This page is one of seven chapters:
Main Page: How to create an LLC
Chapter 1: LLC Answers to Frequently Asked Questions
Chapter 2: LLC Compared to Other Business Structures
Chapter 3: Forming and Managing an LLC, A Comprehensive Guide
Chapter 4: Optimizing Tax Strategies for LLC Pass-Through vs. Corporate Taxation
Chapter 5: How to name your LLC Name Your LLC
Chapter 6: How to write and file an LLC Article of Organization
Chapter 7: How to write an LLC Operating Agreement with Template
Choosing Between Pass-Through and Corporate Taxation: Strategies for LLCs
A significant advantage of establishing an LLC is the “pass-through” taxation. This structure enables LLC proprietors to benefit from the tax perks typically associated with partnerships (or sole proprietorships in the case of a single-member LLC). Business earnings are taxed only once when allocated to each member’s LLC account, regardless of whether the income is actually distributed to them. Members of the LLC then pay individual income taxes on these earnings. This contrasts with the taxation model of corporations where the corporation itself first pays taxes, and then shareholders are taxed again on dividends when profits are distributed. Hence, LLC owners often prefer the pass-through taxation method.
However, there are instances when it may be more beneficial for an LLC to opt for corporate taxation. This is because corporate tax rates can be more favorable on comparatively lower taxable incomes—ranging from 15% to 25% on profits up to approximately $75,000 left in the LLC that chooses corporate tax treatment, in contrast to individual tax rates that can go up to 35%. Some LLCs may decide to retain profits within the company for reasons such as expansion or because profits are invested in inventory, making corporate tax treatment potentially more economical. Nevertheless, the financial advantage of this choice diminishes as profits increase. Profits are subject to higher corporate tax rates of up to 34% on taxable incomes up to $10 million, and even higher rates of 35% and 38% apply to net taxable incomes exceeding $10 million, with a temporary tax rate “bubble” of 39% affecting incomes from $100,001 to $335,000.
Example
Alice and Benjamin manage their own bakery, Sweet Treats Bakery, LLC. Understanding the need to reinvest earnings for new baking equipment and to expand their inventory, they opt for corporate tax status for their business. This year, their sales totaled $1.2 million. After covering all business expenses, including wages and bonuses for staff, Sweet Treats Bakery reports a net taxable profit of $70,000. This profit is taxed at corporate rates—15% on the first $50,000 and 25% on the remaining $20,000. Had Alice and Benjamin not chosen corporate tax treatment for their LLC, this profit would have been transferred to their personal taxes and subjected to their higher individual tax rates.
If you decide that adopting a corporate tax structure is advantageous, where corporate tax rates apply only to profits retained in the business (after paying out salaries and other deductible expenses), you must submit IRS Form 8832 as outlined below. Note, however, that this election only alters the tax treatment and does not affect the legal status of the company, which remains an LLC under state.
Learn more from the IRS concerning LLC filing as a corporation or partnership.
Understanding Pass-Through and Corporate Tax Options
For LLC seeking pass-through tax status: An LLC with multiple members is by default treated as a partnership for federal tax purposes, unless it opts to be taxed as a corporation. This is done by filing IRS Form 8832. Annually, such an LLC must file the same tax forms as a partnership—IRS Form 1065, U.S. Partnership Return of Income. This includes a Schedule K which details the distribution of profits, losses, credits, and deductions among members. Additionally, each member receives a Schedule K-1 from the LLC, outlining their share of profits, losses, credits, and deductions, which they then report on their personal Form 1040 income tax returns.
For single-member LLC that do not elect corporate tax status via IRS Form 8832, the IRS considers the LLC a sole proprietorship. Here, business profits and losses are reported on Schedule C (Profit or Loss From a Business) of the individual owner’s income tax return.
For LLCs seeking corporate tax status: If an LLC opts for corporate tax treatment, it must mark the “corporation” option on IRS Form 8832. The decision becomes effective on the date specified on the form, which must be within 75 days prior to or 12 months after the form’s filing date. New LLC aiming to begin with corporate taxation should file this election within 75 days of submitting their articles of organization to the state. Once made, this corporate tax status generally cannot be changed for 60 months, with certain exceptions, such as a change in ownership of 50% or more.
