Each Tuesday, our new series ‘Accounting Tips Tuesday’, brought to you by Zoho Books, will present articles that fit into one of two categories.
First, the theory behind basic, and even not so basic, accounting concepts with practical applications including the old ‘debits and credits’ appropriate to the situation. Second, we will go beyond the practical theory and actually cover fundamental software use in the proper recording of these types of transactions using Zoho Books.
Many times we will interlace non-series articles with series articles in order to create a friendly and diverse mix of content. Today's article returns to some of the concepts presented in an earlier mini-series on 'Choice of Business Entity', and expands on the selection of the Limited Liability Company as the modus operandi, by discussing the election of taxation associated with this business model.
LLC Taxation Options figure 1
In our previous mini-series, Choice of Business Entity, I described the various entity choices business owners have when setting up their new enterprises. These options are diverse and each has its own advantages and disadvantages, all of which must be considered relative to the business itself, the industry, and the owner’s desires and objectives. However, even with these multiple options, the overwhelming preference today is the limited liability company, or LLC. The primary reason can be found in its name, limited liability.
So, you’ve done your due diligence, established your preliminary business plan, and have contacted your attorney to set up and document your limited liability company. Ready to roll, right? Yeah, not quite. If you do nothing else, you are immediately considered a disregarded entity for tax purposes. What does that mean to the single-member LLC owner? Or, if you have a partner or partners, do you have options other than taxation under partnership rules? What if you have no desire to be taxed as a sole proprietor or partnership? There are always a multitude of questions, but are there options? The answer is a resounding yes, but be careful what you wish for. The complexities are myriad. In this article, we’ll explore the taxation options available to the limited liability member(s), and address some of these complexities.
Most of you have probably heard the term, disregarded entity, but maybe you’re not exactly sure what the term means. The common, theoretical definition of a disregarded entity is a business type that is separate from the owner for liability purposes, but it is the same as the owner for tax purposes. Interpreting then, the limited liability company legally exists to provide liability protection to the owner, but for tax purposes, the taxation of the entity is reported/determined on owner’s income tax return.
For instance, if the limited liability company is owned by an individual and no other elections have been made, the limited liability company will be taxed as a sole proprietorship. On the other hand, a single-member LLC owned by another business entity (LLC, S-corporation, C-corporation, etc.) is also considered a disregarded entity, but is accounted for and treated as a branch or division of the entity owner. Let’s say the limited liability company is solely owned by an S-corporation. This LLC will not file a separate income tax return; rather, it’s activity will be recorded on the S-corporation’s books and records as a separate division of the S-corporation, and will be reported on that S-corporation’s income tax return. In summary then, the single-member LLC is always considered a disregarded entity, and its activity will be taxed based upon the tax attributes of the owner of the disregarded entity.
OK, your limited liability company is set up, and your accountant asks you if you want to maintain the LLC status for tax purposes, or if you want to “flip” your limited liability company to a corporation for tax purposes. No, your accountant isn’t crazy and isn’t trying to confuse you. Most likely, your accountant has some experience with LLCs and the taxation options, and he or she is attempting to provide you with the various alternatives at your disposal. One of the easiest way to depict the options is via the table below.
LLC Taxaction Options figure table
In order to fill in the gaps a bit, these options are discussed in greater detail below. While these discussions are reasonable summaries of the options, I would urge you to read the noted publications and form instructions to fully understand the protocols.
If you, as an individual, are the sole owner of your newly formed limited liability company and do not intend to be taxed as a corporation, your job in setting up your entity is essentially complete. A single-member LLC is considered a disregarded entity (see the discussion above), and is automatically taxed as a sole proprietor. No additional elections or forms are necessary. You will report your business income and expenses on Schedule C to your Form 1040.
As a side note, completing a Schedule C is nothing more than reporting the income and expenses of a business (including depreciation and amortization). As a sole proprietor, there is no requirement to maintain a balance sheet. However, I would strongly urge the sole proprietor to not only prepare a balance sheet at least annually, but maintain all balance sheet accounts meticulously within your general ledger system. There are a few reasons for this, but the most important is that, should you decide to bring on a partner or convert your entity to a corporation in the future, you will likely be required to present a balance sheet. Going back and retroactively recreating a balance sheet can be a nightmare. If you have clients who are sole proprietors, and you’ve never had to recreate a balance sheet for a future conversion, do yourself a favor and follow this advice. Your client will thank you as the cost of a balance sheet recreation can be prohibitive.
