Oddly enough, as far as Federal income taxes are concerned, LLCs don’t really exist. The Internal Revenue Code (the body of law that outlines all Federal income taxation) treats each LLC as if it were one of the other types of entities (sole proprietorship or partnership usually).

Disregarded Entities

LLCs are referred to as “disregarded entities.” They are referred to in such a manner because Federal tax law tends to disregard their existence.

EXAMPLE: Kali owns and operates a restaurant as a sole proprietorship. She later decides to form an LLC for her business. Because the LLC is a disregarded entity, the business will continue to be taxed as a sole proprietorship (for Federal tax purposes at least).

EXAMPLE: Steve and Beth own and operate a winery. After learning about the potential dangers of unlimited liability in a partnership, they decide to form an LLC. Because the LLC is a disregarded entity, the business will continue to be treated as a partnership for Federal income tax purposes.

In other words, single-member LLCs (LLCs with one owner) will generally be taxed as sole proprietorships, and multiple-member LLCs will generally be taxed as partnerships. Because of this tax treatment, LLCs—like sole proprietorships and partnerships—are often referred to as pass-through entities.

LLCs Taxed as Corporations

Sometimes, after forming an LLC, the owner(s) of the LLC will decide that they would benefit from being taxed as a C-corporation rather than as a sole proprietorship or partnership. When this happens, the owner(s) have two options:

1. Form a corporation and transfer all of the assets from the LLC to the corporation, or
2. Fill out a form (Form 8832) electing corporate tax treatment.

The second option is certainly the easier and less costly of the two.

The same thing can be done should the LLC’s owner(s) decide that S-corporation taxation would be beneficial. The only difference is that a different form (Form 2553) is used to notify the IRS of the election.

Is Electing Corporate Tax Treatment for Your LLC Really a Good Idea?

Filling out a form to elect corporate tax treatment is certainly an easier method than actually forming a corporation, transferring all the assets from your LLC to the corporation, and then dissolving your LLC. However, many tax professionals recommend rather strongly against electing corporate tax treatment for a Limited Liability Company.

The reason many tax advisors are hesitant to elect corporate taxation for an LLC is not that corporate taxation is a bad thing. Rather, they’re concerned about the potential for problems resulting from two conflicting sets of laws. In other words, they’re uncomfortable with the situation resulting from a business being treated as an LLC for legal purposes, but as a corporation for tax purposes.

State Taxation of LLCs

Again—unless an election is made otherwise—LLCs will be treated as either sole proprietorships or partnerships for Federal tax purposes. However, depending upon where your business is located, state income taxes might not work the same way.

In some states, LLCs are taxed, by default, in a manner roughly the equivalent to the way that corporations are taxed. This makes for a rather complicated situation in which your business is treated by the IRS as a sole proprietorship (or a partnership if it has multiple owners), but as a corporation by your state.

Other states have a minimum annual income tax for LLCs (though it may be called something else). For instance, in California LLCs are subject to a “franchise tax,” which is basically just an income tax, but with an annual minimum of $800.

EXAMPLE: Braden runs a sole proprietorship in California for his part-time video production business. He earns roughly $3,000 per year from the business, and is considering forming an LLC. However, even with an annual income of only $3,000, a California LLC would still be subject to a tax of $800, or over one-quarter of its total profit. Braden eventually decides that the benefits of forming an LLC would be outweighed by this disproportionately large tax.

Before deciding to form an LLC, it’s definitely a good idea to find out precisely how your state taxes limited liability companies. Generally, you’ll be able to find this information online without too much difficulty by searching for your state’s Treasury Department, Department of Revenue, or corresponding organization.

In Summary

• For Federal tax purposes, single-owner LLCs are treated as sole proprietorships, and multiple-owner LLCs are treated as partnerships.
• The owners of an LLC can elect to be treated as a corporation simply by filling out a form. However, many tax professionals are rather leery about recommending that course of action as opposed to actually creating a corporation.
• Many states do not tax LLCs the same way that the Federal government does, so be sure to find out how your own state taxes LLCs before creating one.

S-corporations, like sole proprietorships and partnerships, are pass-through entities. That is, there is no Federal income tax levied at the corporate level. Instead, an S-corporation’s profit is allocated to its shareholder(s) and taxed at the shareholder level.

Tax Forms for S-Corporations

An S-corporation’s annual tax return is filed on Form 1120S. (This actually makes some sense, given that a regular corporation’s return is filed on Form 1120.) This form consists of pretty much what you’d expect: A section detailing revenues, a section detailing expenses, and a section for calculating the amount of tax owed.