An LLC taxed as a corporation must file a corporate tax return using IRS Form 1120 each year the election is effective. The LLC pays corporate income tax on retained profits at the rates outlined in the previous section.
Navigating Self-Employment Taxes: Strategic Choices for LLC Members
The issue of whether LLC members must pay federal self-employment taxes on their earnings remains complex. The general rule, subject to certain exceptions, is that profits received by an LLC member who is actively involved in the business are subject to self-employment tax. This tax, currently at 15.3%, is considered excessively high by many involved in setting up LLCs.
Due to these concerns, some business founders opt for forming an S corporation instead of an LLC. The advantage of an S corporation in this context is that its shareholders are only required to pay self-employment taxes on the compensation they receive for their services, not on all profits that are distributed to them. Alternatively, some choose to establish an LLC, then elect corporate tax status for it, and subsequently seek S corporation tax classification, thereby potentially reducing the self-employment tax burden. This strategic approach allows LLC members to potentially lower the amount of earnings subject to the high self-employment tax rate.
State Influence on LLC Legal and Tax Requirements
LLCs are governed by state law, requiring that you organize and operate your LLC according to the specific regulations and provisions set out by your state’s LLC laws, alongside adhering to federal tax rules. The key legal frameworks that influence an LLC’s tax treatment primarily reside within the state’s LLC Act as well as its tax statutes and regulations. These state-specific legal requirements are crucial for the proper legal and tax operation of an LLC, and they play a significant role in defining how an LLC is structured and taxed at the state level. Understanding and complying with both state and federal requirements is essential for managing an LLC’s obligations and benefits effectively.
Deciphering State Tax Classifications for LLCs: Aligning with IRS Guidelines
It’s important not to mix up the possibly outdated state LLC laws with the way your state handles the classification of your LLC for state income tax purposes, provided your state imposes an income tax. The earlier state rules were designed to secure favorable IRS tax treatment for LLCs at a time when the IRS was particular about recognizing LLCs as pass-through entities for federal tax purposes.
So, how does your state classify your LLC for state income tax purposes? It’s likely that it follows the IRS’s lead. To cut through the complexity of technical jargon, the simplest approach is to directly contact your state tax department. You can do this by calling them or, even more conveniently, visiting the tax office’s website as indicated on your state sheet. A straightforward question to ask is: “If my LLC is classified as a partnership, sole proprietorship, or corporation under IRS rules, will the state tax department classify it the same way?” If the answer is “No,” it’s crucial to find out the specific treatment for your LLC or consult with your tax advisor for detailed insights.
Tax Considerations When Forming an LLC: Contributions, Profit Division
As you navigate the process of forming your LLC, it’s crucial to address a couple of key tax-related issues that might arise:
- Tax Liability for Contributions: Members who contribute services or property to initiate the LLC could face specific tax liabilities. It’s important to understand how these contributions are valued and how taxes are assessed on them.
- Division of LLC Profits and Losses: How profits and losses are allocated among LLC members is another critical area. This division directly impacts individual tax liabilities and needs careful consideration during the drafting of the LLC operating agreement, typically outlined in detail in Chapters 5 or 6 of your formation guide.
These issues fall under the umbrella of partnership tax law, inheriting both its complexities and advantages. Given the specialized nature of these topics, they often require focused attention as you develop your LLC’s operating agreement.
Because of the complexity and potential impact of these topics, if your concerns are significant, it may be wise to invest in specialized tax advice. Consider consulting Chapter 8 for guidance and possibly seeking a referral to a partnership tax specialist from your regular LLC legal or tax advisor. This specialized insight can be invaluable in ensuring compliance and optimizing your tax strategy. Learn more from the IRS concerning LLC tax classification.
