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
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.