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Consultants: What about LLCs?

If you're a consultant wondering about how to organize your business, you may have read my previous posting Consultants: W-2, 1099 or Corp-to-Corp?. I got quite a few questions on LLCs. I tried to answer each individually but it soon became clear we needed to include more information and the topic deserved it's own page.

What is an LLC?

So just what is an LLC anyway? Although they seem ubiquitious, Limited Liability Companies, or LLCs are a relatively new type of business structure. It is similar to a corporation in that it limits personal liability of its members for the company's debts and obligations. An LLC is organized under the laws of a specific state.

How are LLCs Taxed?

The IRS does not recognize an LLC classification for federal taxes. The good news is that you can decide how you want your LLC to be taxed. Of course, this is also the bad news... :) This means when considering the tax implications of organizing as an LLC you need to understand the options available.

An LLC with one member can be treated as a sole proprietorship (which the IRS also calls a disregarded entity) or a corporation. An LLC with two or more members can be treated as a partnership or a corporation.

The Default Rules

Unless you make an election to the contrary, a single-member LLC is taxed like a sole proprietor. This means you file a Schedule C and include the LLC's Employer ID or EIN on the form. Income from your LLC is subject to income and self-employment tax.

An LLC with multiple members is taxed as a partnership. Your LLC files Form 1065, which is the return partnerships file. The income from the LLC gets allocated to the members based on whatever split you agree to. Each member gets a Schedule K-1 which is reported to the IRS. This income, or loss, is reported on Schedule E of the member's 1040 individual tax return. The member's portion of LLC income is subject to income and self-employment tax.

The Alternative: Tax Treatment as a Corporation

If you don't want to be taxed as sole-proprietorship or partnership, your LLC has the option to be treated as a corporation for tax purposes. This means you will be subject to all the coporate tax rules and rates and the LLC's income can accumulate (usually) tax-free. You'll file tax form 1120 or one of its variants instead of a Schedule C or Form 1065. Managing embers are now treated as employees and need to receive a reasonable salary from your LLC.

Regardless of how your LLC is taxed, it still maintains its legal status as an LLC.

Personal Services Corporations

If your LLC makes the election to be treated as a corporation, you need to be aware of the Personal Services Corporation (PSC) classification. Since you've elected to be treated as a corporation this applies to you if your business is engaged in provided professional services performed by employee-members. PSCs are taxed at a flat rate of 35%. The IRS really needs a good FAQ page on PSC since they are reviewing the tax computations of corporations in certain industries.

Here's the link to the official IRS definition of a PSC from IRS publication 542 on Corporations, but here's paraphrased version...

Personal service corporations. Any corporation whose princial activity is the performance of personal service that are substantially performed by employee-owners.

Personal services. Personal services include any activity performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health (including veterinary services), law, and the performing arts.

Employee-owners. All employees with any stock ownership in the corporation.


One really important missing tidbit from this definition is that an S-Corp is never a PSC. Therefore, if you make the election for tax treatment as a corporation and your business fits the description above, you really want to make the election of being treated as an S-Corporation, more on that later. First, how do make this election?

Making an Election to be treated as a Corporation

To make the election to be treated as a corporation, file Form 8832, Entity Classification Election. This one page form is really easy to file. Simply enter the name address & EIN of your LLC, check box 1a for a new LLC, 1b for existing LLCs. Check box 2a to be treated as a corporation. The effective date goes on line 4, enter the date your LLC was formed for new LLCs. Enter the name and phone number of a contact person for the IRS in boxes 5 & 6. Then have all the members sign in the signature block. That might actually be the hardest part.

For existing LLCs enter, the effective date on line 4 can be back dated upto 75 days. If you're filing the form after March 15, make the effective date January 1 of the following year.

Be sure to keep copies of the form because you'll need to attach a copy to the first year's tax return.