Funding and Financial Rights in Startup LLCs: Capital Interests and Profit Sharing
To begin, let’s delve into how startup LLCs are typically funded. Much like partners in a partnership, the initial members often make financial contributions to the business. In exchange, each member is granted a percentage of capital interest in the LLC. This capital interest determines the member’s entitlement to the business’s assets if the business were to be liquidated and also sets the relative value of the membership interest if it’s sold before the LLC itself is sold. For instance, if a member holds a 50% capital interest in an LLC that sells for $50,000, that member would receive $25,000—a simplified illustration, but it underscores the fundamental concept.
In addition to gaining a stake in the LLC’s assets upon liquidation, members are also entitled to a share of the profits and losses throughout the life of the LLC. Typically, the division of these profits and losses reflects the members’ capital interests, though sometimes they can be distributed disproportionately. These disproportionate distributions are known as “special allocations” in tax law and come with specific rules that must be adhered to, which are discussed in further detail in subsequent sections.
Example 1
Max and Jenna established Bakery LLC. Both partners provided equal portions of the initial funding. According to their operating agreement, Max and Jenna each hold a 50% capital interest and will equally share 50% of the business’s profits or losses.
Example 2
Max and Jenna set up the same Sweet Delights Bakery LLC, but this time Max provides the cash, while Jenna contributes equally valuable property that the LLC can utilize (an interest in a bakery lease and some baking counters and equipment). Max will work full-time at the bakery, whereas Jenna will only work part-time (and neither will receive a fixed salary). They decide that Max will have a 50% capital interest and will receive 75% of the bakery’s profits (or absorb losses) for the first two years. Jenna will hold a 50% capital interest but will receive 25% of the profits (or losses) during the bakery’s initial two years—after that, both partners will share profits and losses equally at 50-50. Max gets the extra share in recognition of his full-time commitment to the bakery. Notably, the bakery’s operating agreement specifies that Jenna’s capital interest is in exchange for her property contribution, not for her labor (refer to “Contributions of Services” below for details on contributing services to the LLC).
Under most state statutes, members of an LLC have the flexibility to make capital contributions in various forms: cash, property, services, or even a promise to provide any of these in the future. In the discussions that follow in this section, it’s crucial for any member who contributes property or services to consider several key tax implications. These considerations can significantly impact both the immediate tax liabilities and the ongoing financial health of the LLC and its members. Careful attention to these tax considerations is essential to ensure compliance and to optimize the financial outcomes of such contributions.
Cash Contributions and Special Allocations of Profits and Losses
When all members of an LLC contribute cash, the process is straightforward with no special tax consequences to consider. This simplicity allows members to focus on other aspects of LLC management without the complications that can arise from non-cash contributions. For details on how profits and losses might be handled differently, you can move directly to the section on “Special Allocations of Profits and Losses.” This section covers the rules that could affect the financial dealings within your LLC, especially if profits and losses are not divided strictly in proportion to each member’s capital contributions.
Tax Implications for Contributing Services to an LLC
When an individual receives a capital interest in an LLC as compensation for performing services, the IRS treats this arrangement as a payment for personal services rendered. Therefore, if the LLC’s operating agreement stipulates that a member’s capital contribution is in the form of services—often those to be rendered in the future and potentially unpaid—this arrangement requires the member to recognize the value of these services as taxable income. As such, the member must pay personal income tax on the fair market value of the services provided to the LLC. This tax implication is an essential consideration for members contributing services instead of cash or physical assets.
Example
Five Los Angeles bakers establish Sweet Futures Bakery LLC. Four of them contribute $20,000 each, making up 20% capital contributions. Cash-strapped Emily is granted her 20% membership in exchange for agreeing to work at the bakery for six months without pay. The IRS treats this $20,000 capital interest as Emily’s personal income. Consequently, she will be responsible for personal income taxes on the full $20,000, which she needs to estimate and pay throughout the year.
Handling personal service income based on the value of a capital interest in an LLC can be challenging for a service-contributing member, who might have to wait to earn from the LLC before being able to afford the taxes incurred from joining. However, the following alternatives could alleviate this tax liability issue; A profits interest only. A member contributing services can be given an interest in the profits of the LLC without a capital (percentage) interest in the LLC assets. In this scenario, as long as the amount of profits to be distributed to the members is neither clear nor predictable (refer to IRS Revenue Procedure 93-27), income taxes are generally not required until the profits are actually distributed to the member. This arrangement could be more manageable for the member, who would likely have access to some cash around the time when taxes are due.
