| LLC
TAX BASICS
LLC Tax Treatment
An LLC’s income passes through to its members, who report
the income on their personal income tax returns. For tax purposes,
a single member LLC is treated as a sole proprietorship, and
a multi-member LLC is treated as a partnership.
The LLC itself does not ordinarily pay federal income taxes
on its own behalf as a separate entity (some states impose
taxes on LLCs as a separate entity). However, an LLC is required
to file an annual informational tax return with the Internal
Revenue Service.
It is possible for an LLC to elect to be taxed in the same
manner as a “C” corporation (double taxation),
but this is generally not advisable, as this election will
last for a minimum of five (5) years and as there may be tax
consequences for switching back to pass-through taxation.
LLC Tax Return Filings
Single Member LLCs
Generally, when a limited liability company
(“LLC”) has only one member, the fact that it
is an LLC is ignored or “disregarded” for the
purpose of filing a federal tax return. Remember, this is
only a mechanism for tax purposes. It doesn’t change
the fact that the business is legally a Limited Liability
Company.
If the only member of the LLC is an individual,
the LLC income and expenses are reported on Form 1040, Schedule
C, E, or F.
If the only member of the LLC is a corporation,
the LLC income and expenses are reported on the corporation’s
return, usually Form 1120 or Form 1120S. If you prefer to
file as a corporation instead of as a “disregarded entity”
Form 8832 must be submitted. Otherwise, you are not required
to file Form 8832.
Single-member LLCs may not file a partnership
return.
Multiple
Member LLCs
Most LLCs with more than one member file a partnership return
- Form 1065. If you would rather file as a corporation, Form
8832 must be submitted
Self-employment Taxes
An LLC member is subject to self-employment taxes (the current
self-employment tax rate is 15.3%) on his/her share of LLC
profits, if any, one of the following conditions apply:
• He/she works more than 501 hours for the LLC during
the LLC’s tax year (members who do not play a role in
the management of the LLC or who are not employed by the LLC,
but simply receive a share of the profits by virtue of their
ownership interest, may be exempt from paying self-employment
taxes);
• The LLC offers professional services in the areas
of consulting, health, law, engineering, architecture, accounting,
or actuarial science;
• He/she is allowed to execute contracts for the LLC.
In most cases, members will be required to make quarterly
payments of their estimated tax liability to both the state
and to the federal government.
In some cases, classification as a self-employed taxpayer
is preferable to being treated as an employee. For example,
deductions for business expenses of self-employed workers
are above-the-line deductions under Internal Revenue Code
Section 62(a)(1) and reduce the taxpayer’s adjusted
gross income. Most employee business expenses are itemized
deductions, and are also “miscellaneous itemized deductions”.
Taxpayers can deduct miscellaneous itemized deductions only
to the extent that the total amount of those deductions exceeds
2% of adjusted gross income. For most taxpayers, this means
that miscellaneous itemized deductions cannot be deducted
at all.
One of the major benefits of being considered self-employed
arises when a taxpayer has to pay for premiums for health
insurance. Self-employed taxpayers can fully deduct the cost
of health insurance. On the other hand, employees can only
deduct the cost of premiums that they pay only to the extent
that the premiums exceed 7.5% of their adjusted gross income.
Contributing Capital to the LLC
In general, no gain or loss is recognized upon the contribution
of money or property to a limited liability company (“LLC”)
in exchange for an LLC interest. Neither the contributing
member nor the LLC is taxed.
The contributor will receive a basis (the basis play a very
important role in accounting for taxable gains) in the cash
or property contributed equal to the amount of cash contributed
and the basis of the property contributed (including any liabilities
associated with the property). In other words, the basis the
contributor had in the property contributed becomes the LLC’s
basis in the property and the contributor’s basis in
the LLC interest granted. Whereas, the contributor’s
capital account (the capital account represents the equity
that member has in the LLC) will equal the amount of cash
contributed and the fair market value of the property contributed
to the LLC (net of liabilities). If a member is providing
services to the LLC, the value of the services provided does
not constitute a contribution of property for tax purposes.