Making the Election to be treated as an S-Corporation

File Form 2553 to make the election to be treated as an S-Corporation. It's actually rather similar to the Entity Classification Form 8832. It's fairly self explanitory. The only trick is to make sure you use a calendar year, if you do you can ignore the second page which is a bit daunting. You need to file Form 2553 by March 15th of the current tax year or within 75 days for a new LLC. Otherwise, make the effective date January 1 of the following year.

There has been some recent IRS guidance that Form 2553 serves a dual purpose and substitutes for Form 8832. But the 8832 is such a simple form it doesn't hurt to file both forms to cover your bases.

LLC Tax Filings after the S-Corp Eection

Once election has been made to be treated as an S-Corp your LLC follows the filing requirements for S-Corporations. That means filing Form 1120S for fedeal purposes. For state purposes the rule may vary. In California your LLC now files Form 100S and notForm 568, Limited Liability Company Return of Income.

LLCs and Payroll

Now that your LLC is treated as an S-Corp, managing members should receive reasonable compensation in the form of salary. This means you will have to deal with payoll, withholdings, quarterly filings, W-2s, etc.

Comparing the Options

You can refer to the 1099, sole proprietors and Corp-to-Corp section of the link above for more details each. The scenrio section also include how the numbers pan out for the different options.

For LLCs with more than one member, you end up filing more forms, but your individual taxes will look a lot like the 1099, sole proprietor in that you're paying income and self-employment tax on your portion of the LLCs income unless you make the election to be treated as a corporation.

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I am one of five members in

I am one of five members in an LLC. I am the only member that receives guaranteed payments (salary). Can I deduct business mileage for the use of my personal vehicle on my personal return without running the deduction through the LLC? If so, where does the deduction go on my personal return?

Thanks for any help.

LLC Tax Issues

Thank you so much for this wonderful breakdown of LLC tax information! I have read tons of info. on the web and talked to tax professionals to no avail. When it comes to LLC's, the info. has been as clear as mud. I really appreciate the summary you have provided. Thank you! Thank you!

LLC electing to be taxed as S-Corp

Linda, this is a great site. I have a question which I haven't been able to find the answer to, despite searching all over the net.

A friend of mine, and myself, have just formed a LLC in 10/2009. We plan to file form 2553 to elect to be taxed as a S-Corp, instead of as a partnership. Since we are just starting up our business and do not expect to have revenues for the next 6 months, do we have to pay ourselves a salary? (salary being one of the requirements for a S-Corp, if I understood correctly). Or can we go salary-less for the first 6 or 12 months, until the revenues come in?

Thanks for your help.
Phil

yes u will have to at least

yes u will have to at least say you are recieving salary. And pay tax on that fake salary. http://taxes.about.com/od/taxplanning/a/loss_strategies_2.htm read the partnership/s-corp portion of this page.

Can LLC filing as 1065 bill corp-to-corp?

I can't seem to figure this out. Can we pay a contractor "corp-to-corp" if our multi-member LLC files a 1065 and thus is not electing to be taxed as a corporation?

Thanks!
-Ken

Corpp-to-Partnership or Partnership-to-Corp??

Hi Ken,

I'm a little unclear. Is your LLC the hiring entity or the contractor?

If the LLC is the contractor, then the hiring entity would have to report payments to the LLC to the IRS on Form 1099-MISC. The LLC members are responsible for the income & SE taxes on their prorated share of the LLCs taxable income.

If the LLC is the hiring entity, you should be ok. You would not have to report payments to your incorporated contractor on Form 1099-MISC.

Doe that help??
L:)

Re: Corpp-to-Partnership or Partnership-to-Corp??

Yes, that helps.
The latter is the case. We're an LLC hiring an incorporated contractor.

Thanks,
Ken

Do you guys have any

Do you guys have any websites for a more detailed computation?Thanks.
Tampa Web Site Design

Just Left You a Voicemail

Hi Linda - Thank you so much for all of this insightful information!

