How does a limited liability company get taxed by the IRS? What nuances and options exist? Many entrepreneurs wonder about considerations like these when deciding on a business structure for their startups. So, it's likely you have been — or will be — on the receiving end of those questions from your clients.
By default, an LLC is taxed as a disregarded entity — either as a sole proprietorship or a partnership (depending on whether it's owned by one or multiple members). However, one of the most attractive features of the entity (second only to the advantage of personal liability protection) is its tax flexibility.
It's not uncommon for eligible LLCs to file for S corporation taxation. After all, filing Form 2553 preserves the tax-reporting simplicity of LLC pass-through tax treatment while helping entrepreneurs minimize their personal Social Security and Medicare tax burden. (i.e., members' wages and salaries are subject to FICA while profit distributions paid to members are subject only to income taxes).
But what about LLCs that want to be taxed as C corporations? What are the possible advantages and what should business owners think about?
Reasons an LLC may want to elect C corp tax treatment
While most
- Fewer limitations on certain types of deductions (such as employee life and medical insurance, childcare benefits, retirement plans and education reimbursements);
- Possibly a lower overall income tax burden if the corporate tax rate is lower than the LLC members' individual tax brackets;
- More flexibility in determining the company's fiscal year, potentially making it easier to carry profits and losses forward or backward; and
- Fewer ownership restrictions than S corporations.
Tax benefits and consequences to consider
Effective since Jan. 1, 2018, the Tax Cuts and Jobs Act has delivered some changes specifically applicable to LLCs and C corporations. Clients should take the following issues into account when considering a C corp tax election.
- The C corp tax rate became a flat 21%. (Previously the corporate tax rates ranged from 15 to 39%.)
- A pass-through entity income tax deduction (for sole proprietorships, partnerships, disregarded entity LLCs and S corps) of 20% was implemented. Note, it is limited to specific industries. The deduction phases out at $326,600 in adjusted gross income for married filing jointly taxpayers and $163,300 for everyone else.
Aside from the TCJA changes, LLC members should also weigh whether the potential double taxation of C corp profits will adversely affect them and their business financially.
Questions and answers about C corp tax treatment for LLCs
Below are some questions the attendees at a recent webinar asked. I thought it might be helpful to address them here to give you food for thought when clients approach you about this topic.
1. Is it free for an LLC to file IRS Form 8832 to elect to be taxed as a C corporation?
Yes! But business owners may incur a small fee if they use an accountant, lawyer or online business document filing service to prepare and submit the form on their behalf.
2. How long does it take for the new election to go into effect?
Processing times vary. Lately, it seems there's a longer turnaround time. However, elections are effective as far back as 75 days before the filing date with the IRS.
3. Can an LLC change back to being taxed as a sole proprietorship or partnership after electing C corporation tax treatment?
Yes, it can. But the IRS has a 60-month limitation rule for LLCs that started as a disregarded entity and later filed Form 8832 to change to C corp taxation. An LLC may not change back to its default method of taxation until 60 months after its election has been in effect.
Some exceptions exist to this rule. For example, the rule doesn't apply to a newly formed LLC that elected C corporation tax treatment effective on the date of its formation. Also, the IRS may permit an LLC to change its election classification before the 60-month period has passed if more than half of the LLC's ownership interests (as of the effective date of the election) are owned by individuals who didn't own interests in the company on the effective (or filing) date of the corporate tax election.
4. If a multimember LLC wants to file for C corporation tax treatment, do all members have to sign off on the change?
Yes. Form 8832 has a "Consent Statement and Signature(s)" section where LLC members, officers and managers must sign their names.
Owners of a multimember LLC considering making an C corp tax election must agree on the tax treatment and follow the rules for how that affects their company and their own personal tax filings.
If an LLC files for C Corp tax treatment, all members on the company payroll will receive a W-2 from the corporation and a 1099-DIV for dividends paid to them.
LLC taxed as a C corp remains an LLC
Clients should understand that electing the C corporation tax election for an LLC does not change the underlying entity's compliance obligations otherwise. When an LLC is taxed as a C corporation, it continues to follow the non-tax-related compliance rules and regulations for limited liability companies. For instance, it does not have to appoint a board of directors or adopt bylaws. LLC compliance requirements vary from state to state, so it's critical your business clients do their homework to understand their responsibilities.
