How are LLCs Taxed in 2020?

How are LLCs Taxed in 2020?


What’s up guys Taylor Mathis here, the KEYTLaw
girl, marketing director, and legal assistant at KEYTLaw, today I’m going to explain to
you all 4 ways LLCs can be taxed. And before I forget like and comment on this
video if you thought it was useful and be sure to subscribe to our channel to check
out more videos! We upload new content every week to assist
with your legal needs. And one other quick tip! All of the forms mentioned this video are
linked in the show more section below the video! So, one of the advantages to forming an LLC
is that it allows maximum flexibility for choosing a method of federal taxation. So, for example, if an individual formed a
limited partnership, the limited partnership must be taxed as a partnership. Whereas, an individual who forms a corporation
must be taxed as either a C Corporation or S Corporation. But the person who forms an LLC, can choose
their federal tax option. You can elect to be taxed as a partnership,
a C Corporation, S Corporation, or a sole proprietorship. So Here are 4 ways your LLC can be taxed and
some of the pros and cons to each. The First way: Sole Proprietorship Method
A sole proprietorship is the default classification for a single member LLC. Only a single member LLC may be taxed as a
sole proprietorship. A sole proprietorship doesn’t have to file
any separate tax returns and is a disregarded entity for federal income tax purposes. The member of the LLC reports all the economic
activity of the LLC on their personal income tax return on Schedule C. The taxpayer then
pays any tax associated with the LLC on their personal income tax return. A major advantage to having an LLC taxed as
a sole proprietorship is the ease of reporting the income or loss of the LLC. And with sole proprietorship you don’t need
to file an additional tax return unlike the rest. This is a big advantage because the LLC doesn’t
have to prepare a balance sheet and other schedules which may be required on the tax
returns for the other methods. This allows many small business owners to
focus more time and money on their business, rather, than having to pay an accountant or
prepare the additional tax forms themselves. But there are two major cons to sole proprietorship. The first disadvantage is that taxpayer’s
who file Schedule C tend to get audited at a higher rate than taxpayers who don’t. This means members must be especially diligent
in maintaining documentation supporting any deductions they claim associated with the
LLC, so keeping receipts and other supporting items for at least 3 years after the return
has been filed. If the member fails to do this, the IRS may
disallow many deductions during an audit and the taxpayer may be faced with a substantial
tax bill. The second major disadvantage associated with
sole proprietorship taxation is that the member must pay self-employment tax. An employee pays 6.2% for social security
on the first $106,800 of wages and 1.45% for Medicare on all wages. Self-employment tax is similar to payroll
taxes paid by employees. The key difference is that the member of the
LLC must also pay the employer’s portion of social security and Medicare. Generally, self-employment tax is calculated
by taking the sole proprietor’s net earnings from self-employment which includes any allowable
business deductions. The LLC member pays 12.4% for social security
on the first $106,800 of net self-employment earnings and 2.9% for Medicare on all net
self-employment earnings. With self-employment tax, the member must
pay both the employee and employers share of the payroll taxes on self-employment income. So, they are paying double the amount of payroll
taxes they would have to pay if they were an employee. But, the member does receive a tax deduction
for one half of the self-employment taxes paid for the tax year. So, the next way is the C-Corporation Method
So, the default classification for a LLC will never be a C-Corporation. Therefore, the LLC must file Form 8832 to
elect to be taxed as a C-Corporation. This form can be filed any time after the
LLC has been formed, but the time the LLC will begin to be taxed as a C-Corporation
can’t be more than 75 days before the date of filing with the IRS. A C-Corporation is considered a separate entity
for federal tax apart from its shareholders. The C-Corporation must file its own tax return
and pay whatever tax is owed. The C-Corporation files a Form 1120. This is becoming increasingly less relevant
as an effective method of paying reduced taxes, because individual income tax rates have dropped. The decrease in individual income tax rates
has brought the individual rates roughly equal to the corporate tax rates. Because the rates are now roughly equal which
prevents shareholders from using the C Corporation to shelter income, more people use partnerships
or S-Corporations to take advantage of the tax saving opportunities that those two forms
offer over the C-Corporation. The major problem with the C-Corporation is
the concept of “double taxation.” The government taxes corporate earnings as
the corporation earns the income and taxes the earnings again when the corporation distributes
the money to shareholders. A shareholder of a C-Corporation might try
to avoid paying taxes on dividends by not making any dividend distributions and keeping
all earnings within the C-Corporation. To prevent people from utilizing this strategy,
Congress enacted the accumulated earnings tax (“AET”). The AET gives the IRS the ability to assess