I currently live in North Carolina. Until recently I was an IT contractor, w-2 employee. Additionally I am a sole proprietor with a company I've dabbled a bit with. Today I received a 1099 offer/opportunity considering I currently have an EIN (I've also gone through the necessary requirements - business license and zoning in my state). I noted all of your information but I think my question is simpler than what's available. In a nutshell, can I remain a sole-proprietor (1099)and be paid in my company's name, to then file a regular tax return at the end of the year (or quarterly), taxed at my individual rate, or are there additional tax ramifications of going this route that would make taking my company all the way through the LLC process more to my advantage? Also, since I am a sole-proprietor, regardless of straight 1099, LLC or S-Corp, do I HAVE to pay myself or can't I simply take the payments received? I left you a voicemail (area code 646). If you get that feel free to call me back.

LLC vs 1099 15% Corp Rate and SE Question

Hi Linda, awesome site. I'm trying to decide between 1099 and LLC. I already have FT position over 100K and am taking on another consulting position on the side at 50/hr.
As 1099 I dont have to pay Social Security since I'm already maxed from the FT position right? As LLC is that also the case?
Do both 1099 and LLC offer pretty much the same option to max out a retirement plan? This would be good to have less income to ultimately report right?
And finally, what is left reportable to income tax on the 1099 is my personal tax rate 25-35% right? But if I'm LLC would this be taxed at only 15%?
I really don't care about the tax breaks of owning a business - the home office and house depreciation aren't worth it to me.
Thanks alot!

Consulting on the Side

Hi Robert,

This definitely puts a twist on things. :)

Yes, 1099 & single member LLCs are pretty much the same thing from the IRS's perspective (unless you opt otherwise) for both the Social Security and retirement plans. Before you form the LLC be sure you understand what your state tax obligations are. For instance the minimum annual LLC tax in CA is $800 per year.

The retirement plan contribution calculations are slightly different for corporations and 1099. They are still subject to the social security & medicare taxes. Be sure to carefully review the contribution limits for the various plans and how the limits are calculated before you select a plan.

I'm not sure how you figure the LLC income would be taxed at 15%. Maybe an example would help...

Let's say you make 25K. And you put $20K into retirement savings. Since you maxed out FICA via your day job, you would pay 2.9% medicare tax on $25,000 or $725 and income tax on $4763 (25K - 20K - (725/2)) at, let's say, 30% or $1392 for a total of $2116. An effective tax rate of 8.5%. :)

Hope this helps.
L:)

Linda, Great articles,

Linda,
Great articles, great info. My scenario is similar to Roberts. Day job around $95k and I will be starting consulting on the side at $50/hr. Already putting into my work 401k as well as Roth and other investments and have a huge house deduction. Given that (and other things), I expect my taxable income at retirement will NOT be much less than my current taxable income so I am not that interested in deferment of my income taxes.
Based on your responses to Robert, it looks like 1099 and LLC are the same (not including state requirements) although the LLC provides the extra liability protection? If I do not see a benefit of deferring taxes to retirement and take the hit now, does that change the numbers in any way. I am leaning towards LLC to keep it simple (income reported on personal taxes) and will not have any significant expenses to deduct. I still expect to max out on the SS tax from my FT position so do these numbers work:

Same 25K. Maxed out FICA via day job, pay 2.9% medicare tax on $25,000 or $725 and income tax on $24637 (25K - (725/2)) at, let's say, 35% or $8623 for a total of $9347. An effective tax rate of 37%.

Are there benefits / penaltires I am not considering with this scenario especially with regards to the retirement accounts (besides deferring the tax hit)?

Thanks.

Maxed Out FICA w/day Job

Wasabi... this is a real interesting topic. I'm like you and Robert. I'm way over 6 figs on the day job so is my spouse. But we also have an LLC (as S-Corp). Our entire goal with the 80k or so we will make this year from that is to take 10k off for expenses, then split the 35k equally as income maxing out the 25% SEP-IRA contribution (minus the 15k each that our employers provide) and then let the tax man take his piece of what is left not having to pay SS tax (just 2.9 like you described). LLC's are cheap in most states so no worries there - just do it!

