Llcs And The Federal Income Tax

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What is an LLC?

A Petite Liability Company (LLC) is a business structure that combines aspects of a corporation and a partnership. The owners are called members and not partners or shareholders. The number of members is normally not subject to any limit, and the members can be individuals, corporations, or other limited liability companies.

Advantages

One of the main advantages of an LLC is that it is treated as a separate legal entity, similar to a corporation, and the members are not personally liable for the company’s debts or obligations. There are two exceptions to this limited liability: when a member grants a personal guaranty for an obligation of the LLC, and when a court determines that the company is actually an alter ego of the owners themselves, in which case the members could be held personally liable.

In general, there are no restrictions on the persons or entities that can be members of an LLC. It may be necessary to obtain written consent from the members prior to admitting unusual owners, unless the articles of organization (see below) provide otherwise.

The majority of states and the Internal Revenue Service (IRS) recognize an LLC with a single member as a legitimate business structure.

LLCs generally require fewer formalities than a regular corporation or an S corporation. For example, the shareholders’ and directors’ meetings that are required for corporations are normally not required for LLCs.

There is flexibility in how LLCs are managed and how earnings are distributed. All the income and losses of an LLC pass through the company to the individual members. This avoids the double taxation of having to pay income tax on the company’s earnings and then again having to pay individual income tax on the company’s distributions. The LLC may have to file a tax return, but the individual owners include the company’s earnings in their individual tax returns and pay tax on them.

Disadvantages

A corporation can have an indefinite life, but LLCs normally have a fixed duration. Generally, the articles of organization must establish the date on which an LLC will end. In the absence of a provision to the contrary in the articles of organization or in the operating agreement, an LLC will also be dissolved when one of the members dies, retires, resigns, is expelled, or declares bankruptcy, unless within 90 days a majority of the other members vote to continue the LLC.

Forming and operating an LLC require greater formalities than a sole proprietorship or a partnership.

Forming an LLC

An LLC is formed according to state law and not according to federal law. All 50 states in the U.S. now allow the formation of LLCs.

There are two main actions that need to be taken to form an LLC: articles of organization and an operating agreement.

Articles of Organization:
The articles of organization have to be drafted and presented to the corresponding Secretary of Station, paying the required charges. These articles will have to be in the form required by the Secretary of Region. Among the information normally required is the date on which the LLC will be dissolved and a statement regarding the administration of the LLC, for example whether the LLC will be managed by one administrator, more than one, or whether the members themselves will be in charge of the administration.

Operating Agreement:
Although in many states it is not an obligation, it is advisable to have an operating agreement for the LLC. This agreement can be made before or after the presentation of the articles of organization. This agreement can establish the way in which earnings will be distributed and can define the owners, how the ownership can change, and the responsibilities of the members.

You should contact the office of the Secretary of State in the state where you are planning to set up an LLC to find out the specific requirements for formation.

Registered Agent

Almost all the states require that a registered agent be named for the LLC. In the majority of cases, this agent can be any person who has a domicile in the state in which the LLC is constituted.

The registered agent acts as the LLC’s representative for purposes of accepting the serving of process, or notification of legal action; that is, for acknowledging any legal proceeding, or receiving notification of any legal or official communication from the government that is presented to the company.

Federal Income Tax

LLCs are established according to the laws of each state, and the federal government has no classification for LLCs. Therefore, for purposes of the U.S. federal income tax, an LLC must file a return as a corporation, a partnership or a sole proprietorship.

LLCs with a Single Member

In general, when an LLC has only one member, the fact that it is an LLC is ignored for purposes of filing a federal income tax return, but that does not change the fact that legally it continues to be an LLC.

When the only member is an individual person, the LLC’s income and expenses are reported on that person’s individual income tax return on Form 1040, Schedule C (Profit or Loss from Business), Schedule E (Supplemental Income and Loss), or Schedule F (Profit or Loss from Farming), as applicable.

When the only member is a corporation, the income and expenses of the LLC are included in the corporation’s income tax return on Form 1120 (for a normal corporation) or Form 1120S (for an S corporation). In the case of a normal corporation (1120), the income and expenses are not transferred to the shareholders. For an S corporation (1120S), each owner or shareholder declares his or her portion of the earnings, credits and deductions declared on Schedule K-1 (Form 1120S).

LLCs with More than One Member

LLCs with more than one member must file a tax return as a partnership, using Effect 1065. Then, the members include their portions of the earnings, credits, and deductions from the LLC, as reported on Schedule K-1 (Form 1065), on their individual income tax returns.

Form 8832

In order to choose the way an LLC will be treated for tax purposes, you can file Compose 8832, Entity Classification Election. If this originate is not filed, the LLC will be treated as indicated above. If you do not want to change this treatment, there is no need to file Form 8832.

An LLC with only one member can elect to be treated as an association subject to tax as a corporation, instead of a sole proprietorship, and an LLC with two or more members can elect to be treated as an association subject to tax as a corporation or a partnership.

Do 8832 is also old when you want to subsequently change the arrangement the LLC is considered for federal income tax purposes.

Self-Employment Tax

When a business formed as an LLC has net earnings of over $400, it may be necessary to file Schedule SE, Self-Employment Tax, which is the equivalent of the social security and Medicare taxes.

Generally, when an LLC has only one member, who reports the LLC’s earnings on Schedule C or F of his or her individual income tax return (Form 1040), Schedule SE will also have to be filed and the self-employment tax paid.

When an LLC files a tax return as a partnership (Form 1065), the members pay the tax on self-employment income (Schedule SE) on their portion of the partnership (LLC) earnings. But if there are members who are the equivalent of limited partners, they would pay this tax only if the LLC pays them for their services.

When the LLC Has Employees

When the LLC has hired employees, it needs to withhold, characterize, and deposit the corresponding payroll taxes: the social security and Medicare taxes, federal income tax, and the dwelling or local income taxes that may apply, and pay the employer’s portion of the social security and Medicare taxes.

Form 941, Employer’s Quarterly Federal Tax Return, needs to be filed (Form 943 in the case of a farming business). After the close of the year, W-2 forms have to be prepared and sent to the employees and to the IRS, reporting the compensation paid for the year and the taxes withheld. Also, Form 940 or 940-EZ, Employer’s Annual Federal Unemployment (FUTA)Tax Return, must be filed when the LLC paid salaries of $1,500 or more in any quarter during the calendar year, or had one or more employees working at least part of a day in 20 different weeks during the year.