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Limited Liability Company (LLC) Federal Tax Election Regime Selection Considerations and Federal Form Filings

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Limited Liability Company (LLC) Federal Tax Election Regime Selection Considerations and Federal Form Filings

One size does not fit all when it comes to the way in which an LLC can be taxed.  This is because LLC’s can be classified into any one of the following 4 tax regimes:  

  1. Disregarded Entity;
  2. Partnership;
  3. S. Corp; and 
  4. C. Corp.

The Key characteristics of each of these tax regimes are outlined below.     

  1. Disregarded Entity

The default classification for an individually owned aka single member LLC is to be disregarded for federal income tax purposes.  

Key Characteristics:

  • A disregarded entity does not exist for federal (and state) tax purposes and is therefore not required to file an entity income tax return; all income and losses from the LLC’s operations are accounted for on the member’s personal income tax return: Form 1040, Schedule C.  
  • All transactions occurring between the member and the LLC are disregarded for tax purposes as though there was no transaction.
  • Husband and Wife wholly owned LLC may qualify as a single member LLC if the entity is not treated as a corporation under applicable treasury regulations, husband and wife reside in a community property jurisdiction and no person would be considered an owner pursuant to federal tax purposes.      
  1. Partnership

This default classification for instances in which an LLC has 2 or more owners (members) is a partnership. 

Key Characteristics:

  • There are no restrictions on ownership. 
  • An LLC taxed as a Partnership does not pay income tax at the corporate level, but an annual partnership income tax return must be filed with the IRS on Form 1065, U.S. Return of Partnership Income.   
  • Individual partners receive a 1065 Schedule K-1 from the partnership to reflect income, gains, losses, deductions, credits, etc. to be reported on their individual personal income tax returns.  
  • Distribution income does not need to reflect a pro rata partnership interest (not the case for S Corps).
  • Preferred for real estate investing because it is possible to borrow against the property and distribute money to owners usually tax free.  
  • All income, to the extent member-partners are working in the business, is likely subject to self-employment tax or in the event the partnership is an investment partnership to net investment income tax. 

Of course, Limited Liability Companies do not have to adopt the default tax classifications, as outlined above, because they are “eligible entities” that may choose to “check the box” to be taxed as corporations of which there are two types, S Corp and C Corp.

  1. S. Corp 

Key Characteristics:

  • S Corporations are limited in terms of owner(s) to no more than 100 shareholders, US Citizens, trusts, estates, and limited tax-exempt organizations.
  • S Corporations cannot have more than one class of stock for economic purposes.  This means that if a shareholder owns 50% of the stock s/he is entitled to 50% of LLC economic gain or loss and 50% of dividend distributions.   Stock may however have different voting rights such as voting and nonvoting rights.   
  • An S Corporation does not pay income tax at the corporate level, but an annual S Corp income tax return must be filed with the IRS on Form 1120-S, U.S. Corporation Income Tax Return. 
  • Individual shareholders receive a Form 1120-S Sch. K-1 from the LLC to reflect income, gains, losses, deductions, credits, etc. to be reported on their individual personal income tax returns.  
  • Working shareholder compensation must be at reasonable market levels which compensation is subject to usual payroll taxes.  All dividends received from the LLC in excess of reasonable market levels may avoid self employment and net investment income tax.
  1. C. Corp

Key Characteristics:

  • A C Corporation has no restrictions on the number of owners, ownership type and stock class.
  • Income is taxed at both the corporate (Federal Corporate Income Tax as at Nov. 1, 2022 – 21%; State Corporate Income Tax Payable in addition thereto ranging from 0% (NV OH, SD, TX, WA, WY)  to 11.5% (NJ) and individual levels.
  • C Corporations file a Form 1120, U.S. Corporation Income Tax Return.  
  • Shareholders receiving a dividend will receive a 1009-DIV. from the Corporation and will report that income on their personal income tax return.  

Some High Level Considerations as to Selecting the Appropriate Tax Regime*

In determining which tax regime the LLC should adopt, careful consideration should be given to each regime’s requirements, advantages, and disadvantages in the context of corporate and member goals.  

In this regard, and by way of example, if the predominant aim is LLC expansion and growth keeping income within the LLC rather than distributing it to members would be best achieved through a C Corp election.  This is because the LLC would only be subject to corporate level income tax and would not have to allocate or distribute income in the form of dividends to individual members which means it can keep more income, compared with other tax regimes, within the organization to use for expansion and growth. 

If however the primary goal is for members to receive LLC income, electing to be taxed as a partnership or S Corp may prove to be a better choice than a C Corp because with both these tax regimes there is no corporate level tax due to the fact that income passes through the LLC to its individual members or partners, as is the case within a partnership, where it is taxed at the individual member level.  Further, and if you add to the scenario an agreement between the owners of the LLC a desire which reflects that percentage ownership and economic gain from the LLC’s operations are not equivalent, but the desire is still to have a pass through election a partnership election would be the preferred option notwithstanding any other material considerations.      

In sum, making an LLC tax regime election requires consideration of the LLC’s and membership’s overall objectives in the context of each specific tax regime to determine which regime is most appropriate for achieving overall objectives. To the extent you would like to learn more about anything herein, please contact Gary T. Harker, Esq., or Darrell Belch, Esq. at 518 583 0639 or gary.harker@3hcs.com and darrell.belch@3hcs.com.

*The information herein is not intended as legal advice and may not be applicable to your specific set of circumstances and therefore should not be relied upon. It is recommended that an appropriately qualified Attorney or CPA should be consulted prior to making an LLC tax regime election.