For example: Steve contributes a building to the LLC. The
building has a fair market value of $10,000, with a basis
to Steve of $6,000. Steve receives a 10% interest in the LLC
in exchange for contributing the building. Steve has no gain
on the contribution: his basis in his LLC interest is $6,000,
and the LLC’s basis in the building is $6,000 (a “carryover
basis”). However, Steve’s capital account in the
LLC is $10,000 (the fair market value of the building on the
date of contribution). Alternatively, if Steve contributed
$1,000 in cash to the LLC, Steve’s basis in the LLC
Interest he received and his capital account would be $1000.
The Computation of LLC Profits or Losses
A limited liability company (“LLC”) shall not
be subject to federal income tax. Persons carrying on their
business as members shall be liable for income tax only in
their separate or individual capacities.
Computing the LLC’s amount of profits or losses is important
in determining how much profits or losses should flow through
to the members. Once the LLC’s amount of profits or
losses has been determined, the profits or losses can then
be allocated proportionally to the members according to the
allocation determined by the LLC’s Operating Agreement.
In general, LLC taxable income is computed in the same manner
as an individual’s taxable income with certain modifications.
The most important modification is that items described in
Internal Revenue Code Section 702(a) are separately stated.
The reason for separately stating these items is that they
have special significance to individual members. Internal
Revenue Code Section 703(a) also denies two types of deductions
that individuals are normally permitted. The first type of
deductions are those that are considered inappropriate for
LLCs, such as the deduction for personal exemptions and the
itemized deductions. The second type are those deductions
which the benefits are passed through to the members in their
individual capacities, such as certain foreign taxes, charitable
contributions, net operating losses, and depletion and of
oil and gas wells.
The taxation of LLCs is based on a blend of entity and aggregate
notions of partnership taxation. There are some items that
will affect all members the same way, without regard to the
members’ tax profits. For example, consider ABC, LLC
whose only tax item is for the year is a $10,000 capital gain,
which is allocated equally between its two members, Steve
and Jane. If Steve has no other capital gains or losses for
the year, and Jane has a $2,000 capital loss for the year,
the tax effect of the $5,000 LLC capital gain allocated to
each member would be different. Steve would report a $5,000
net capital gain, while Jane would report a $3,000 net capital
gain. If the LLC gain was expressed simply as net $4,000 income
for the year, without specifying its character as capital,
the members would not have the information necessary to adequately
report their income for the year. Thus, the LLC information
return must separately state this capital gain, as well as
other items that can affect the members in different manners.
The
Tax Treatment of an LLC Distribution
Generally, the LLC and its members do not recognize gain or
loss on a distribution of cash or property. Gain or loss would
only be recognized when deferral is impractical or when it
would result in a change of character.
Internal Revenue Code Section 731 provides for nonrecognition
of gain or loss to all parties when LLC property or money
is distributed. In the case of a cash distribution, the distributee
simply reduces his/her outside basis by the amount of money
received, preserving any inherent gain or loss in his/her
LLC interest. A member’s initial outside basis equals
the amount of cash the member contributes to the LLC, the
basis the member had in any property contributed, and the
member’s share of the LLC’s debt. In the case
of a property distribution, the distributee’s outside
basis is allocated among both the property or properties received
and his/her continuing interest in the LLC (if any). Any pre-distribution
inherent gain or loss in the distributee’s LLC interest
is preserved either in the property received or in his/her
continuing interest in the LLC. Gain or loss is recognized
only when deferral is impractical or would change the character
of income or loss.
Recognition of Gain
Distributions generally trigger a gain if a member receives
a distribution of money in excess of his/her outside basis
or when an LLC with “hot assets” makes a non-pro
rata distribution. In general, “hot assets” are
defined as unrealized receivables or inventory of the LLC.
However, when an LLC distributes property to a member, the
inherent gain or loss in the member’s interest can be
preserved by adjusting the basis of the distributed property.
Recognition of Loss
A member recognizes a loss only in a liquidating distribution,
and then only under certain circumstances. A loss is never
recognized in a current (non-liquidating) distribution. In
a situation where a liquidating distribution consists only
of cash, unrealized receivables and inventory, the distributee
will recognize a capital loss if his/her outside basis exceeds
the sum of money distributed plus the basis he/she takes in
the distributed property. This is because, in this situation,
the distributee receives no capital asset in which to defer
the loss.
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