In addition to the above, Form 1120S also includes a Schedule K as well as a Schedule K-1 to be filled out for each shareholder. The Schedule K and Schedules K-1 fulfill the exact same purpose as they do on a partnership’s tax return. That is, they’re used to show how the business’s profit or loss is allocated among the owners.

No Self-Employment Tax!

The big benefit of S-corp taxation is that S-corporation shareholders do not have to pay self-employment tax on their share of the business’s profits.

The big catch is that, before any profits can be distributed, each of the owners who also work as employees must be paid a “reasonable salary.” This salary will of course be subject to social security and Medicare taxes to be paid half by the employee and half by the corporation. As such, the savings from paying no self-employment tax on the profits only kicks in once the S-corp is earning enough that there are still profits to be paid out after paying the mandatory “reasonable salary.”

EXAMPLE: Larissa is the sole owner of her S-corporation, an advertising agency. Her revenues from the business are $60,000 per year, and her annual expenses (not counting salary) total $10,000. As such, her S-corp’s profit for the year (before subtracting her own salary) is $50,000.

Larissa’s plan is to pay herself $40,000 in salary, and count the remaining $10,000 as profit, thus saving money as a result of not having to pay self-employment tax on the $10,000 profit.

Unfortunately, Larissa learns that the average advertising professional earns in the $60,000 range annually. As such, she’s going to have a difficult time making the case that $40,000 is a “reasonable salary.”

In the end, Larissa ends up setting her salary at $50,000 in order to avoid trouble with the IRS. Sadly, her S-corp’s profit (after paying her salary) ends up being $0, so she isn’t really saving any money on taxes as a result of S-corp taxation.

Determining a “Reasonable Salary”

So what’s a reasonable salary? Good question. This exact question is frequently the topic of great debate in court cases between the IRS and business owners who are, allegedly, paying themselves an unreasonably small salary in order to save on Self-Employment Taxes.

One way to get an estimate for reasonable salary is to visit salary.com. There you can run a search, and it will tell you the average salary earned by people in your profession and in your geographical area.

In Summary

• S-corporations are pass-through entities. That is, the corporation itself is not subject to federal income tax. Instead, the shareholders are taxed upon their allocated share of the income.
• Form 1120S is the form used for an S-corp’s annual tax return.
• Shareholders do not have to pay self-employment tax on their share of an S-corp’s profits. However, before profits are calculated, any owners that work as employees for the S-corp will need to receive a “reasonable salary.”

S-corporations are simply C-corporations that have elected (under Subchapter S of Chapter 1 of the Internal Revenue Code) to receive a special kind of tax treatment. As such, the only difference between an S-corporation and a C-corporation is taxation.

Electing S-Corp Taxation

Electing S-corp taxation couldn’t be any easier. All you have to do is fill out a single form (Form 2553), and your corporation will continue to be taxed as an S-corp for as long as you continue to meet the various shareholder requirements for S-Corp taxation.

Also, LLCs are allowed to elect S-corp taxation by filling out a Form 2553.

Who Can Elect S-Corp Taxation?

In order for a corporation to be eligible for S-corp taxation, it must meet all of the following requirements:

1. It must be a domestic corporation (as opposed to a foreign one).
2. It must have no more than 100 shareholders.
3. The shareholders can only be individuals, estates, and tax-exempt organizations. (In other words, no corporations or partnerships as shareholders.)
4. It can have no nonresident alien shareholders.
5. It can have only one class of stock.
6. It cannot be a bank or insurance company.
7. All shareholders must consent to the election.

Simple Summary

• The only difference between an S-corp and a C-corp is the way in which they are taxed.
• To elect S-corp taxation for a corporation or an LLC, simply fill out IRS Form 2553.
• In order to be eligible for S-corp taxation, a corporation must meet several requirements.

Corporate taxation is unique in that the business itself is subject to an income tax. Note how this is different from a sole proprietorship or a partnership in which the business itself is not taxed, but the owners are taxed based upon their allocated share of the income.

A C-corporation’s income tax is unaffected by how many owners (shareholders) the corporation has or by how much of the profit is distributed to the owners. C-Corporation income is taxed according to the following table:

Tax Rates for Corporations (2010)

Double Taxation of Dividends

When a corporation makes a distribution of earnings to its owners, the payment is known as a dividend. Dividend income is taxable to the recipient (though at a maximum rate of 15% as compared to ordinary income rates).
As such, corporate profits, if they are paid out to shareholders, will be taxed twice: Once at the corporate level and once at the shareholder level.