taxes against a C-Corporation for failing to pay dividends to their shareholders. If the IRS believes a corporation has accumulated
excess earnings, it can assess this penalty tax against the corporation. The tax rate of the penalty coincides with
the tax rate shareholders pay on dividends. Another disadvantage of C-Corporation taxation,
is that capital gains aren’t subject to a preferential rate. Most individuals receive the benefit of paying
a lower rate on capital gain income. Capital gain income is typically the income
associated with selling stocks, bonds, or from other capital assets. With a C-Corporation, capital gain income
will be taxed at whatever the corporate tax rate is. Compared to an S Corporation or Partnership
whose capital gain income would flow through to the individual where it would be subject
to the special rate. So capital losses would be kept inside the
C-Corporation and could only be utilized by the corporation; whereas, with the S Corporation
or Partnership, the capital losses could be used to offset any capital gains the individual
taxpayer might have. Third way S Corporation Method
So, S-Corporations are a pass-through entity taxed under subchapter S of the Internal Revenue
Code. A pass-through entity does not pay tax; rather,
the S-Corporation passes earnings and losses through to the shareholders. The shareholders then report the earnings
or losses of the S-Corporation on their personal income tax return. There are a few unusual situations under which
a S-Corporation might pay tax. One situation occurs when converting a C-Corporation
into an S-Corporation. If you have a LLC taxed as a C-Corporation
and want to change the method of taxation to a S-Corporation, then any assets of the
C-Corporation which have appreciated in value could be subject to the built-in gains tax. So, a LLC must elect to be taxed as an S-Corporation. This is done by filing a Form 2553. And The filing of the form is time sensitive. See the instructions to Form 2553 linked in
the video description. In order to be eligible for S-Corp taxation,
the members of the LLC must meet certain eligibility requirements. The limited liability company must be a domestic
LLC meaning it is formed within the United States. The LLC cannot have any members who are partnerships,
corporations, or non-resident aliens. Also, certain types of trusts may not be members
of the LLC. The LLC can’t have more than 100 members. and certain types of businesses such as financial
institutions, insurance companies, and domestic international sales corporations are prohibited
from being taxed as a S-Corporations. Keep in mind the that the prohibitions against
different types of LLC members are very important. If the LLC admits a new member, who is of
the prohibited type or another member disposes of their interest to a prohibited type of
member, the S-election will be terminated leading to major tax consequences. The S Corporation does offers many tax benefits. S-Corporations don’t suffer the sting of
double taxation associated with C-Corporations, because the S-Corporation passes through all
the economic activity to the shareholders. Shareholders, generally, don’t have to pay
tax on distributions they receive from the S-Corporation unless the distribution exceeds
their stock basis in the S-Corporation. Owners of entities taxed as S-Corporations
calculate their stock or membership interest basis using this formula. The owner adds any contributions of either
cash or property which the owner made to the S-Corporation and deducts any distributions
that the owner receives from the entity. at the end of the tax year if the entity made
a net profit, the owner would add the owner’s share of the entity’s profits to the owner’s
stock or membership interest basis. But if at the end of the year the entity has
a net loss, the owner will decrease the owner’s stock membership interest basis by the amount
of the net loss. So, its Contributions of Money/Property +
Corporate Earnings – Distributions of Money/Property – Corporate Losses equals Stock or Membership
Interest Basis The ability of an owner of an entity taxed
as an S-Corporation to deduct losses on the owner’s personal income tax return depends
upon the owner’s stock / membership interest basis. An owner may only deduct a loss to the extent
of the owner’s stock / membership interest basis. For instance, assume the entity taxed as an
S-Corporation has a $100 net loss for the year, and the owner has stock / membership
interest basis of $50 at year end. The owner can deduct $50 of the loss on the
owner’s personal income tax return. The remaining loss is suspended and may be
deducted when the owner has sufficient basis in their stock / membership interest to take
the loss. Entities taxed as S-Corporations can minimize
the sting of the self-employment tax. An owner of an entity taxed as an S-Corporation
can be treated as an employee. The entity pays the owner a reasonable salary
for the services which the owner performs on for the entity. The entity pays the payroll taxes with respect
to the owner’s wages. The entity may deduct the owner’s wages
and corresponding payroll taxes associated with those wages in computing the entity’s
net income. The owner reports the wages as ordinary income
on the owner’s personal tax return. The owner may also report the owner’s share
of the entity’s net profits on the owner’s personal income tax return. However, the owner does not have to pay any
