Although an LLC (limited liability company) is widely recognized as being a “pass-through” entity for federal income tax purposes, this status does not mean that there are no tax considerations involved in operating a company as an LLC. While there may not be entity-level tax liability at the federal level, a multi-member LLC must still file an information report. In addition, the LLC may be liable for other types of taxes and may be required to file various returns with state and local governments.
Federal tax treatment is based on LLC’s election
A limited liability company is a tax chameleon. It may be taxed for federal income tax purposes like a C corporation, an S corporation, a partnership, or a sole proprietorship, depending upon what elections are made and how many members it has. Federal tax regulations provide for default classifications of an LLC based on whether there is only one or more than one member. Under the default rules, an LLC with two or more members will be taxed as a partnership. An LLC with only one member is treated as a “disregarded entity,” which means that for federal income tax purposes, it simply does not exist.
However, an LLC can elect to be taxed as a corporation by filing Form 8832, Entity Classification Election, with the IRS. What’s more, once the election to be taxed as a corporation is in place, the LLC can make an S corporation election by filing Form 2553, Election by a Small Business Corporation.
If an LLC is taxed as a partnership or a disregarded entity, its tax items will flow through to the member(s). The LLC will not have to pay any entity-level tax. A multi-member LLC will need to file a partnership tax return and prepare a Schedule K-1 for each member, allocating the tax items among them. If the LLC elects to be taxed as a corporation but files an S corporation election, its income and tax items will pass through to the members. As with an LLC taxed as a partnership, an LLC taxed as an S corporation must file an S corporation tax return and prepare Schedules K-1 for the members.
If the LLC elects to be taxed as a C corporation, it will be taxed as an entity. The LLC will have to file a corporate income tax return and pay taxes on its taxable income. Further, income distributed to the owners as dividends will be subject to double taxation because, in addition to its income being taxed at the entity level, the amount is taxed again on the owner’s individual income return.
CT tip: Savvy tax planning can often eliminate or greatly reduce the exposure to double taxation. It is important to realize that only dividends are actually taxed twice. Amounts that are paid to the owners as compensation are deducted from the company’s income before the tax is calculated. This is also true for amounts paid into a pension and other deferred compensation arrangements. A C corporation can also retain its earnings, which also avoids a second tax being imposed. These are only some of the options that are available to reduce the corporation’s tax liability. A talk with your tax professional will help you determine what the real tax impact will be.
States follow the federal classification
Most states follow the classification that the limited liability company has elected for federal income tax purposes. So, if the LLC is taxed like a partnership for federal purposes, it will be taxed like a partnership for state purposes, and generally will not have to pay state income taxes. Similarly, if the LLC opts to be taxed as a C corporation for federal tax purposes, it will be treated as a corporation for state purposes and will have to pay state income taxes on income attributable to that state.
LLCs may be responsible for withholding and FICA
A limited liability company that has employees may be required to withhold federal income tax from its employees’ wages. The amount withheld depends upon several factors including the amount of wages paid and the number of exemptions the employee claimed. In addition, the Federal Insurance Contributions Act (FICA) commonly referred to as “social security,” requires both employers and employees to contribute a stated percentage of wages. The employee portion must be withheld by the employer from each payment of taxable wages until a designated amount of taxable wages has been reached. Limited liability companies withholding income or FICA taxes from their employees must file a return and deposit the withheld tax with an authorized bank.
The LLC is also required to furnish each employee with an annual statement of wages paid and taxes withheld during the previous calendar year. A limited liability company employing people in states with an income tax must withhold tax from its employees’ wages and similarly remit the withheld taxes to the state.
LLCs often must pay franchise tax
In many states, a limited liability company is subject to taxation by reason of its status as a limited liability company — even if it is a disregarded or pass-through entity for income tax purposes. A franchise tax is imposed on certain business types in exchange for being allowed to do business in the state. Some states refer to this tax as a license, privilege, excise, or registration tax or fee. Regardless of the name, the essence of this kind of tax is that it is levied on a privilege granted by the state, and not on the actual exercise of that privilege.
The basis of the tax varies from state to state. Some impose a flat fee and some a fee based on the number of members. Other states base the tax on the amount of the LLC’s capital accounts or income or the members’ distributional share. The failure to pay a state’s franchise tax when it is due can expose the LLC to severe penalties including administrative dissolution.
LLCs must pay property taxes
A limited liability company that owns or uses property may have to pay property taxes. There are three types of property that may be taxed:
- real property
- tangible personal property
- intangible personal property
Real property includes land and any buildings, structures, improvements, or other fixtures on the land. Tangible personal property includes any physical (tangible) object, other than real property, that one can own. Common examples of tangible personal property include cars, office equipment, and machinery. Intangible personal property is property that does not have a physical substance but represents particular value. The most common intangible asset a business has is its “goodwill.”
Real property is taxed in all states. Many states tax tangible personal property. Fewer states tax intangible personal property. The tax is based on the value of the property. A state may impose a property tax only on property whose tax situs — or location — is considered to be within the state.
Sales and use taxes may be due
Most states have sales and use taxes — although the rates imposed and the types of goods and services that are taxed vary widely. Sales taxes are imposed upon the gross amount involved in certain transactions — particularly, the retail sale of various types of tangible personal property. Use taxes are imposed upon the use, storage, or consumption of tangible personal property not subject to the sales tax. Use tax issues often arise when “big ticket” items are bought out-of-state for use in a particular state. The use tax rate is the same as the sales tax rate. In addition, many counties and cities impose their own sales and use taxes.
Although sales and use taxes are paid by the consumer, it is the retailer’s responsibility to collect the tax and remit the amount collected to the state. Therefore, if an LLC sells taxable goods or services to the consumers of a state it must collect and pay over the appropriate taxes to the state. In order to facilitate collection of these taxes, the LLC is required to obtain a sales tax license or permit from the state.