LLCs And Taxation – To Be Or Not To Be (A Corporation)
As I have noted previously (along with numerous other commentators), LLCs are not corporations. Both the basic structure of, and the laws applicable to, each respective entity are significantly different. However, there may be similarities as to the tax structure of LLCs and corporations if the LLC members so elect. A corporation can choose only between a “C” type corporate tax structure (2 levels of tax) or an “S” type corporate tax structure (one level of tax that “flows through” to shareholders). On the other hand, LLCs can choose to be taxed as partnerships, C corporations, S corporations or as a “disregarded entity”.
Taxing an LLC as a Corporation
The “check the box” regulations go together with the Tax Code when making the choice of tax structure. These regulations provide tremendous flexibility to entity owners to choose how their entity will be taxed. If an entity is organized as a corporation, the entity is taxed as a C Corporation, unless it is eligible for and elects to be an S Corporation (the C and the S here merely refer to the applicable subchapter within the Tax Code). All other entities (general partnerships, limited partnerships, LLCs etc.) are taxed as partnerships, unless the entity “checks the box” to be taxed as a C Corporation. In other words, LLCs can choose to be taxed as a corporation while retaining all of the state law provisions associated with an LLC. In addition, an LLC with only one member can choose to be a “disregarded entity” for tax purposes.
Considerations for Tax Classification
In order to make the best choice of tax consequences for an entity, understanding the difference between the tax treatment of partnerships and corporations is critical. Shareholders of C corporations incur what is known as the “double tax”: one layer of tax on the corporation’s annual taxable income (at the corporate income tax rate) and a second layer of tax on the dividends paid to shareholders. S corporations and LLCs taxed as partnerships operate as “pass-throughs,” and thus pay no taxes on any taxable income at the entity level. Any taxable income is “passed through” to the LLC’s members and taxed at the members’ applicable individual rate.
Prior to the 2017 tax reforms, tax classifications were relatively straightforward. The maximum corporate tax rate was 35%, the maximum individual tax rate was 39.6%, and the maximum rate on net capital gains was 20%. As such, C corporation shareholders incurred tax once at 35% on the corporation’s annual income and again at 20% on distributions. Contrarily, LLC members who happened to pay the highest individual rate only paid once at the 39.6% rate. As such, setting self-employment tax issues aside, advising most clients as to their LLC tax classification before the 2017 tax reforms was straightforward—choose to be taxed as a partnership.
The 2017 reforms changed the analysis. First (and most obvious), the maximum corporate rate (now one flat rate) decreased to 21%, while the maximum individual rate decreased to 37%. As such, the corporate form became more compelling as the double-tax burden significantly decreased. The second (and less obvious) change was a new deduction that generally entitled non-corporate entities to a 20% deduction for “qualified business income” from a “qualified trade or business.” With this additional deduction, the case for taxation as a partnership remained compelling.
All of this is to say that the tax classification selection for LLCs is no longer straightforward. Self-employment taxes, the personal financial situation of the members and the interests of the entity all must be considered prior to adopting the entity’s tax classification. Now, more than ever, an understanding of both the myriad of tax considerations and state law considerations are critical to entity selection.
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