self-employment taxes on the entity’s profits. Under the sole proprietorship method of federal
income taxation, all the net profits are subject to the self-employment tax. One key difference between the S-Corporation
and partnership methods of taxation concerns the allocation of profits and losses. With a partnership, the partners can choose
to allocate income and losses any way they choose if those allocations comport with “substantial
economic effect” requirements of Internal Revenue Code Section 704(b). The entity taxed as an S-Corporation must
allocate all profits and losses pro-rata based on the owner’s ownership interest in the
entity. If there were two shareholders of an entity
taxed as an S-Corporation with owner A owning 10% and owner B owning 90%, owner B must be
allocated 90% of any profit and loss, and owner A must be allocated the remaining 10%. Further, distributions made by the entity
to the owners must be made pro-rata. If the entity fails to follow these rules
regarding profit and loss allocations and distributions, then the IRS can terminate
the entity’s Selection. Way 4 Partnership Method of Federal Income
Taxation The other way an LLC can be taxed is as a
partnership. The IRS default classification for a multi-member
LLC is partnership taxation. A LLC with only husband and wife as members
may elect to have the LLC treated as a partnership all they have to do is file the Form 8832
. The partnership must file a tax return on Form 1065. The return is only for informational purposes. The partnership is like the S-Corporation
method of income taxation in that the entity is considered a pass-through entity. The owners of an entity taxed as a partnership
must report all the economic activity of the entity on the owner’s personal income tax
returns. Owners have a tax basis in their partnership
/ membership interest, but partnership basis rules are much more complex than the basis
rules that apply to entities taxed as S-Corporations and are beyond the scope of this article. Entities taxed as partnerships, unlike entities
taxed as S-Corporations, can specially allocate income and losses to the owners. However, the Internal Revenue Code requires
that allocations of income and losses must have substantial economic effect. The IRS briefly summarizes substantial economic
effect as: If the IRS does not view the entity’s allocations
of profits and losses as having substantial economic effect, then the IRS will reallocate
the items based on the owner’s percentage interest in the entity. Thus, an owner of an entity taxed as a partnership
cannot receive wages for services performed on behalf of the entity. The amount of money the owner would have received
in wages is treated as a guaranteed payment. The guaranteed payment will be subject to
self-employment taxes on the owner’s individual tax return. The self-employment tax issue has created
controversy within the context of LLCs taxed as partnerships. Before the advent of the LLC, the general
rule was that limited partners of limited partnerships didn’t have to pay self-employment
tax on their distributive share of partnership income, but general partners were required
to pay self-employment tax on their distributive share of partnership income. Because the legal structure of the LLC differs
from that of partnership, the rule is not easy to apply to LLCs. An LLC doesn’t have the equivalent of a
general partner. Members of a LLC all have limited liability,
so it appears it would be easy to apply the limited partner rule to the LLC. The IRS has taken a different position examining
the facts and circumstances surrounding each situation to determine whether LLC members
must pay self-employment tax. So, for example if the LLC is manager-managed
and the member doesn’t serve in the role as a manager, then the member probably wouldn’t
have to pay self-employment tax. So, the bottom line is that you should consult
with your tax adviser to determine the correct reporting requirements for your situation. Entities taxed as a partnership are not subject
to the double taxation problem that plaques entities taxed as C-Corporations. But one of the drawbacks of the partnership
method of taxation is that the reporting requirements can be much more complex than that of the
other entities. The instructions to Form 1065 alone estimate
that one should spend 35 hours on keeping and maintaining partnership records, 24 hours
on learning about the law and form, 35 hours preparing the form, and 3 hours copying and
assembling the form to send to the IRS. That’s 97 hours spent on completing your
partnership informational tax return. The LLC offers its owners the most flexibility
and choice (the four methods described above) as to the type of federal income taxation
that will be best for the owners’ situation. The good news is that when you form an LLC,
you have 75 days to consult with your tax advisor, determine which of the four tax methods
is best for your company and make an election to change the default method of income taxation
by filing either an IRS Form 8832 to elect to be taxed as a C -Corporation or an IRS
Form 2553 to be taxed as an S-Corporation. All the forms talked about in this video are
in the description below! So hopefully you guys found that helpful! The four different ways your LLC can be taxed
along with some of the benefits and downfalls to each. Be sure to like this video and comment with
any questions you have, also subscribe to our channel for more videos!