Consulting on the side...

Thanks for this info Linda! My main concern was being sure that maxxing out FICA during day job covers either 1099, LLC, S-Corp side businesses. To me it seems 1099 would be the way to go if the tax rate is the same as LLC - that being my personal tax rate. Thought I read somewhere that you could do an LLC taxed as an S-Corp like John Edwards did and pay your self mostly in dividends (15%?), with a small salary (taxed at 35% since personally I'm already in the highest bracket), and maxing out the retirement contributions to lower the tax burden further, maybe a few real legit expenses would help too.

S-Corp as side business

Yes an LLC can be treated as an S-Corp, but that would not be as good an option in your situation.

First off, you would have to withhold and pay the full FICA tax on your wages from your side, even though you hit the cap on your regular job. You could eventually get back what was withheld when you file your income tax return. But the IRS would have your money in the mean time adversely affecting your cash flow. And the amount the IRS gets to pocket the amount the company pays. :(

Second, the IRS is cracking down on S-Corps that try to avoid the FICA tax by giving big dividends. If you're a shareholder that materially participates in the business the IRS expects you to have a "reasonable" salary.

Good Luck!!
L:)

1099 Income...

Thanks a bunch Linda - this is such valuable info. An interesting stat that may be of interest from 2004 IRS Audit Rates
Sole Proprietors with income < $25k: 3.15%
Sole Proprietors with income $25-100k: 1.47%
S-Corporations (all): 0.19%
C-Corporations, assets under $250k - 0.18%

So as long as I can open a SEP-IRA (not 401k) (in addition to my full-time 401k) and contribute 25% of my 1099 earnings I'm happy. I'll be sure to file quarterly tax estimates and hopefully all will work out! :)

Since I'm not planning to expense much and pay my fair share of taxes the IRS audit shouldn't be an issue when/if it came.

1099 Income...

Thanks a bunch Linda - this is such valuable info. An interesting stat that may be of interest from 2004:

IRS Audit Rates
Sole Proprietors with income < $25k: 3.15%
Sole Proprietors with income $25-100k: 1.47%
S-Corporations (all): 0.19%
C-Corporations, assets under $250k - 0.18%

So as long as I can open a SEP-IRA (not 401k) (in addition to my full-time 401k) and contribute 25% of my 1099 earnings I'm happy. I'll be sure to file quarterly tax estimates and hopefully all will work out! :)

Since I'm not planning to expense much and pay my fair share of taxes the IRS audit shouldn't be an issue when/if it came.

Question about LLC and Entity Classification Election

Hi Linda

I just created an LLC in Missouri with my business partner doing webpage design.. he already had his own llc that is owned by him. The new company is owned 50% by me and 50% by his llc. His llc is just his small web design company he operates part-time and it is taxed as a sole-proprietor.

I am trying to determine if I should file the paperwork to have the new llc taxed as a corporation? (IRS Form 8832, Entity Classification Election)

We want to do this for 2 reasons. This way the money isn't passed through to us and we can keep it separate. And also we want to do this because we both have full-time jobs and the money would be taxed at a higher rate if we passed it to us instead of taxing at the 15% corporate rate.

I don't think that we can file as a S-Corporation because one of the owners of the company is an LLC.

Is any reason why we should not proceed with the paper work to be taxed as a corp? How can we go about pulling out some of the profits without double-taxation?

I would really appreciate any information you can provide.

Thank you
Andrew

LLC can be S-Corp Shareholder

Hi Andrew,

I would be careful opting to be treated as an Corporation. Since your business is providing professional services, your LLC treated as a corporation will be treated as a Professional Services Corporation or PSC and taxed at a flat 35%. Yikes!! A far cry from your 15% assumption. :(

The good news is since your partner's LLC is being treated as a sole-proprietorship, the LLC can be a shareholder of the S-Corp. (See IRS Private Ruling Letter 200107025.) Note this only applies because the LLC is treated as a disregarded entity. If your partner had elected to have his LLC treated as a corporation, this wouldn't apply.