Example
Harold’s Artisan Breads, Ltd. Co. (HAB), a supplier of premium baking ingredients to bakeries, welcomes Henry Harold (son of the founder, Harold) to assist in managing the LLC. Business is thriving, with HAB providing ingredients to top domestic bakery brands. In exchange for signing a ten-year employment contract, Henry is awarded a 25% share in the LLC’s profits, plus a guaranteed annual salary. Since Henry does not acquire a capital interest in the LLC, he is not subject to upfront taxes based on his commitment to work for HAB.
However, consider the following important points:
- Even if a profits-only interest is granted to a member, taxes may still be due if the interest is sold or transferred within two years from the date it was granted.
- Under the proposed Treasury Regulation 105346-03, dated May 24, 2005, LLCs and their members are required to adhere to specific rules, enter into special agreements, and ensure that special tax elections are made by individuals receiving LLC interests in return for services within 30 days of the interest issuance to secure favorable tax treatment.
- Consult your tax advisor on how to adhere to these and other special rules and requirements before deciding to issue profits or other LLC interests in exchange for services. For more details, refer to Notice 2005-43, “Proposed Revenue Procedure Regarding Partnership Interests Transferred in Connection with the Performance of Services,” available at www.irs.gov (though the notice refers to partnership interests, it is applicable to LLC interests as well).
- A member may obtain a loan from the LLC, another member, or an external source to purchase a capital interest. To secure and define the terms of repayment, the member might need to sign a promissory note specifying repayment conditions, including interest, and may also be required to pledge property as security for the loan repayment.
Example
Mia and Oliver form Delightful Dough Bakery LLC, with plans to operate a bakery and café in Riverside, California. Mia can invest $50,000 in cash and property as her contribution to the new business—sufficient to finance a down payment on a building with surrounding space that can be transformed into a bakery with a café area. Oliver, though short on funds, is brimming with energy that he’ll use to renovate and convert the space. Mia agrees to loan Oliver the money to become a cash member of the LLC upfront. Oliver will receive a capital interest without being taxed on the value of the future services he promises to perform for the LLC. As Oliver earns his salary, he can repay Mia (and he’ll also pay individual income taxes on the salary the LLC pays him).
Another option is for someone to delay joining the LLC until they have the funds to buy in. For instance, an individual could start as an employee of the bakery and, assuming the members agree, buy a capital interest in the LLC with the savings accumulated from their earned salary.
Example
Returning to Delightful Dough Bakery LLC, Mia and her husband, Noah, establish the LLC as the initial members. Oliver patiently waits to buy into the LLC—He doesn’t become a member immediately, but works at the bakery as a regular employee while saving his earnings. Once Oliver has sufficient funds, he buys out Noah’s capital interest in the LLC.
Tax Strategies for Contributing Appreciated Property to an LLC: Benefits and Responsibilities
Tax complexities come into play when a member decides to contribute property to an LLC that has appreciated in value since it was acquired, whether purchased, inherited, or received in another manner. Typically, these contributions involve real property, such as land or buildings, but can also include personal property like collectibles or airplanes.
- The Good News: Contributions of property to an LLC are generally tax-free at the time of the contribution. The tax consequences are deferred until a later event—either when the LLC is sold, or when the member sells their interest in the LLC. This is a distinct advantage of pass-through entities like LLCs and partnerships, which contrast with corporations. In corporations, property transfers are subject to stringent “control tests” to qualify for tax-free treatment.
- The Not-So-Good News: The member who contributes appreciated property must eventually pay taxes on the increase in value that occurred before the transfer. This tax liability arises either when the LLC is sold or when the member sells their LLC interest. The tax basis of the property at the time of its contribution (known as the “income tax basis”) is carried over to the member’s basis in the LLC. As a result, any taxes due on the property’s appreciation are paid later when the member sells their interest in the LLC, not at the time of the contribution.
