Why Your LLC May Want To Be Double-Taxed
As attorneys for many new ventures, our determination for the type of entity is
usually brief. Between the additional bookkeeping, statutory requirements, and
double taxation inherent with C-corps, most new ventures are best suited as limited liability companies. With significantly more flexibility in their operational structure, easier compliance with state regulators, and no tax at the corporate level, LLC’s are easier (and thus cheaper) to structure and manage than corporations. The additional bonus – not paying tax on corporate profits – kicks in when the LLC elects to be taxed as a partnership, so profits flow through the entity to the partners, leading to only one level of taxation, as opposed to corporations, which tax both the business on their profits, and the shareholders on their dividends – double taxation.
This seems ideal – no corporate tax and easier setup. However, depending on the nature of your business, particularly given the corporate rates in the new tax code, there may be reason to classify your LLC as an S-Corp, or even elect for C-Corp double taxation.
Available to both LLC’s and Corporations, a S-Corp election also provides the benefit of pass-through taxation while also allowing business owners to minimize self- employment tax. When the owner of an LLC is also an employee, they are responsible for paying self-employment taxes on any compensation received from the Company, including distributions paid to yourself and other owners of the business. While the non-employed owners are not subject to self-employment tax, the business owner is, even if the distribution is related to investment, not employment.
By electing for an S-Corp treatment, business owners can allocate some of their
income to salary and some of their income to equity ownership, avoiding having to pay self-employment tax on all of the income derived from the venture. S-Corps do have drawbacks – you cannot have different classes of distribution rights for different classes of stock, and LLC’s cannot be owners of stock in a C-Corp – so it is important to know if your structure even allows for an S-Corp election.
But unlike the S-Corp election, which has been for years a preferred method of
avoiding taxation for LLC’s, there may now be a situation where it is advantageous for LLC’s to elect to be taxed a C-Corps. This seems immediately illogical – why would any business owner sign up for double taxation when they don’t have to?
Because, like all tax calculations, this election has a chance to lower the overall rate of tax paid by your members – if you have both (a) corporate profits on an annual basis and (b) no plan to distribute those profits to your equity holders.
If an LLC has profits but chooses not to distribute them, choosing instead to build up financial reserves in the company, this will create a situation where the profits will still “flow” to the equity holders, so they will have a tax burden, but will have no money distributed from the Company to pay for that burden. Typically LLC’s will provide for “tax distributions” – money paid to investors to cover their tax burden for the company profits so that they aren’t coming out of pocket to pay for the profitability of the investments. While the law does not require these distributions, they are often provided, or demanded by investors, in Operating Agreements to protect investors against massive tax burdens with no means to pay.
This leads us back to the beginning – the C-Corp. If an LLC plans to make no
distributions to members and simply build financial reserves, they would only be
paying the 21% corporate tax rate. As this rate is lower than the top three individual tax rates – ranging from 32% to 37% - that are typically paid by equity holders. As such, an LLC could elect to pay the 21% corporate tax and not make tax distributions, maximizing the LLC’s financial reserves.
While for most companies the decision on which type of entity is simple – if you
aren’t seeking institutional funding, and don’t have an investor that requires a
corporation instead of an LLC – the LLC is the way to go. But depending on who is working for the company and the plans for profits of the Company, an LLC’s tax election may be best as a partnership, an S-Corp, or even a double-taxed C-Corp.
Before your make these elections – which are often timely and expensive to reverse – consult with your accountant and Troglia Kaplan to learn which structure and tax election are most beneficial for your venture.