as managers.
Members: Members are the owners of an LLC, just like the stockholders of a corporation.
Membership interest: A membership interest is all of a member's ownership rights in an LLC. A membership interest includes the member's right to vote and participate in management and the member's economic interest in the LLC. A membership interest is similar to the shares of stock in a corporation and the partnership units in a limited partnership.
Operating Agreement: The Operating Agreement sets forth the rules regarding the operation of the LLC and the rights and obligations of the members. It is similar to the bylaws in a corporation and the partnership agreement in a partnership. This is the most important part of the LLC. Key mistakes are often made in the operating agreement.
Regulations: Texas and Florida refer to the Operating Agreement as the regulations.
An LLC and its members do not recognize gain or loss when the members contribute property to the LLC in exchange for membership interests unless any of the following apply:
There is a net decrease in liabilities of a member exceeding that member's basis in the assets transferred.
There is a disguised sale.
The member contributes services to the LLC in exchange for a capital interest or a profit interest that does not meet IRS guidelines. This would come into play if you have one partner putting up capital to start the LLC and the other was going to perform services for their interest. This is a taxable event to the person who contributed services.
No gain or loss is recognized if a member contributes only cash to the LLC in exchange for membership interests.
Assumption of Liabilities in Excess of Basis
A member recognizes gain if the LLC assumes liabilities of the member that exceeds the member's adjusted basis in the contributed property. It is important to examine the assets you may be contributing to an LLC.
Member's Basis in Membership Interest
A member's basis in his membership interest equals the amount of money and the adjusted basis of property contributed to the LLC. A member's tax basis in his/her membership interest is different from the member's capital account.
Upon formation of an LLC, the member's adjusted basis equals the cash and adjusted basis of property contributed to the LLC. The capital account is equal to the value of the contributed properties. Taxable gain or loss is based on the tax basis rather than the capital account value.
1 David J. Cartano, "Federal & State Taxation of Limited Liability Companies", Panel Publication (2000), 2-3.
2 David J. Cartano, "Federal & State Taxation of Limited Liability Companies", Panel Publication (2000), 80
Example of the Difference between a Tax Basis in
Membership Interest and the Capital Account
An LLC has two equal members. Member A contributes $10,000 cash to the LLC. Member B contributes property with an adjusted basis of $5,000 and a fair market value of $10,000. The capital accounts of each member after the contribution and their adjusted bases in the membership interests are as follows:
Tax Basis in Membership Interest
Key: Tax loss or gain is measured from tax basis. In this example, member A, would have a higher tax basis.
Personal Use Property
A member's contribution of personal use property to an LLC is nontaxable. The LLC receives a basis in the property equal to the lower of the property's fair market value at the time of contribution or the contributing member's adjusted basis.
Example of Contribution of Property to an LLC
An LLC has two members, who share equally in profits and losses. Member A contributed $12,000 cash to the LLC. Member B contributed property with a tax basis of $4,000 and a fair market value/capital account value of $12,000.
Property ($4,000 basis and $12,000 market value-remaining depreciation life of 10 years).
The property has a remaining depreciation life of 10 years. For book purposes, the LLC takes a depreciation deduction of $1,200 per year (10 percent of the book value). The LLC allocates $600 of book depreciation to each member. For tax purposes, the LLC takes a depreciation deduction of $400 per year (10 percent of the $4,000 tax basis). The LLC must allocate $600 of tax depreciation to Member A, which is equal to her book depreciation. However, since the LLC has only $400 of tax depreciation for the year, the LLC may allocate only $400 of tax depreciation to Member A. No depreciation is allocated to Member.
The LLC must comply with the anti-abuse provisions applicable to contributed property. These anti-abuse provisions are referred to as the "mixing bowl problem." They apply when one member contributes appreciated or depreciated property to the LLC and the LLC distributes property to members within a certain period of time thereafter. The IRS understands these accounting "games" people may play and have anticipated most of them.
This is similar to using a C corporation to pay lower tax rates for service orientated businesses and then realizing there is something called the Personal Service Corporations rules that make this undesirable 8.
An LLC and its members may not currently deduct start-up expenses, organization expenses, and expenses connected with the sale of membership interests. Code Sections 263 and 709 require the LLC to capitalize these expenses.
An LLC may amortize certain organization expenses over a period of not less than 60 months. The amortization period starts with the month that the LLC begins business. The election is irrevocable; the amortization period that the LLC chooses cannot be changed. If the LLC elects to amortize the expenses and is later liquidated before the end of the amortization period, the remaining balance in the account may be deducted as a loss.
The LLC may make the election to amortize expenses by attaching a statement to the LLC's return for the tax year in which the LLC begins its business. This is another reason we recommend having your CPA complete the first year tax return for the LLC. The statement must describe the following:
Each organization expense incurred, whether or not paid.
The amount of each expense.
The date each expense was incurred.
The month the LLC began its business.
The number of months, not less than 60, over which the expenses will be amortized.
A cash basis LLC must also indicate the amount paid before the end of the year for each expense.
The LLC may amortize the following expenses:
Services to form the LLC.
Accounting fees for services incident to the organization of the LLC.
The LLC may not amortize expenses connected with the following:
Acquiring assets for the LLC or transferring assets to the LLC.
Admitting or removing members other than at the time the LLC is first organized.
Making a contract relating to the operation of the LLC's trade or business (even if the contract is between the LLC and one of its members).
