Barber, Banaszynski & Hiatt, PSC

TAXATION OF LIMITED LIABILITY COMPANY
posted by Thomas J. Banaszynski
Tags: In the news 

A limited liability company (“LLC”) is not a separate tax entity like a normal corporation. Rather, it is what the Internal Revenue Service (“IRS”) calls a “pass-through entity.” This is taxed like a partnership or sole proprietorship. The profits and losses of the LLC “pass-through” business to the LLC owners, or members, who uses information for their personal tax returns. The LLC itself does not pay any federal or state income taxes. There may, however, be an annual reporting fee payable to a state such as Kentucky, as discussed below.

Each LLC member’s share of the profits or losses, called a distributive share, should be set out in the operating agreement of the LLC. They will be specifically set forth on the appropriate IRS reporting schedule, e.g. Schedule E.

Regardless of how the members’ distributive shares are divided up, the IRS will treat each LLC member as though the member receives his or her entire distributive share each year, whether a profit or a loss. This means that each LLC member would pay taxes on his or her wholly distributive share whether or not the LLC actually distributed all (or any of) the money to the member(s). The practical effect of this IRS rule is that even if the LLC members need to leave some or all of the profits in the LLC, for example, to buy inventory or expand the business, each LLC member will be liable for income tax on his or her rightful share of that money.

File the Form 1065 with the IRS. Even though an LLC will not pay its own income taxes, it must file a Form 1065 with the IRS. This form is the same one that a partnership files, and is an informational tax return that the IRS reviews to make sure that the LLC members are reporting their income correctly. Further, the LLC is also to provide each LLC member with a Schedule K-1, which breaks down each member’s share of the LLC’s profits or losses. In turn, each LLC member will report this profit or loss information on his or her individual Form 1040 with appropriate schedules, e.g. Schedule E, attached.

Have the LLC elect corporate taxation. If the LLC will regularly need to keep a substantial amount of profits in the LLC (“retained earning”), the LLC might benefit from electing corporate taxation. The LLC can choose to be treated like a corporation for tax purposes by filing IRS Form 8832, Entity Classification Election, and checking the corporate tax treatment box on the form.

Typically, corporate income tax rates for the first $75,000 of corporate taxable income are lower than the individual income tax rates which would apply to most LLC owners. This can save the individual owners money in overall taxes. Further, the election corporate taxation status could allow the LLC to offer owners and employees, if any, various tax-advantage fringe benefits, stock options and stock ownership plans.

Paying income taxes. LLC members are considered self-employed business owners, rather than employees of the LLC. So, they are not subject to tax withholding. Rather, each LLC member is responsible for setting aside enough money to pay the taxes on that member’s share of profits. The members, thus, must estimate the amount of tax that will be owed for the year make quarterly payments to the IRS, and as necessary, to the appropriate state tax agency, e.g. Revenue Cabinet. Those tax deposits are normally made in April, June, September and January (for the prior year).

Presently, it is the rule that any owner who works in or helps manage the business must pay tax on his or her distributive share (his or her rightful share of the profits). However, owners who are not active in the LLC, i.e. those who have merely invested money, but do not provide services or make management decisions for the LLC, may be exempt from paying self-employment taxes on his or her share of the profits.

It should also be further noted that any LLC member can deduct his or her proportionate share of the losses, expenses and deductions for the LLC.

Kentucky taxation. Kentucky has a “Limited Liability Entity Tax” (“LLET”), as well as a corporate income tax. A business may be subject to one, or both, or neither of these taxes.

Kentucky’s limited liability entity tax applies to LLCs, based upon the business’s annual gross receipts. For businesses with gross receipts less than three million dollars, there is a minimum LLET of $175.00. For businesses with three million dollars, or more, in gross receipts, the LLET is based on the amount of gross receipts, or 75 cents per $100.00 in gross receipts.

In Kentucky, LLCs are pass-through entities, as discussed above, and are not required to pay federal income tax. However, in Kentucky, LLCs are required to pay the LLET. Typically, Kentucky LLCs will be classified, for tax purposes, as partnerships. However, it is possible to elect to have the LLC classified as a corporation, filing the IRS Form 8832. In that case, however, the LLC would be subject to Kentucky’s corporate income tax. Further, Kentucky requires LLCs to file an annual report, due between January 1 and June 30, for which the fee is $15.00.