Paying Yourself a Salary

One way to avoid the double taxation of the corporate structure is to pay the owners a salary—or year-end bonus—that will leave the corporation with exactly zero income. (Salaries paid to employees count as deductions for a corporation, thus reducing the corp’s taxable income.)

Of course, the amount received as salary will still be taxable income to the owners. In fact, when a corporation pays its owners a total amount of salary equal to what profits would have been without the salary, the net result is actually exactly the same as if the business was simply being taxed as a sole proprietorship or partnership. How about an example
to clarify?

EXAMPLE: Debbie is the only owner of her business (a dietetics-consulting practice). Her business is currently a sole proprietorship, but she’s attempting to determine if forming a C-corp would be beneficial. Her revenues for the year are projected to be $90,000, and her expenses (not counting any salary she pays herself if she incorporates) are projected to be $20,000.

If Debbie continues to run her business as a sole proprietorship, she’ll have $70,000 of earnings from self-employment. (And regular income tax and Self-Employment Tax will be computed as normal.)

If Debbie decides to incorporate and pay herself a $70,000 salary, the corporation will have a taxable income of $0. She’ll have $70,000 of salary, upon which she’ll pay regular income taxes. She won’t have to pay Self-Employment Tax. But she and the corporation will each be responsible for 7.65% of social security and Medicare taxes, totaling 15.3% anyway.

End result: Debbie pays the same total amount of tax in each scenario.

Potential for Savings: Income Splitting

But what if a business owner doesn’t need every last dollar of her business’s profits in order to pay her personal bills? Such situations are the reason why people sometimes discuss incorporation as a method to save on taxes.

Often, business owners can pay less total tax if they’re comfortable leaving some money in the business’s bank account. They can pay themselves a salary, but not a salary so large that it wipes out the corporation’s profits entirely. The end result is that the corporation has some taxable income, and the owner has some taxable income. The tax savings are achieved because the income is split between the owner and the corporation (thus keeping them each in a lower tax bracket).

EXAMPLE: Let’s use the same information from the example above, and assume that Debbie has decided to incorporate. But we now have one more piece of information: Debbie lives a very simple lifestyle, and knows that she won’t need all of the profits from the business in order to pay her personal bills. In fact, she only expects to need $30,000 of income in order to maintain her standard of living.

Debbie realizes that she can save money by splitting her taxable income. She decides to pay herself a salary of $30,000, and let the rest of the profits ($40,000) remain in the corporation’s checking account. This way, the corporation has a taxable income of $40,000, and she has a taxable income of $30,000, and she ends up paying less total tax than she would if all $70,000 of income were taxable either to herself or to the corporation.

Qualified Personal Service Corporations

As mentioned in the previous chapter, many types of professionals (doctors, lawyers, etc.) are barred from forming corporations in certain states. However, some states do allow them to incorporate.

The IRS is likely to treat such corporations as “Qualified Personal Service Corporations.” This designation isn’t a positive one. What it means is that the corporation’s income will be taxed at a flat rate of 35%, rather than the rates shown above, which begin as low as 15%.

Two requirements must be met for the IRS to assign the designation of Qualified Personal Service Corporation:

1. Substantially all of the corporation’s activities are services performed in the fields of law, medicine, engineering, accounting, architecture, performing arts, actuarial science, or consulting.
2. 95% or more of the corporation’s stock is owned by employees performing the above-mentioned services, or by retired employees, the estates of employees, or other people who acquired the stock as a result of an employee’s death.

Simple Summary

• Unlike sole proprietorships or partnerships, C-corporations are taxable entities. That is, they have to pay tax on the income they earn.
• After a corporation is taxed on its income, it can distribute it to the owners (in a payment known as a dividend). The owners are then taxed on the dividend income, thus resulting in two levels of taxation.
• It’s possible to achieve some tax savings by utilizing income splitting if you think your business is likely to generate more income than you need for personal use.
• If a corporation is ruled to be a Qualified Personal Service Corporation, its income will be taxed at a flat rate of 35%.

Generally speaking, the reason for forming an LLC is to obtain some protection from unlimited liability. And part of the reason that LLCs have become so popular in recent years is that they generally do a fairly good job of providing such protection.

That said, the limited liability provided by an LLC is not perfect. So it’s essential to determine whether or not the protection afforded by an LLC will be beneficial for your particular situation.

Rather than attempting to explain all the situations in which operating your business as an LLC would protect you, let’s just cover the types of situations in which having an LLC would not protect you from personal liability. It’ll go much faster that way.

Signing Personally for Business Debt

If the owner of an LLC personally signs for a loan for the business, the lender will be able to hold the LLC owner personally liable for payment of the debt, regardless of the fact that the business is an LLC.

