Limited liability companies (LLCs) are a popular choice of entity for small businesses and investment activities.
Reason. LLCs have legal and federal income tax advantages that we will explain here.
LLC owners are called members.
Single-member LLCs have one owner, although spouses who jointly own an LLC in a community property state can elect treatment as a single member LLC for federal income tax purposes.
We will call LLCs with two or more members multimember LLCs.
Key point: LLCs are not corporations. But LLCs can offer similar legal protection to their members (owners).
Here are the most important things to know about LLCs.
LLCs Offer Legal Protection
Using an LLC to conduct a business or investment activity generally protects your personal assets from LLC-related liabilities—similar to the legal protection offered by a corporation.
As you know, liabilities can arise from simple things—like the Federal Express guy slipping on the banana peel someone left on your front steps—or in seemingly endless and complicated ways if you have employees.
Key point. As a general rule, no type of entity (including an LLC) will protect your personal assets from exposure to liabilities related to your own professional malpractice or your own tortious acts.
Tortious acts are wrongful deeds other than by breach of contract—such as negligent operation of a motor vehicle resulting in property damage or injuries. The issue of liability protection offered by an LLC is a matter of state law. Seek advice from a competent business attorney for details.
Single-Member LLC Tax Basics
Single-member LLC businesses owned by individuals are treated as sole proprietorships for federal income tax purposes unless you elect to treat the single-member LLC as a corporation.
In other words, the default federal income tax treatment for a single-member LLC business is sole proprietorship status.1 Under the default treatment, you simply report all the single-member LLC’s income and expenses on Schedule C of your Form 1040.
If the single-member LLC business activity generates net self-employment income, you will report that on Schedule SE of your Form 1040.
Rental. If the single-member LLC activity is a rental activity, you report the rental income and expenses on Schedule E of your Form 1040.
Farm or ranch. You report the numbers for a farming or ranching activity on Schedule F.
Simple. You don’t need to file a separate federal income tax return for the single-member LLC. And other things being equal, simple is good.
Three key points
1. The big federal income tax advantage of operating as a single-member LLC is extreme simplicity.
2. The big non-tax advantage is liability protection, under applicable state law.
3. As mentioned, you can elect to treat a single-member LLC as a corporation for federal income tax purposes, but we don’t recommend that, for reasons we explain later.
Multimember LLC Tax Basics
Multimember LLCs are treated as partnerships for federal income tax purposes unless you elect to treat the LLC as a corporation.
In other words, the default federal income tax treatment of a multimember LLC is partnership status. Under the default treatment, you must file an annual partnership federal income tax return on Form 1065.
From the Form 1065 partnership return, the LLC issues an annual Schedule K-1 to each member to report that member’s share of the LLC’s income and expenses. The member then takes those taxable and deductible amounts into account on the member’s own return (Form 1040 for a member who is an individual).
The LLC itself does not pay federal income tax. This arrangement is called pass-through taxation, because the income and expenses from the LLC’s operations are passed through to the members who then take them into account on their own returns. (The same pass-through taxation concept applies to entities set up as “regular” partnerships under applicable state law.)
Partnership Taxation Advantages for Multimember LLCs
Before the Tax Cuts and Jobs Act (TCJA), multimember LLCs treated as partnerships for federal income tax purposes were often the preferred choice of entity for business and investment activities with more than one owner—mainly because of the favorable federal income tax treatment of partnerships and partners.
Those favorable partnership taxation rules are still around after the TCJA, so let’s review how they work for an LLC treated as a partnership for tax purposes and for the LLC’s individual members, who are treated as partners for federal income tax purposes. Here goes.
Pass-Through Taxation
As explained earlier, your share of the LLC’s taxable income, gains, deductions, losses, and credits are passed through to your personal Form 1040 under the partnership taxation rules, with the resulting federal income tax consequences at your personal level.
Deduct LLC Losses on Form 1040 (within Limits)
You can deduct LLC losses passed through to you on your personal return, subject to various federal income tax limitations. The limitations can include
the passive loss rules,
the at-risk rules,
the excess business loss disallowance rule, and
the LLC membership interest basis limitation rule.