The way to take money out of the corporation (S or otherwise) is take a take salary. Make sure it's reasonable, neither too large nor too small to keep the IRS satisfied.

Hope this helps!
L:)

Single Member LLCs

Hi,

Great column! Stumbled upon it as I was searching for some resolution on the question I have below.

I have a NJ single member LLC that I use for consulting work.

Since I'm the sole member, I don't bother paying myself a salary. Instead, I pay estimated taxes for the monies I'm making, and at the end of the year pay SE taxes on ALL of the money I earned during the year (after deducting appropriate expenses such as Section 179, or contributions to my solo 401K). Similarly, for the NJ state taxes as well. All this as my payments as a consultant are on a Net 30/60 basis and not regular in schedule

Is this OK as far as the IRS is concerned? Also, what is the comprehensive list of federal/state taxes that'd apply to my situation above?

Thanks!
Nikhil

Taxes on Single Member LLC

Hi Nikhil,

Sounds like you've got everything covered. You are doing things exactly the way the IRS wants.

As a single-member LLC, you report your income an expenses on Schedule C and calculate the self-employment tax on Schedule SE. Make sure you make your quarterly estimated payments, which you can do on line now at EFTPS.

As far as NJ goes, I'm not an expert on NJ taxes, but digging a bit on the NJ website yielded this gem...

Single Member Limited Liability Companies — P.L. 1998, c.79 (signed into law on August 14, 1998) amends various sections of the New Jersey Limited Liability Company Act to provide for single member limited liability companies and to treat such companies as sole proprietorships for State income tax purposes unless the company is classified otherwise for Federal income tax purposes. The act became effective immediately and applies to all existing limited liability companies regardless of their formation date.

So it sounds like you'll report your LLC income & expenses on your NJ personal income tax return the same way as your federal return. There's no additional forms to complete for your LLC. If you have more questions for NJ, here's the number to their Taxpayer Customer Service Center (8:30am - 4:30pm, Mon. - Fri.) 609-292-6400.

Hope this helps.
Linda :)

Thanks!

Thanks Linda!

Please take some time to write a book for people like us!!! Pretty please!!!

Your advice is so much clearer and relevant and comprehensive and I hope you will consider my idea.

I'll buy a copy!

Thanks,
Nikhil

I have recently set up an

I have recently set up an LLC with the s-corp election. However my current client will only deal with 1099. How do I handle this? Would they make out the 1099 to the name of my company or does the 1099 go to me and if so how do I make it count as revenue for the LLC

Getting a 1099 for an LLC

This is a little unusual. Usually clients don't want to do a 1099 to an individual.

They have to make the 1099 out to the entity they make payments to. If they make payments to your LLC, then they will 1099 your LLC (which technically isn't required but sometimes companies do it anyway).

If they make payments out to you as an individual, then they will 1099 you which pretty much wipes out the advantages of your LLC. :(

Make sure your client has your LLC's tax id number and preferable not your own SSN. Make sure you submit a bill to them with your company name and include your LLC's tax id number on the invoice to make it easier for their accounting dept make payments to the LLC and so the 1099 goes to the LLC too.

If that doesn't work there is something called a 1099 Nominee Recipient. This means you received a 1099 for income that actually belongs to someone else, in this case your LLC.

You file a 1099 with the IRS assigning the income from you to your LLC. This is much messier and if the actual checks are made to you the IRS may raise questions about the income. Best to avoid this if possible.

The best answer to your question is to make sure the checks are made payable to your LLC and all the other issues will fall into place nicely.

