Similar to S corporations, LLCs (and partnerships) are considered “passthrough” entities where a business’s income and expenses flow through to the partners and are reported on the partners’ personal income tax returns.
The most significant tax difference between LLCs and S corporations is the treatment of self-employment taxes. In an LLC, each member’s share of profit is subject to self-employment tax. In an S corporation, each shareholder’s share of profit is NOT subject to self-employment tax. The IRS does, however, require S corporations to pay shareholders who contribute substantial services a “reasonable” salary. This salary is subject to payroll taxes.
Here are several other significant areas of LLC taxation:
State Taxation – Partners need to be aware that some states require LLCs to withhold taxes on behalf of the partners. This withholding is oftentimes mandated using the state’s highest marginal rate.
Partnership Audit Rules – Legislation in 2015 instituted new procedures for federal audits of partnerships. Audits will now be conducted, and any additional taxes will be levied, at the partnership level. Partnerships and LLCs have the option to elect out of these new audit rules. Under the old rules, the IRS would be forced to collect any additional taxes levied from the partnership’s partners, not the partnership itself. This election to opt out of the new audit rules must be made annually.
Special Allocations – Another tax-related advantage that partnerships have over S corporations is being able to implement special allocations. As an example, let’s consider an LLC which has four members, each of whom owns 25% of the LLC. The LLC isn’t required to allocate 25% of the LLC’s profits and losses to each member. If agreed on by all the members and documented in the operating agreement, one of the members can be allocated 50% of the LLC’s profits and losses while the other three members split the remaining 50%. There are guidelines and limitations for how an LLC can structure special allocations. Please consult your tax advisor for more information.
Complicated Annual Reporting – While special allocations are what has partially made LLCs a popular business entity, special allocations can also cause tax compliance to become expensive and time consuming for the LLC itself and its members. Complex tax consequences shouldn’t deter you from at least considering the LLC structure for your business with your team of advisers. The benefits of having an LLC may be greater than the time and money resources required to comply with state and federal tax laws.
Flexibility – An LLC always has the option of choosing to be taxed as an S corporation instead of a partnership. The LLC files Form 2553 with the IRS to make the election to be taxed as an S corporation. This is the same form used by a C corporation who elects to be taxed as an S corporation.