August 2008 Tax Tip
How Should Your Single Member LLC Be Taxed?
As the name suggests, a Limited Liability Company (LLC) limits the liabilities of the members (owners) for the debts of the company. In this respect, it is similar to a corporation. A single member LLC has an option of being taxed as a sole proprietorship, an S Corporation, or a C corporation. Most LLC’s being formed have a single member and are used to operate a business or hold rental property, usually real estate. As relatively few LLC’s find sufficient advantages in being taxed as a C corporation, this discussion covers only the proprietorship and S corporation options.
A single member LLC by default is taxed as a sole proprietorship, meaning if it desires to be taxed as a corporation it must make an election to do so. The member will report the income and deductions of the business directly on Schedule C of his/her individual tax return and be subject to self employment tax on the net earnings, if $400 or more. A separate tax return is not required.
While an S corporation is not a tax paying entity, it must file a tax return reporting the operations of the business. The S corporation basically follows partnership taxation rules, with a few exceptions based upon partnership taxation principles. Its income and deductions pass through to the owners who then report and pay income tax on their individual tax returns.
So what advantages are there in a single member having, by default, an LLC over an S corporation, as the business operations will be reported on his/her individual tax return in either case. Here are some points to consider:
1) Cost/ease to establish the business structure. S-corporations can usually be established as inexpensively as LLCs. LLCs often spend money in attorney fees to develop a proper membership operating agreement (probably not required with a single member LLC). While both structures can be formed by yourself, I would not advise it as there could be potential traps. Remember, upon forming an LLC, you can make the S corporation election. You do not have to form a separate S corporation.
2) Ease of ongoing administration. Corporations are more formal. You'll need to maintain corporate minutes and document corporate actions. An LLC does not have these requirements.
3) Self-Employment/Employment Tax issues. A member who is active in running an LLC must pay self employment tax on his/her earnings. S-corporation owners have the option of paying lower wages and more in distributions. While this can potentially save significant dollars in employment taxes, there is a huge tax exposure. In the past few years, the IRS has been targeting S corporations that pay unreasonably low salaries to its owners in order to avoid the payroll taxes. The consequences can be great as not only will distributions be reclassified as salaries, but penalties can be asserted for non-filing and non-payment of payroll tax returns. This is an area you should definitely seek advice from a competent tax professional
Since payroll tax reduction has traditionally a motivating reason in forming an S corporation, I have been recommending to a large number of my single-member LLC clients to not elect S corporation status and just report the business operations on their personal tax returns. This also saves the cost of having an S corporation return prepared each year, which can outweigh any advantages of having an S corporation.
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