One of the more obvious advantages of LLCs are their greater number of options they have with regard to the manner is which they are taxed. Under U.S. Treasury Department regulations, known as "Check-the-Box" regulations, LLCs may (under appropriate circumstances) be taxed as a sole proprietorship, general partnership, C-corporation, or S-corporation.
Under these regulations, named for the ease in which choice of taxation status is granted, a domestic, non-publicly traded, one-member LLC is by default (automatically, without doing anything more) treated as a “disregarded” entity for federal tax purposes. This means that the member will not report any company tax items at the company level, but that profits or losses from the LLC will be directly taxed to the member. If the member is a real person (not a separate entity) the income or loss will be recorded on either Schedule C, Profit (or Loss) from Business, or Schedule C-EZ, Net Profit from Business, submitted with the member’s federal and state Form 1040 personal income return. In other words, the member will be taxed for all intents and purposes as a sole proprietorship. (See Sole Proprietorship Federal Income Taxation for further details.)
Whereas employees have personal income taxes withheld from each employee paycheck by their employer, the sole proprietor is responsible for directly paying his or her own personal income taxes as a self-employed individual and therefore pays quarterly estimated taxes of his or her self employment income. These estimated taxes are based on his or her self-employment income from the prior year. Thus, when the sole proprietor’s tax returns are prepared for the preceding tax year, quarterly estimated tax payment statements are also created at that time by the sole proprietor or his or her accountant, with any increases or decreases from the prior year’s self-employment income to be reconciled in the final quarter, typically when his or her personal annual return is due.
Under the check-the-box regulations, a domestic, non-publicly traded LLC with multiple members is by default (without doing anything more) taxed as a general partnership. The income, gains, losses, credits, and deductions of the company are “passed through” to the members based on each member’s share in these items, as usually agreed to in the operating agreement. (See General Partnership Federal Income Taxation for further details.)
A member of an LLC taxed as a general partnership is typically considered “self-employed” and not an employee. The member, therefore, is not obligated to pay themselves a regular salary or wage. Moreover, the member is also not subject to the additional administrative burden of withholding income tax or payroll taxes from each of his or her distributions of profit. Nor are they required to pay federal or state employment security taxes on his or her distributions. Self-employed individuals also do not count as employees for the purpose of meeting the worker’s compensation requirement threshold (generally four or more employees within twelve months) or the South Carolina Wage Payment Act threshold (generally five or more employees). Instead, the members are required to pay income taxes and self-employment taxes (social security and Medicare) on a quarterly estimated basis. In contrast, shareholders or members who provide personal services to an entity taxed under Subchapter “C” or Subchapter “S” in exchange for compensation are considered employees with respect to such services, not unlike any other employee, and are therefore subject to the same withholding tax, payroll tax (FICA taxes), federal and state employment security taxes, and (if having four or more employees) worker’s compensation coverage and (if having five or more employees) South Carolina Wage Payment Act requirements.
Although a limited liability company taxed as a general partnership itself pays no tax, it must file an information return to the IRS on Form 1065, U.S. Partnership Return of Income, and to the South Carolina Department of Revenue on Form SC-1065. These forms show the financial result of the company’s operations for its tax year and the items and their proportions that must be “passed through” to the members. Each member, in turn, receives a copy of Schedule K from the company showing his or her share of income, deductions, credits, losses, and tax preference items of the company, which will be then appended to the member’s individual income tax return.
One-member LLCs and multiple-member LLCs may also elect to be taxed as a corporation under Subchapter “C” or Subchapter “S” (assuming it meets the standard requirements for Subchapter “S” election for the purposes of the latter). It may start out being taxed one way, as a sole proprietor if having only one member or as a general partnership if having two or more members, and, when it makes tax sense to do so, elect to be taxed another way, under either Subchapter “C” or Subchapter “S.”