Qualified Business Income Deduction
Thanks to the TCJA, the qualified business income (QBI) deduction is potentially available to individual LLC members for 2018-2025. The deduction can be up to 20 percent of QBI passed through to you from an LLC.3 At higher income levels, hurdles and limitations apply. The Section 199A QBI deduction will expire at the end of 2025 unless Congress extends it.
Basis from LLC Debts
Under the partnership taxation rules, you receive additional tax basis from your share of LLC liabilities for purposes of determining the amount of passed-through LLC losses you can deduct. This is a significant tax advantage. It allows you to deduct passed-through LLC losses in excess of your investment in the LLC membership (ownership) interest—subject to various federal income tax limitations.
Basis Step-up for Purchased LLC Interest
If you purchase an LLC membership (ownership) interest from another member (owner), you can step up the tax basis of your share of LLC assets to fair market value, under the partnership taxation rules. The basis step-up minimizes taxes for you when the LLC later sells appreciated assets or converts them to cash.
Tax-Free Transactions with the LLC
The partnership taxation rules give you much greater flexibility to make tax-free transfers of assets (including cash) between you and the LLC, compared to operating as an S or C corporation.
Special Tax Allocations
Thanks to the partnership taxation rules, LLCs can make special (disproportionate) allocations of taxable income, tax deductions, and tax losses among the members.
For example, a 50 percent high-tax-bracket member (you) could be allocated 80 percent of the LLC’s depreciation deductions while the 50 percent low-tax-bracket member (the other guy) is allocated only 20 percent of the LLC’s depreciation deductions. Later on, the high-bracket member (you) could be allocated more of the LLC’s income and gains to compensate for the earlier special allocations of depreciation deductions.
Partnership Taxation Disadvantages for Multimember LLCs
Partnership taxation is not all good news. Keep the following two important tax disadvantages in mind when evaluating the wisdom of operating as a multimember LLC that will be treated as a partnership for tax purposes.
1. Exposure to Self-Employment Tax
You may owe self-employment tax—consisting of the 12.4 percent Social Security tax component and the 2.9 percent Medicare tax component—on most or all of the income passed through to you by an LLC.
At higher income levels, you may also owe the 0.9 percent additional Medicare tax. In contrast, if you operate as an S or C corporation, Social Security and Medicare taxes (FICA tax) are owed only on amounts paid out as salary to you and the other members (owners). This factor favors operating as a corporation, and it can be an important factor.
2. Unfavorable Fringe Benefit Tax Rules
Compared to C corporations, multimember LLCs treated as partnerships for tax purposes cannot provide as many tax-free fringe benefits to their members (owners). This factor favors operating as a C corporation, but it’s usually not a terribly important factor.
For instance, say your multimember LLC treated as a partnership for tax purposes pays health insurance premiums for you and the other members (treated as partners for tax purposes), for services rendered to the LLC. The LLC treats the premiums as deductible guaranteed payments made to you and the other members.
In turn, you and the other members must report the insurance-generated guaranteed payment as income on Form 1040. Usually, you can then write off the insurance amount on your Form 1040 as a self-employed health insurance deduction.
Because the guaranteed payment income and the self-employed health insurance deduction offset each other, you get no net fringe benefit write-off. In contrast, if you operate as a C corporation, the corporation can deduct the cost of health insurance coverage provided to employee-shareholders, and the coverage is a tax-free fringe benefit for the employee-shareholders.
Key point. The unfavorable partnership fringe benefit taxation rules that apply to multimember LLCs treated as partnerships for tax purposes and their members also apply to S corporations and their shareholder-employees. Strange but true!
C Corporation Option Deserves Consideration
The TCJA permanently installed a flat 21 percent corporate federal income tax rate for tax years beginning in 2018 and beyond.
Before the TCJA, the conventional wisdom was that, for tax reasons, most small business activities should be conducted using a
sole proprietorship,
single-member LLC treated as a sole proprietorship for tax purposes, or
pass-through entity (multimember LLC treated as a partnership for tax purposes, a partnership, or an S corporation).
These choice-of-entity options were attractive mainly because (1) they avoided the pre-TCJA 35 percent federal income tax rate paid by profitable C corporations and (2) they avoided (and still avoid) the double taxation issue that still afflicts C corporations even after the TCJA.