24 Comments

  1. KEYTLaw says:

    What method are you using or will you use to tax your LLC?

  2. scott11219 says:

    Nice job Taylor!

  3. Kelvin Roberts says:

    Good stuff

  4. Rooskie 73 says:

    Great video, and key information!

  5. Daniel Arbuckle says:

    I'd like to see a video on what would be suggested for a 50/50 married couple LLC

  6. Samuel Mariano says:

    Hey interesting video great information

  7. Andy Branco says:

    👌🏼

  8. Bobby Kurzweg says:

    Thanks for the info Taylor!

  9. ImplantedAgenda says:

    so how do i set up a corporation that benefits my abroad?

  10. ponca ok says:

    Oh yes good video I watched it several times thanks for they clarity

  11. Transcendence Media LLC says:

    Good info… but please use a lav, lapel mic, or desktop microphone… the audio quality for your voice is quite repelling.

  12. Gerald says:

    Girl…

  13. PandaBase says:

    I clicked this link cuz I love ur dog

  14. Joe Clyburn says:

    Chicagoan? Thanks for the info.

  15. Bill Zebub says:

    Thanks for the free advice. If I start an LLC as single-member and I get an EIN # for bank and other reasons, do I file a separate tax return for the EIN? Also, can I start an LLC with members who will get not voting rights until after my death? They'd then have voting and can elect a leader and assign roles, but until then the will be dormant. Of course, I don't expect you to answer this for free here, but these questions might make for good videos in the future. Or am I an outlier? ha ha

  16. Mind of masters says:

    Beautiful an smart 😎

  17. [T]urboTax Support Phone Number says:

    Good

  18. version2media says:

    so if host 2 events per year (as a single member llc) january & july. i file all expenses/reports/taxes once "at the end of the year" , ….i do not file quarterlies, correct?

    i do not file quarterlies ever as single member llc correct? — sorry just trying to be 100% sure, this was always my big question/reason holding me back

    i'll have a 6 month gap without no income // 10 overall months without business income.

  19. Aarif Mansuri says:

    Great information style

  20. Aarif Mansuri says:

    I want a open a componey LLC in Atlanta USA. I will come USA after next month but before come want a form a componey.
    I have valid visa till 2027.
    Please assist me with your fees.
    Arif : +919879216040
    Thank you

  21. Rain Atlanta says:

    Direct, straight to the point, and easy to understand.

  22. bangarang74 says:

    I can't do the bratwurst and cheese accent.

  23. Bubba Ole says:

    Maam, I so glad I ran unto your video before filing the EIN application. Thank you very much! God bless!

  24. Tiffany Shurrii says:

    I need your help!
    When applying for my EIN number it asks for “Legal Name Of LLC (must match articles of organization, of filed)” I have filed all the paper work but I was told since I am a single member LLC and filing as a sole proprietor not to put my business name but instead out my First and Last Name instead… is that correct? Also because i am operating my business online do I click the option retail or other?

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