By: Tamara Pow
One of the major considerations in determining the right entity for a business is how it is taxed. There are major differences in the taxation of owners in corporations that pay their own corporate income taxes and owners in pass through entities. Like general partnerships, limited partnerships, limited liability partnerships and S corporations, the LLC is a pass through entity for tax purposes. This means that it is not a separate taxpaying entity for income tax purposes. Instead, the members of the LLC, like partners in a partnership, report their share of LLC income, gain, loss, deductions and credits on their personal tax returns by using the numbers from a Form K-1 received from the LLC, and attaching the Form K-1 to their individual tax returns. The LLC is treated as a partnership for tax purposes and files a Federal Partnership Tax Return on Form 565.
The Form 565 filed by an LLC is an information return which shows the taxable income of the LLC and each Member’s share of that income. Certain deductions are disallowed on the LLC information return, usually to avoid a double deduction (doubling up with deductions that can be taken on a Member’s personal return). Also, certain income and deduction items are separately stated, rather than being lumped into overall income or expenses, so that the character of that particular item can be passed through and treated correctly on the Member’s tax return. Some examples of separately stated items include short and long-term capital gains and losses, charitable contributions, medical and dental expenses and nonbusiness expenses. This means that if an LLC owned by two Members donates $1,000 to charity, and the Members share profits and losses equally, each Member’s Form K-1 will show a $500 charitable donation attributable to that Member. This $500 donation will flow through to be included with any other personal charitable donations that Member made in that taxable year, and will be jointly subject to any limitation on deduction of that person’s total donations.
Because the LLC is a pass through entity, it usually must have the same tax year as its Members. If the LLC Members are individuals, this typically means a calendar year, but not always. The general rule is that an LLC must have the same taxable year as members who own, in total, more than 50% of LLC profits and capital. If there are no majority owner(s) with the same taxable year, then the LLC must use the same taxable year as all of its principal Members (a principal member owns five percent or more of profits and capital of the LLC). If the principal Members have different taxable years, or if there are no principal Members, then the LLC must default to using the calendar year as its taxable year. There is a limited exception to this rule. If an LLC can establish a sufficient business purpose for adopting a different taxable year, or if a different taxable year will not cause more than 3 months’ deferral of recognition of income for its Members, the IRS will allow it.
In addition to the taxable year, the LLC can make certain tax elections which will affect the tax treatment of LLC items, such as methods of depreciation for LLC property, the choice of inventory method, the choice to adjust the basis of LLC assets on the transfer of an LLC interest or on certain distributions from the LLC, and others. There are also some elections that may be made by the individual Members, such as credits for foreign taxes paid.
Although the LLC itself may not pay any income tax, the information reporting of the LLC tax items directly affects the taxation of the Members, and should be planned for well in advance of the tax reporting deadline.
If you are forming a limited liability company, or investing in any partnership or other pass-through entity, be sure to talk to your tax advisor and ask all the questions you can think of until you understand what the tax implications will be for your personal tax return so that you don’t get a surprise next April.
Tamara B. Pow is a founding partner of Strategy Law, LLP (a pass-through entity) in downtown San Jose. She has been forming LLCs and partnerships and helping business founders with the choice of entity decision for 20 years. She has also invested in numerous partnerships and LLCs personally and prefers not to get surprised by what is on any Form K-1 she receives.
The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.