The Entrepreneur's Guide to Understanding LLC Frameworks

Could navigating the tax labyrinth of LLCs be the key to safeguarding your assets and ensuring your small business flourishes? That's the golden nugget we're hunting in our Espresso Tax and Small Business Essentials podcast. Join me, Eric Bonney, seasoned CPA and founder of Harvest Tax and Accounting Services, as I share over 28 years of expertise to guide you through the essential tax knowledge every LLC owner needs. From single-member entities to complex partnerships, we dissect the default classifications, tax advantages, potential pitfalls, and the crucial decisions that could shape your business's financial future.

This episode is a treasure trove for both the solo entrepreneur and the multi-member LLC team, as we examine the impact of different tax elections, such as C and S Corporations, on your bottom line. We'll unravel the mysteries of self-employment taxes, reasonable compensation, and distribution protocols. Plus, I'll stress the importance of professional guidance when making these critical tax decisions. Don't miss out on these insights – they could be the difference between a thriving business and a tax nightmare.

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Transcript

Speaker 1: 0:03

Welcome everyone to Espresso Tax and Small Business Essentials, where we are brewing up success for the owner-led entity by providing education on useful tax strategies and other essential business topics. I am your host, eric Bonney, founder of Harvest Tax and Accounting Services and a CPA with over 28 years of experience servicing business owners like yourself. Each week, I will take a look at the most pressing tax issues and business questions that small business owners are facing. Welcome everyone. Today we are going to be talking about limited liability companies, or LLCs, and how they are taxed. A limited liability company is a legal entity that has been registered with your state and typically owners will do this so that they can shield their personal assets and help give themselves a little bit of liability for things that may happen inside the business.

Speaker 1: 0:56

We start every one of our new partner business meetings with the question of how are you taxed, and typically that will be answered in a fashion such as we're an LLC, we're taxed as an LLC. Well, an LLC can be taxed in many ways depending on the number of owners that are in the LLC and elections that you may have made. So it really isn't just as simple as we're taxed as an LLC. So how are LLCs taxed? It depends on the number of owners. Typically, First off, if you are the single owner of an LLC, then that LLC can be taxed either as a disregarded entity or it could be taxed as a C corporation or also as an S corporation. The default classification for a single member, llc, is called a disregarded entity and what this means is that if you are a business, you're going to probably file a Schedule C on a 1040. If it's a rental property, then you're probably going to file a Schedule E, or if you are in farming, then you're probably going to file a Schedule F. While this is the least complicated of all of the methods, it also has a downside of everything that is going to be on. That LLC, from an income standpoint, is going to be subject to self-employment tax if it is an active business, which means that the business owner is going to pay an extra 15% tax and that may or may not be the best option for them.

Speaker 1: 2:27

The member could decide to file a Form 8832 and elect to be taxed as a C-Corporation, so the C-Corporation. One of the biggest downsides to that is double taxation. There's going to be a flat 21% tax that is going to be paid by the corporation itself, but then you're also, as owners, are going to be taxed on any wages that you take out of that business and you're going to be taxed on any dividends that you may take out of the business. One main benefit of a C corporation is that there is no limitation to the number of shareholders in a C corporation. Also, there's no limit as to who can be an owner of a C corporation, and many times C corporations will be used as an LLC for those individuals that are looking to take their entity and get a lot of funding or looking to take that entity public. Another option is that you could file Form 2553 to make the tax election to be taxed as an S-Corporation. Now, this must be done, usually within the first 75 days of the taxable year. If you don't get it in within the first 75 days, there are some late filing provisions that you can do. If you're looking at something like that, I highly encourage you to talk to your tax professional. If you're looking at something like that, I highly encourage you to talk to your tax professional.

Speaker 1: 3:53

Biggest benefit to being taxed as an S-corporation is that you are no longer going to be subject to the self-employment tax for any income that flows through to you individually. Again, there's going to be some downsides and drawbacks to this. There's going to be a separate entity that needs to be filed and that tax return is going to be an 1120S. All active members in the LLC will need to be paid a reasonable compensation. So now you have payroll issues and any distributions to the owners must be done in a pro rata basis. What I mean by that is is that if you've got two members that are 60-40 owners and you're going to take money out of the business, then that money has to be divvied up in that 60-40 percentage. So additional complications for a S-corporation are again all active members must have a reasonable compensation.

Speaker 1: 4:48

You also have a limited number of members that can be a shareholder in an S-Corporation. Typically, you are limited to a total of 100 owners. Most of our partners don't have to worry about that, but it is something that you need to be aware of. Also, most of the members that are inside an S-Corporation must be US residents or have a permanent residence here in the US. The other big issue with an S-Corporation is that you are limited to only one class of stock. Now you can have voting and non-voting stock. But what they mean by one class of stock is that you cannot have something like you can in a C-Corporation, where you can have a preferred stock or a common stock, where one owner of the LLC has preferential treatment in getting money from the business, and we discussed earlier already about how the distributions must be in a fashion similar to the ownership of the LLC.

Speaker 1: 5:56

Now what happens if we have multiple members in an LLC? If we have multiple members in an LLC, then the default classification is going to be a partnership that again is going to file a separate entity return. Separate entity return. That is going to be a form 1065 and all active members inside that entity are going to also still be subject to self-employment tax, so they're still going to most likely pay an additional 15% tax. It does offer a little bit of flexibility when you are going to be taking money out of the business and, again using our example from earlier, if you've got two partners that are 60-40 owners, if one person wants to take money out of the business, generally speaking they can take that money and the other partner does not need to take that money. They could still file that form 8832 and decide that they want the entity to be taxed as a C corporation Again has all the same benefits and downsides that we discussed earlier flat tax of 21%, but still have the double taxation. And then, finally, they could still also file the Form 2553 to decide that they want to be taxed as an S corporation Again all the same benefits and downsides, again.

Speaker 1: 7:14

At that same issue of you need to make sure that your distributions are in accordance to your ownership and active members still need to be on a reasonable compensation. So if you're looking at an LLC and you're looking to decide whether or not you want to make an election, I highly encourage you to have a conversation with your tax professional about what is going to be the best tax benefit for you in your specific circumstances. Thank you for joining me today for this episode of Espresso Tax and Small Business Essentials. Don't forget to sign up for our monthly newsletter and if you have a specific topic that you would like to hear me cover here on the show, please send me an email at espressotax at harvestcpafirmcom. There are links in the show notes for both the monthly newsletter and how to request a topic.