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Tax implications

Posted on 09. Jul, 2008 by squareroots in Formation

LLC (Limited Liability Company)

An LLC is the more flexible of the two types of entity discussed in this article (LLC and S-Corp).  In essence, you can have any tax treatment you want.  A couple of examples:

• All tax write-offs (during periods of losses) to someone who hasn’t contributed capital, or to someone who has only provided a limited % of the total capital raised.  Compare this to an S-Corp where everything is based off the individual’s tax basis (discussed below in S-Corp section).  Angel investors sometimes find this flexibility attractive.
• Can behave as a pass-through tax entity, or not.  This is determined by an election.  By comparison, an S-Corp is a pass-through tax entity, and a C-Corp is not (meaning that owners of C-Corps are double taxed).

Another interesting difference between LLCs and S-Corps is the treatment of owners with respect to tax withholding.  If an individual owns more than 2% of the LLC, the IRS considers them a partner that will receive a “guaranteed payment”.  Because of this, withholding taxes are not performed for the owners of greater than 2% of an LLC (each owner must pay the IRS quarterly).  Each owner must instead file a K1 and pay taxes quarterly.

S-Corporations

Some notes about S-Corporations and their limitations:

• Up to 75 shareholders, who must be U.S. individuals or trust funds; cannot be an entity (e.g. LLC or Corp), or foreigners.
• Only one class of stock, although can have differences in voting.

For S-Corps owners, withholding taxes are paid the same for owners as employees.

The examples below are focused on S-Corporations.  Notes regarding LLCs are summarized at the end of each example.

IF OPERATING PROFITABLY

Revenue            $200,000

Owner 1 Wage     $25,000  W2 Form (Owns 75% of company)

Owner 2 Wage     $50,000  W2 Form (Owns 25% of company)

Other Expenses   $25,000

———————-

Net Income (K1)  $100,000

Owner 1 Net Income $75,000   K1 Form

Owner 2 Net Income $25,000   K1 Form

For an Net Income with an S-Corp social security and medicare is not required (saving 15.3% in taxes to each owner).  This is the reason that the IRS flags S-Corps where owners do not have a salary component to their compensation.

For LLCs, the 15.3% employment taxes is still typically paid on the Net Income.

Tax basis for this example:

Owner 1          $75 + $75,000 = $75,075

Owner 2          $25 + $25,000 = $25,025

IF OPERATING AT A LOSS

Revenue              $50,000

Owner 1 Wage     $25,000  W2 Form (Owns 75% of company)

Owner 2 Wage     $50,000  W2 Form (Owns 25% of company)

Other Expenses   $75,000

———————-

Net Income (K1)  ($100,000)

Tax basis determine amount (up to pro-rata of loss, assuming no investors)

Tax basis Owner 1   $50,075  (50k investment, and 75 for buying shares)

Tax basis Owner 2   $25      (25 for buying shares)

Therefore, Owner 1 can only deduct loss of $50,075 of the ($75,000) pro-rata loss amount.  Owner 2 can only deduct $25 of their pro-rata loss amount of ($25,000)

For an LLC, owners can get tax basis for outside loans especially if loans are secured by guarantee or real-estate.

Tags: New Entrepreneurs