This mechanism allows for the deferral of tax but does not eliminate it. The timing of the tax liability depends on when the member decides to exit the LLC or when the LLC disposes of the property. This system aims to ease immediate financial burdens but requires careful tax planning to manage future liabilities effectively.
Example
Tom purchased a building for $20,000, which has appreciated to $120,000 by the time he transfers it to his newly established bakery-themed LLC (appreciating by $100,000). Through this property transfer, he secures a $120,000 capital stake in his LLC.
Tom’s original investment in the property is $20,000 (for simplicity, we assume there have been no adjustments to the basis; in reality, this could increase with capital improvements and decrease with depreciation taken on property). Tom incurs no taxes at the time of the transfer, but his basis in the LLC membership is set at $20,000 (matching his basis in the real property at the time of transfer). Assuming no further adjustments to Tom’s basis in his LLC (another unrealistic but convenient assumption), when the LLC is eventually liquidated or sold, or when Tom sells his interest in the LLC, his taxable gain—the amount he will owe taxes on—will be the difference between the sale price of his LLC interest and his basis. For instance, if Tom sells his interest back to the other members for $120,000 (assuming the value of his interest remains the same as when he acquired it), he will need to report a gain of $100,000 and pay taxes on this amount at the time of sale.
There are additional complexities when real property is contributed to an LLC. For instance, different tax considerations arise when real property is encumbered by a mortgage or other debt. Such liabilities must be recorded on the LLC’s books and will influence the gains or losses realized by LLC members both during the operation of the LLC and when the business or membership interests are subsequently sold. The takeaway: Before transferring property to your LLC, consult your tax adviser regarding any potential immediate and deferred tax consequences.
Special Allocations in LLC: IRS Rules for Equitable Profit and Loss Distribution
In an LLC, just like in partnerships, there exists the option for members to diverge from the typical method of dividing profits and losses based on each member’s proportionate capital contribution. Such a deviation is termed a “special allocation.” For instance, it could occur if a member who contributed 10% of the initial LLC cash is allocated a 20% share of the profits and losses.
While special allocations are entirely legal, they are heavily regulated by the IRS. The IRS has established detailed rules to manage these allocations. Essentially, for a special allocation of profits and losses to be recognized and accepted by the IRS, it must have a “substantial economic effect.” This means that the allocation should not be structured merely to reduce the tax liabilities of the owners unfairly. For example, the IRS might challenge a special allocation if it places no real economic burden on a member but allocates all the LLC’s losses to that member—especially if the member has substantial non-LLC income—solely to allow that member to claim a large tax deduction and reduce their personal income tax liabilities.
This rule ensures that special allocations reflect genuine economic arrangements and aren’t used as tools for tax evasion. Any LLC considering such allocations must ensure they are structured to meet IRS standards, maintaining a clear connection to actual economic transactions and member contributions.
Example
Rise and Roll Ventures, LLC, operates as a passive investment entity, channeling investor funds into businesses managed by others. Its key revenue sources are multilevel bakeries located in urban business areas, supplemented by a broad network of automated bakery kiosks at suburban shopping centers. Chris and Jordan have contributed equally and each possesses a 50% capital interest in the business. Chris seeks to claim the majority of the LLC’s deductions for the first two years while he’s in the 35% income tax bracket, and Jordan prefers to be allocated most of the income as he is in a lower tax bracket. Would the IRS object? Possibly, unless the LLC ensures that Chris’s capital account is reduced by his allocated deductions and, conversely, that Jordan’s capital account is increased by his allocated share of LLC income.
If the IRS audits the tax returns of Rise and Roll Ventures, LLC, or its members, and finds the special allocations unacceptable, it might redistribute the income and losses according to each member’s capital interest. Typically, this means income and losses would be reallocated to members based on their respective capital interests.
Understanding IRS Safe Harbor Rules for Special Allocations
The IRS has established a set of complex regulations that guide LLC owners—and more specifically, their tax advisors—on how to adjust their capital accounts to ensure that special allocations are recognized as having substantial economic effect. These regulations, known as “safe harbor” rules, are crucial for LLCs that utilize special allocations of profits and losses.