Of course, the obvious lesson is to do everything possible to avoid personally signing for a business loan. Unfortunately, if your business is new, it’s very likely that creditors will be unwilling to loan you a large amount of money unless you are willing to be on the hook for it personally.

Liability Resulting from Services Performed by the LLC Owner

Usually, if an owner of an LLC performs a service for a client, the client will be able to hold any of the owners personally liable for any damages caused by the service performed.

EXAMPLE: Karen, Christopher and Kyle are the owners of an LLC. They provide networking services for local businesses. One day while setting up a wireless network at a client’s office, Kyle accidentally causes the client’s network (and self-hosted website) to crash.

Because Kyle is one of the LLC’s owners, the other business would be able to sue Kyle, Karen, or Christopher for the damages resulting from Kyle’s mistake. However, if the person who had made the mistake wasn’t one of the owners, but was simply one of their employees, the client would only be able to sue the LLC for the damages, rather than being able to sue the LLC’s owners directly.

Simple Summary

• If you end up signing personally for a business loan, you’re going to be held personally responsible for its repayment, regardless of the fact that your business is an LLC.
• If an LLC’s owner performs a service that results in a lawsuit, any of the LLC’s owners can be held personally liable.

It’s obvious that before you form a partnership with somebody, you should make sure that he or she is a person you can trust and have confidence in. What’s not necessarily as obvious is exactly how much you must trust this person before forming a partnership actually becomes a good idea.

Unlimited Liability—Even for Each Other!

Generally speaking, every partner in a partnership has unlimited liability for all of the partnership’s debts. [Note: Limited Partnerships, which we’ll be discussing momentarily, work somewhat differently.] It’s very much like a sole proprietor’s unlimited liability but with one crucial difference: You’re now personally responsible for debts of the business, even if you had nothing to do with creating them.

EXAMPLE: Tom and Jennifer run a local newspaper, and their business is organized as a partnership. One week while Jennifer is on vacation, Tom reprints—without permission—an article from another newspaper. The other paper decides to sue for copyright infringement. Even though Jennifer had nothing to do with the legal infraction, the other newspaper can sue her for the entire amount of the debt, should it decide to. Such is the risk of being a partner in a partnership.

Of course, Jennifer would likely be successful if she took Tom to court to sue for the amount that she ended up paying. But she’d still be out the cost of the legal fees, not to mention the hassle involved.

Partners as Agents of the Partnership

Each partner can be held responsible not only for liabilities resulting from a lawsuit, but also for liabilities stemming from a contract signed by only one of the partners. Such a situation is the result of the fact that each partner is what is referred to legally as an agent of the partnership. Each partner (agent) has the legal power to bind the partnership—and thus each of the partners—to a contract.

Fortunately, there are some limitations to a partner’s power as an agent of the partnership. Most importantly, each partner can only act as an agent in affairs that are within the scope of the partnership’s business. For example, if you run a retail store that sells locally grown produce, you don’t have to worry about your partner buying a house under the name of the partnership. Given that the purchase of a house is clearly outside the scope of the business, your partner would have no power as an agent to bind the partnership to the contract.

Limited Partnerships

So far, our discussion of partnerships has been about what are known more precisely as “general partnerships.” In addition to general partnerships, there is another form of partnership known as the “limited partnership.” Generally speaking though, whenever somebody simply uses the term “partnership,” he’s referring to a general partnership.

Limited partnership taxation works the same way as general partnership taxation. The difference between the two structures is that, in a limited partnership, there are two types of partners: General partners and limited partners.

General partners have unlimited liability for the debts of the partnership while limited partners do not. Limited partners (much like shareholders of a corporation) cannot lose an amount greater than their initial investment in the partnership. A limited partnership can have as many or as few of each type of partner as it wants, with the one notable exception that there must be at least one general partner.

One important rule about limited partnerships is that the limited partners cannot participate in managerial decisions or the day-to-day operation of the partnership. If they do, they’ll lose their limited liability. As such, in many limited partnerships, the general partners are the original founders, and the limited partners are outside investors.

In Summary

• In a general partnership (commonly referred to as simply a “partnership”), each partner has unlimited liability for all of the partnership’s debts.
• Each partner, as an agent of the partnership, has the power to bind the partnership to a contract.
• Partners do not, however, have the power to bind the partnership to contracts that are clearly outside the scope of the business.
• In a limited partnership, limited partners have limited liability. They can only lose the amount that they initially invested. General partners in a limited partnership have unlimited liability.
• Limited partnerships can have as many or as few limited partners as they choose, but they must have at least one general partner.