---

Federal Tax Classification and Taxation

Unless an LLC elects to be taxed as a corporation, it will have “pass-through” taxation. It will not pay federal income taxes as an entity, but will pass through its taxable income to its owners (members). Losses of the LLC are also passed through to the members.

The pass-through taxation is the same as sole proprietorships and partnerships and prevents the income of an LLC from being subject to double federal taxation. While the profits (and losses) are often distributed to the members in the same proportion as they membership interests, they are not required to be. If one member makes a substantial contribution to the formation of the LLC, this may be recognized by agreeing to give that member a higher profit distribution than his ownership interest would provide.

Conversely, the members may agree to give a wealthy member a higher percentage of the initial losses of the LLC business to offset income of the member from other sources, thus reducing the taxes the member would otherwise pay on such income.

Like partnerships, the members in an LLC must pay income taxes on their distributive share of the LLC’s taxable income whether or not the member receives the distribution of such profits. If the LLC does not intend to distribute all of the profits on which the members will have to pay income taxes, the members should understand this in advance, or the LLC should consider electing to be taxed like a corporation so that members are taxed only on profits they actually receive.

Self-employment (SE) Taxes

SE taxes warrant a separate discussion because they represent a distinct disadvantage for LLC’s, particularly if a business is considering forming a corporation as an alternative entity. SE taxes consist of Social Security and Medicare taxes and combine for a 15.3% tax on the income received by individuals engaged in business.

SE taxes are paid by sole proprietors and by partners in a partnership. Under current IRS rules, individual members who actively participate in the management of the LLC business must also pay SE taxes on the income they receive. For example, if a member receives $100,000 as his distributive share of profits, he will pay $10,528 in SE taxes in addition to federal and state income taxes. (The SE taxes are less than $15,300 because there is a maximum amount of income that is subject to the 12.4% Social Security portion of the SE tax).

Compare this to an S corporation, for example, which is also a pass-through tax entity. If the same $100,000 is received by a shareholder as a distribution of profits, no SE taxes will be imposed—a savings of $10,528. It is generally not advisable, however, to have all of a shareholder-employees share of profits paid as a distribution of profits. A reasonable salary should be paid. In this example, suppose the salary is $30,000 and the remaining $70,000 is paid as a distribution of profits, In this case, only the $30,000 salary portion is subject to a combined 15.3% tax, which amounts to $4,590. This is still a savings of $5,938 over the SE taxes that would be paid by the owner as a member in an LLC.

For further examples of how an S corporation can save on SE taxes, go to our home page and click on our quick link to “Calculate Your Tax Savings By Incorporating.”

Fringe Benefits

Another important tax consideration for LLC’s is the tax treatment of certain fringe benefits. These commonly include group life, health and disability insurance plans provided by corporations to its employees, including its shareholder-employees. It also may include various retirement plans, such as pension or profit sharing plans made available to employees to defer taxable income.

While there are some limitations and restrictions that apply to S corporation shareholders, in C corporations these fringe benefits are generally tax deductible by the corporation and the value of the benefit is not included in the income of the employee receiving the fringe benefit, including shareholder-employees.

With LLC’s, the payment of fringe benefits, such as health insurance premiums, is generally included in the deemed distribution of income to each member, and is therefore taxable to each member. In short, LLC’s do not enjoy the advantage given to corporations when it comes to the tax treatment of fringe benefits.