LLC Taxation Overview
With the holiday season upon us, taxes are likely the last thing on most people’s minds. However, whether you are looking to launch a new business or are already operating a business and getting ready for the close of the calendar year, it is important to understand how taxes may be applied to the most common entity type utilized in the United States nowadays, the LLC. Understanding some basic tax features can provide some significant benefits. Potential benefits include allowing you to better plan the structure of your business and improving the accuracy of your expectations. Most importantly, it can often make a big difference in the amount of money that you end up getting to keep in your pocket.
Setting the Table
Before getting to the meat (likely turkey) of this post, a few general points should be noted. First, states have various potential taxes of their own that may be imposed on business income. You cannot and should not ignore the potential responsibility of your business to pay any potential state income taxes that may be owed. This blog post, however, concerns only federal income tax as administered by everyone’s favorite agency, the IRS. Second, when it comes to federal income tax, most business entities have options for choosing how they are taxed. In this post, we are going to assume that the default rules are being applied. However, please note that this may not always be what is most favorable for your business.
The Main Course
Now that we have moved beyond some of the threshold issues, we can begin the main course of this post. The first important concept to understand is that states and the federal government have different categories of potential business entities that may be utilized. For example, LLC’s are creatures of state law but do not formally exist under federal tax law. As such, LLCs are slotted into one of the categories of business entities that are recognized under federal tax law.
According to the default rule for how an LLC will be taxed at the federal level, it will generally be classified as a partnership (if more than one member) or a disregarded entity (if one member). Under either of these categorizations, an LLC will be treated as what is called a “pass-through“ entity.
A “pass-through” entity refers to one that does not pay taxes at the entity level. Instead, taxable income is viewed as passing through the entity, and in the eyes of the IRS, the income is allocated amongst the LLC’s members in proportion to each’s ownership interest. Alternatively, other arrangements can be in the company’s organizational documents about how profits may be split.
Allocation, Rather than Distribution, is the Key Point in Time
Another important aspect of pass-through taxation to note is the timing of when gain or loss is viewed as being earned by an LLC’s members. Generally, taxable gain/loss that is “passed through” to the LLC’s members is treated as taxable income or loss when it is received by the LLC. This is true even if the money remains in the company bank account and is not distributed to members. Therefore, if an LLC decides to distribute money from the LLC account to the company’s members, these amounts will have already been accounted for in terms of calculating the taxes owed by each member. The distribution alone would not create any new tax obligations.
To see how this may work in practice, let’s run through a simple example.
Imagine there is a company called ABC LLC. A, B, and C are the three owners of the LLC.
- A owns 50%
- B owns 25%
- C owns 25%
Now, imagine that ABC LLC made $1,000 in taxable income for the year. From the point of view of the IRS, it basically ignores the LLC and, instead, views the taxable income as being divided amongst the LLC’s members as displayed below.
- A as a having $500 of taxable income
- B having $250 of taxable income
- C having $250 of taxable income
To summarize, an LLC generally receives pass-through tax treatment. Applying this type of tax treatment, income is allocated to LLC members in amounts proportionate to each member’s ownership stake in relation to all other members. The income is allocated to each member as it is earned, regardless of when or if the money is actually distributed by the LLC. Therefore, it is how the profits of the LLC are allocated in the organizational documents that determine how taxable amounts will be allocated to an LLC’s members. So, ultimately, the tax liability of each member in a given year is determined at the outset of the company’s existence. This exemplifies why it is important to ensure a company’s internal documents are set up properly from the start.