Taxation as a corporation under Subchapter “C” allows taxing authorities to treat the LLC as a separate entity for income tax purposes. Separate entity status results in the double taxation of company profit from the perspective of a member of an LLC. Tax on net profit is paid on the entity level according to a graduated tax rate. Thereafter, when the after-tax net profit is distributed to the members, such distributions are again subject to taxation as personal income to the members. Thus, the same net profit is taxed twice, first on the entity level then on the member level. The IRS form that LLCs must file to elect C-corporation taxation is Form 8832. This form must be filed with the IRS within 75 days after the LLC files its articles of organization. The company must also file Form CL-1 with the South Carolina Department of Revenue. When paying federal income taxes on profits, a limited liability company taxed under Subchapter “C” is required to annually file Federal Form 1120 and state Form SC1120. Each member, in turn, receives a copy of Schedule K from the company showing his or her share of income, deductions, credits, losses, and tax preference items of the company, which will be then appended to the member’s individual income tax return. (See Subchapter “C” Federal Income Taxation for further details.)
With LLC taxation under Subchapter “S” there is no income tax on profits at the entity level. Rather, profits and losses of the company are “passed through” directly to the members, much in the same manner as a partnership income passes through to the individual partners. Thus, under Subchapter “S” there is only a single level of taxation on company profits, the member level, with company profits being taxed to each member according to his or her individual income tax rates.
Insofar as a single member limited liability company is by default taxed as a disregarded entity (a sole proprietorship) and insofar as a multiple member limited liability company is by default taxed under Subchapter “K” (a partnership), both of which already have only a single level of taxation, LLCs are generally less concerned with avoiding double taxation on distributions of profits under Subchapter “C,” than are corporations, and are therefore less frequently motivated to elect taxation under Subchapter “S.”
However, under certain circumstances, even a limited liability company may wish to consider electing tax treatment under Subchapter “S.” This is particularly the case when doing so may legitimately help to reduce social security taxes and Medicare taxes otherwise imposed on the members providing personal services to the company, just as might shareholders of a corporation who provide personal services to the corporation also reduce social security and Medicare taxes in limited circumstances. However, one must be cautious in doing so in either case, because such a method for reducing social security taxes and Medicare taxes is commonly abused. Only under certain specific circumstances can corporations (whether standard, professional, or statutory close corporations) or LLCs elect to be taxed under Subchapter “S.” And then only under still other limited circumstances should shareholders or members attempt to reduce their social security taxes or Medicare taxes under Subchapter “S.”
To obtain Subchapter “S” status under the federal income tax law all of the following requirements must be met: the entity must be a domestic corporation or LLC. The entity may not have more than one class of stock, though voting rights may vary. The entity may not have more than 100 shareholders or members. (See Subchapter “S” Federal Income Taxation for further details.)
The IRS forms that LLCs must file to elect S-corporation taxation are generally both Form 8832 and Form 2553 with the IRS and Form CL-1 with the South Carolina Department of Revenue. Form 8832 must be filed with the IRS within 75 days after the LLC files its articles of organization. Form 2553 generally must be filed with the IRS on or before the 15th day of the 3rd month after the company’s formation.
Although it does not pay federal or state income taxes, an LLC taxed under Subchapter “S” must file a Federal return on Form 1120S, U.S. Income Tax Return for an S Corporation and a South Carolina state return on Form SC-1120S. These forms show the results of the company’s operations for its tax year and the items of income, gains, losses, deduction, or credits that affect the member’s individual income tax returns. The proportion of each of these tax items is based on the proportion of shares held by each member. Each member, therefore, receives a copy of Schedule K from the company showing his or her share of income, deductions, credits, losses, and tax preference items of the company, which will be then appended to the member’s individual income tax return.
In some instances, this process of choosing the correct tax regime can be a complex one, especially because of the greater number of tax regimes available to LLCs. However, for most LLCs the process is relatively straight forward. A great majority of one-member LLCs owned by other entities accept (by default) to be disregarded as an entity for tax purposes. The member’s are therefore taxed like sole proprietors. A great majority of multiple-member LLCs accept (by default) the general partnership tax regimen under Subchapter “K.” Substantially fewer LLCs elect taxation as a corporation under Subchapter “S,” and then principally to reduce their Social Security tax liability and the only if appropriate. A smaller number still elect to be taxed as corporations under Subchapter “C.”
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