That was then. This is now. In the post-TCJA world, we must compare the flat 21 percent corporate federal income tax rate with the federal income tax rates that individuals pay on income from a single-member LLC treated as a sole proprietorship for tax purposes or income passed through from a multimember LLC treated as a partnership for tax purposes.
For 2020, the maximum individual rate is 37 percent, but it’s scheduled to increase to 39.6 percent after 2025. Obviously, 21 percent is a much lower rate than 37 percent or 39.6 percent. But consider the following potential negatives of C corporation status.
Double taxation. The C corporation double taxation issue still exists, although it has been toned down by the flat 21 percent corporate federal income tax rate.
Double taxation occurs when a C corporation is taxed once on its income at the corporate level and again at the shareholder level when shareholders receive taxable dividends paid out by the corporation.
But double taxation is not an issue for a C corporation that retains all or almost all of its profits to finance growth. Double taxation is also not an issue for a C corporation that pays out all or almost all of its income to shareholder-employees in the form of deductible salaries and fringe benefits.
No QBI deduction. A C corporation shareholder cannot claim the QBI deduction based on the corporation’s income. That said, the QBI deduction is scheduled to disappear after 2025, if it does not disappear sooner.
Losses. If a primary tax goal is deducting losses from your venture on your personal return, operating as a C corporation is a bad idea, because C corporation losses cannot be passed through to the shareholders.
Appreciating assets. As in the past, it’s generally still a bad idea to hold valuable assets that are likely to appreciate (such as real estate and intangibles) in a C corporation. If the assets are eventually sold for substantial gains, it may be impossible to get the profits out of the corporation without double taxation.
In contrast, gains from selling assets held by an LLC treated as a partnership for tax purposes will be taxed only once at the member (owner) level.
Electing to Treat the LLC as a Corporation for Tax Purposes
As stated at the beginning of this article, you have the option of electing to treat a single-member LLC or multimember LLC as a corporation for federal income tax purposes. You do that by filing IRS Form 8832, Entity Classification Election, to change the default classification of the single-member LLC or multimember LLC to the new classification as a corporation.
If your desire is to have your LLC treated as an S corporation, it can elect S corporation status directly using IRS Form 2553, or it can elect C corporation treatment on Form 8832 and then S corporation treatment on IRS Form 2553.
While there may be valid non-tax reasons for electing to treat an LLC as a corporation, we think tax reasons generally dictate against taking that step.
If you conclude that there are tax advantages to electing corporate status, why not just actually incorporate your operation in the first place? That’s simpler. Keeping your tax matters simple is generally good policy.
Electing corporate status from the LLC could have unintended tax consequences. For example, you can potentially collect federal-income-tax-free gains from selling stock in a qualified small business corporation (QSBC). But you must own shares and hold them for over five years to cash in on this super-favorable deal. Can an LLC membership (ownership) interest count as QSBC stock for this purpose? Apparently not. It’s not stock.
If you are looking for the QSBC stock break, just set up as a corporation in the first place.
Here’s another example: a special federal income tax break allows you to annually deduct up to $50,000 of losses from selling eligible small business stock, or $100,000 if you’re a married joint filer, and treat the loss as a tax-favored ordinary loss instead of a tax-disfavored capital loss.
Can an LLC membership interest count as eligible stock for this purpose? Apparently not. It’s not stock. Avoid the problem—set up as a corporation in the first place.
Don’t Overlook State-Specific Factors
Sometimes the choice-of-entity question is decided based on state-specific issues. If we live in different states, what works for thee might not work for me. Do your homework to understand all the state legal and tax consequences for making a final decision about whether to operate as an LLC.
Key point. Under some state laws and/or applicable professional standards (such as state bar association rules), LLCs may be prohibited from operating certain types of professional practices.
Takeaways
Single-member LLCs offer liability protection plus super-simple federal income tax treatment.
Multimember LLCs taxed as partnerships offer liability protection and might be preferred for tax reasons, particularly if you desire to use special allocations of income and expenses.
When compared with the C corporation, the LLC offers the possible advantage of the Section 199A deduction.
But don’t use the LLC if you plan to operate as a C corporation, because you would not qualify for favorable Section 1244 stock losses or Section 1202 tax-favored capital gains. If the goal is the C corporation, start with the C corporation.
The big downside to the LLC is the self-employment tax. It’s something you have to weigh against the advantages you gain with the LLC.