Limited liability companies with multiple members are, by definition, a partnership, and are taxed as such. As a result, should the members decide that a corporate format is not right for them, they do not need to file any elections beyond the organizing documents for their LLC. This limited liability company will file Form 1065 to report its annual income and expenses. Additionally, in most cases, a balance sheet is required to be presented within the tax return.
One of most popular entity structures going today is the limited liability company “flipped” to an S-corporation for tax purposes. (I’ve used the word “flipped” a couple of times so far; it means nothing more than a limited liability company making the election to be taxed as a corporation). So, why is this LLC-to-S-corporation so prevalent? Because it is considered the best of both worlds. The owner(s) receive the legal protections of limited liability, but enjoy the benefits of S-corporation taxation attributes. Given the popularity of this configuration, we’ll discuss it in a bit more detail.
An LLC can make the election to be taxed as an S-corporation under the ‘check-the-box’ rules promulgated by the Treasury (‘check-the-box’ is IRS-speak for “flipped”). A limited liability company can elect to be treated as an S-corporation concurrent with the LLC organization, or it can make the election at a later date. It is important to note that if you form your limited liability company on January 1st, you have 75 days to make the S-corporation election to ensure the election is retroactive back to January 1st. For instance, let’s say you form your LLC on January 1, 2016 and on June 15, 2016, your accountant tells you that it would be a good idea for you to flip your limited liability company to an S-corporation. You instruct your accountant to prepare Form 2553 for you, and you file it with the IRS. Is your S-corporation election retroactive to January 1st? No, it is not. Without some machinations and reasonable cause, your limited liability company will be taxed as a partnership from January 1, 2016 through June 14, 2016, and as an S-corporation from June 15, 2016 through December 31, 2016.
Now, let’s say you don’t want to have a split tax year requiring both LLC and S-corporation tax filings. What are your options? The primary option is to wait until January 1, 2017 (the beginning of the following tax year) when a new 75-day S-corporation election period begins. So, in the following year, on February 12, 2017, you decide to make your S-corporation election. Your limited liability company is now treated as an S-corporation for tax purposes retroactive back to January 1, 2017. The other option is filing for late S-corporation election relief.
The late S-corporation election relief requires you to jump through a few hoops, but it is a viable option for many who find themselves in this quandary. In order to qualify for late filing relief, the following requirements must be met (from IRS Revenue Procedure 2013-30):
- The entity intended to be classified as an S corporation, is an eligible entity, and failed to qualify as an S corporation solely because the election was not timely;
- The entity has reasonable cause for its failure to make the election timely;
- The entity and all shareholders reported their income consistent with an S corporation election in effect for the year the election should have been made and all subsequent years; and
- Less than 3 years and 75 days have passed since the effective date of the election.
The overriding theme of being approved for late relief is that the entity and owners treated the entity as though it was an S-corporation and accounted for it as such (the proverbial ‘if it walks like a duck and talks like a duck, it is a duck’).
While we gave a reasonable level of detail discussing a limited liability company flipping to an S-corporation, I won’t devote nearly the same time describing the flip of an LLC to a C-corporation. Why? Because it is a rare situation! Yes, I’ve seen it, but it is typically due to one or both of the following: 1) S-corporations are limited to one class of stock, and 2) S-corporations can only have 100 shareholders. These two attributes loosely define ‘larger business,’ which most of us deal with infrequently. If one or both of these attributes is present however, the options are limited to the C-corporation choice. Again, while it does occur, it is not very common. Regardless, the process is not a lot different than the S-corporation flip other than, instead of filing Form 2553, you will file Form 8832 to make your C-corporation election.
Form 8832, Entity Classification Election, is a three-page form to be completed by an LLC owner or owners to make the election to be treated as a corporation for income tax purposes. Should your limited liability client want to be treated as a C-corporation, you will complete the appropriate information on page one of Form 8832, and then check Box 6a on page two. It is important to note that each member of the limited liability company must consent to the entity classification change by signing Form 8832.
The Bottom Line
When you set up your limited liability company or assist in establishing one for a client, your work is not finished. The importance and benefits of establishing an LLC can be completely overshadowed by the negligence of not making the correct entity taxation election. Over the years, we have been the beneficiaries of obtaining clients because their previous accountants were not familiar with the entity taxation options. This is typically costly for the client and the accountant. Do yourself a favor and make sure you understand the options, protocols, and requirements.