Incurring other costs for starting or operating the LLC's trade or business.
An LLC that is classified as a partnership for federal tax purposes (meaning it has two members) is subject to the partnership tax rules under subchapter K of the Internal Revenue Code. The LLC does not pay taxes at the entity level; it is a pass-through entity. Some states do tax LLCs at the state level. If the members are individuals, the income will flow to their personal tax return, if an entity, the income will flow through to the entity. All items of income, gain, credit, loss, and deduction pass through to the members. The members report their distributive shares on their personal tax returns, whether or not the income or other amounts are distributed. This means the member may have to pay taxes on money that was not even distributed by the LLC. This is a benefit of the charging order that discourages creditors.
An LLC must compute its taxable income for reporting purposes even though it is not a taxpaying entity. The LLC reports its taxable income on IRS Form 1065, which is an annual information return. It reports each member's distributive share on Schedule K-1. Schedule K-1 is filed as part of Form 1065 and sent to each member.
Partners do not have payroll obligations. This particular difference is an important part of the end of year procedures because of certain rules that need to be observed with regard to distributions.
Distributions to partners should not result in negative capital accounts. The partner (member) will receive the K-1 once the tax return for the partnership has been prepared for the year. Partnership K-1's are not due until April 15.
Distributions of partnership profits may occur periodically through the year; however care needs to be taken to observe the rules above. If, at the end of the year, distributions are not in accordance with the above rules, they may need to be reclassified as loans that will need to be repaid in the following year.
To get an automatic three-month extension for filing an LLC return for the previous year, you must file form 8736. An additional extension of no more than three months may be granted upon a showing of reasonable cause by filing Form 8800.
What Accounting Insights do I need to be aware of?
The taxable income is computed in the same manner as for an individual, subject to certain exceptions. However, the LLC must present its taxable income in a format that is very different than for an individual.
The LLC must separately report or account for the following four types of income, gain, credit, loss, and deduction:
Items that must be separately stated.
All other items of income and expense that are grouped together as "ordinary income (loss) from trade or business activities." The LLC' s taxable income for reporting purposes is the total of all items of income, gain, loss, and deduction other than the items that are separately stated or that are disallowed as deductions.
Special allocations and each member's distributive share of income. A member's distributive share of income, gain, loss, credit, and deduction is determined in accordance with the operating agreement. However, special allocations to members are not respected unless the allocations have substantial economic effect.
Each member takes into account her distributive share of taxable income, the separately stated items and the disallowed amounts. These are reasons why it is recommended to have a CPA complete your LLC taxes.
The character of any item of income, gain, loss, deduction, or credit is normally determined at the LLC level rather than at the member level. For example, if the LLC sells a depreciable business asset at a gain, the gain is a Section 1231 gain even though the member is not engaged in a trade or business.
If the LLC has losses, the members may deduct the losses on their individual tax returns, subject to the passive loss rules. The LLC may not carry back or carry forward the losses to other years as a net operating loss. However, the members may use those losses as net operating loss carrybacks and carryovers on their individual returns.
Basis is a tax concept that determines whether any taxable disposition of property creates a recognized gain or loss . It can be summarized as the amount of cash or the fair market value of property a person actually has invested in another piece of property, which may be adjusted by several factors .
A taxpayer is, absent an exception, generally subject to tax on the sale or exchange of property unless the cash or fair market value of property received exceeds that taxpayer's tax basis in the property transferred. Basis also can relate to other basis or values. For example, property inherited from a decedent generally has a basis equal to its fair market value at the date of death or alternate valuation date; a donee generally inherits the basis of the living donor.
Alson R. Martin, "Limited Liability Company & Partnership Answer Book", Panel Publication, (1999), 7-2,7-3.
With your LLC taxed as a partnership, basis is important because you as a member can deduct certain losses of an LLC allocated to you to the extent of your tax basis in your LLC interest, subject to some limitations. Your tax basis can never be less than zero. There is a term called "negative basis," the term actually means a deficit capital account, which can trigger tax (often depreciation recapture) upon sale, foreclosure, gift or other nondeath transfer.
Overall, you want to have a high basis in your membership interest. You will discover that partnership taxation allows you to have more basis with certain transactions, than you would with an S corporation (the other main flow through entity). More basis means the ability to distribute more money tax-free to the members!
A member's tax basis in an LLC interest initially is equal to the amount of cash and adjusted tax basis of property contributed by that member to the LLC in exchange for the LLC interest. [IRC § 722] If the member purchased the interest from anther member, the purchasing member's tax basis initially would be equal to the amount of cash or fair market value of property transferred in exchange for the interest. [IRC §§ 742, 1101].
As member's interest in an LLC is adjusted from time to time as follows:
Increased by the member's distributive share of the LLC's income and tax-exempt income;
Increase by the member's distributive share of the LLC's deductions for depletion over the basis of the property subject to depletion;
Increased by the member's share of the LLC recourse (and in some cases, qualified nonrecourse) liabilities for which no other member is personally liable;
Decreased by the member's distributive shares of the LLC's losses and nondeductible expenses, which are not property chargeable to capital accounts; and
A member's tax basis includes any portion of the LLC's liabilities, unless (1) the debt is nonrecourse to that member and another member is personally liable for all of the debt, or the debt is not qualified [IRC § 752], or (2) the member is not at risk. [IRC § 465].