Hope this helps!
L:)

Timing of S Corp Election

Hi-

Thanks, this is very informative. I have a client who is currently a sole proprietor but would like to form an LLC and make the S Corp election right now (in September). Since she is already in business, does she have to wait until January 2007 for the S Corp election to be effective? Or, because she will be a new LLC, could the S Corp election take place in 2006?

S-Corp Election

Hi,

As long as she makes the S-Corp election within 75 days of forming the LLC the election can be effective in the current year.

Since she isn't an LLC/S-Corp yet she should file as a sole proprietor for the first part of the year, Jan to date the LLC is formed. File the 2006 return on Form 1120-S with a short year, Sept to Dec 2006.

L:)

S Corp Election

Thanks, Linda!

I'm new to this website and I think its great!

Are single person LLC's

Are single person LLC's providing consulting services more likely to be re-classified as W-2 employees than a straight S-Corp? I would imagine that an LLC with S-Corp would provide the same protection for the client, but I can't find an affirmation of that assumption anywhere.

Thanks...

One-Member LLC vs. S-Corporation

Hi Linda,
Is the option of a one-member LLC taxed as a sole proprietorship preferable to an S-Corporation as thus do not have double taxation as a corporation and we are taxed at the rate we should be as individuals?

Thank you,
Guy

One-Member LLC vs. S-Corporation

Hi Guy,

Not necessarily. Except for certain rare circumstances, the only time you have to worry about double taxation is on dividends. Don't pay dividends out of your corporation & you dont' have to worry about double taxation. :)

Since S-corp employee/shareholders have to take a salary you can take out some income that way. The big advantage of an S-Corp LLC over a sole proprietor LLC is income can grow in your "corporate LLC" without paying SE tax. A sole proprietor will have to pay SE tax on your net taxable income every year, while a S-Corp LLC will only pay the equivalent on salary. That's usually where you can garner big savings with the S-Corp.

You can take distributions from your S-Corp as a return of capital that reduces your basis in the company but isn't necessarily taxable. You have to be careful with your calculations on this one to make sure you can do this but it is possible.

Hope this helps.
L:)

One-Member LLC vs. S-Corporation

Confused now... if the IRS treats a single member LLC which has elected S-Corp treatment as a pass through entity for tax purposes, how can profit of the S-Corp LLC be taxed twice? Won't all S-Corp LLC profit (that profit not distributed as salary to the owner) be taxed to the owner at his/her applicable capital gains rate whether or not it is left in the S-Corp LLC or paid to the owner as a "dividend"?

LLCs Electing to be S-Corps

If the LLC makes the S-Corporation election it will be treated as such for all facets of IRS rules and regulations. Therefore, LLCs treated as S-Corps have the same protection for the client as a "regular" S-Corp.

As this quote of IRS Training Manual TDS 84238I points out, the corp-to-corp arrangement does provide protection from being re-classified:

Questions sometimes arise concerning whether a worker who creates a corporation through which to perform services can be an employee of a business that engages the corporation. Provided that the corporate formalities are properly followed and at least one non-tax business purpose exists, the corporate form is generally recognized for both state law and federal law, including federal tax, purposes. Disregarding the corporate entity is generally an extraordinary remedy, applied by most courts only in cases of clear abuse. Thus, the worker will usually not be treated as an employee of the business, but as an employee of the corporation.

I completely understand your confusion over this. All you need to remember is if your LLC makes the S-Corp election you are a S-Corp as far as the IRS is concerned. So make sure you act like an S-Corp when your interacting with the IRS.

Hope this helps!!
L:)

Payroll Details

Great stuff. Could you also write an article on payroll 101 details for a corporation? Questions such as:

Do sites like paycycle.com and paychex.com cover all the bases with handling taxes? What about end of year taxes?

Does the owner of the corporation need to file a W2 since he is also on payroll? How does he set himself up with a salary?

Steps to hire someone? etc

Great Topic Idea!

Thanks excellent topic idea! May take a bit to pull together but I will definitely get started on that.

L:)

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