- Understanding Safe Harbor Rules: Safe harbor rules mandate that an LLC adjust its members’ capital accounts to reflect special allocations accurately. A capital account represents a member’s economic interest in the LLC, indicating what each member would receive upon the liquidation of the LLC. By aligning capital accounts with special allocations, the IRS ensures that these allocations result in actual economic consequences for each member, reinforcing the principle that these are not merely tools for tax avoidance but have legitimate financial impacts.
- Operational Requirements: For an LLC’s special allocations to be deemed as having substantial economic effect, the operating agreement must stipulate that the LLC will maintain and adjust capital accounts in accordance with safe harbor rules. Practically, this involves incorporating specific provisions, often referred to as “704(b) language,” derived from Internal Revenue Code Section 704(b), into the operating agreement. This language is tailored to ensure that the capital accounts are managed in a way that upholds the integrity of the economic transactions within the LLC.
By adhering to these requirements, LLCs can safeguard their special allocations against IRS scrutiny, ensuring that these allocations are recognized as valid under federal tax laws. This not only aids in compliance but also secures the economic foundation of the allocations, making sure they are rooted in the real financial dynamics of the LLC.
Example
Glyphstone Pastries Ltd. Liability Co. is founded by Simon Baker. The business specializes in uniquely shaped pastries, including a popular item called the “Dough-Wedge 2000.” As demand grows, Simon seeks additional funds to upgrade and expand Glyphstone’s production facilities. His friends, Audrey and Leo, have the necessary funds and agree to invest an amount of cash equal to half of the existing capital of the enterprise. However, they insist on receiving a five-year 65% profits interest in the Dough-Wedge 2000, plus a 50% share of net profits from other Glyphstone pastry sales. The LLC consults its tax adviser to incorporate 704(b) language into its operating agreement, which mandates the maintenance of its capital accounts under the safe harbor rules and requires members to restore any deficits in their capital accounts upon the LLC’s liquidation or under other specified conditions, ensuring that its special allocations will be respected by the IRS.
Implementing IRS 704(b) Safe Harbor Provisions in LLC Operating Agreements: Key Requirements for Special Allocations
Adopting 704(b) language in your LLC operating agreement brings significant financial and tax implications, as this is the very purpose of these rules. To comply with the IRS’s safe harbor rules for special allocations, your operating agreement must include a series of detailed provisions. Here are the fundamental points these provisions must cover:
- Maintenance of Capital Accounts: The business’s capital accounts must be established and maintained according to specific rules based on Section 704(b). This ensures that all financial transactions within the LLC are tracked accurately, reflecting each member’s economic contributions and entitlements.
- Liquidation Distributions: Any distributions of cash or property to owners upon the liquidation of the business must align with the capital account balances that are maintained under Section 704(b). This requirement ensures that distributions are fair and proportional to each member’s economic stake in the LLC.
- Restoration of Negative Capital Accounts: When an owner exits, or if the business is sold or liquidated, members with negative capital account balances (which can occur if losses allocated to a member exceed their capital contributions) must restore their balances to zero. This is typically done by contributing cash or property equivalent to their negative balances before exiting the LLC or its liquidation. This rule could potentially make an LLC member personally liable for LLC losses if they have to cover negative balances caused by allocated losses.
Fortunately, safe harbor regulations include an alternative provision, known as a qualified income offset, which can be added to an LLC operating agreement. This provision is designed to help members avoid personal liability when their capital accounts go negative.
Practical Implications: If you intend to make special allocations of profits or losses within your LLC, it’s wise to engage a partnership or LLC tax specialist who can incorporate the necessary technical provisions into your operating agreement. These rules are not only complex and detailed but also crucial for ensuring compliance with IRS regulations.
Given the complexity and the potential liabilities involved, many smaller LLCs may opt not to use special allocations, which is why such provisions are often not included in the operating agreements provided in standard guides or books. If special allocations are essential for your business structure, professional advice is not just recommended; it’s necessary.
