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OPTIONS IN SELECTING THE TAX STATUS OF DELAWARE LLCS
Unless it elects otherwise, a Limited Liability Company (or LLC) is taxed as a partnership, and is not itself federally taxed on its profits and losses. Instead, its items of gain or loss are “passed through” to the LLC’s members (owners) to be claimed on their individual income tax returns. The character of the LLC’s profits and losses for tax purposes is also passed through to members (e.g., capital gains treatment).
For Delaware tax purposes, a Delaware LLC that is not physically operating in the State is only required to pay the State a simple, flat-rate franchise tax of $300 per year, due annually on June 1. The franchise tax covers the previous calendar year’s business activity, and is due for so long as the LLC exists, regardless of its level of activity or whether it made any money. An LLC that is cancelled remains responsible for the full $300 franchise tax for the year in which it is cancelled, regardless of how far into the year cancellation occurs.
LLCs have four options for taxation treatment under the U.S. Internal Revenue Code: (1) pass-through taxation as a partnership, the default treatment for LLCs, (2) C-Corp entity-level taxation, (3) S-Corp partnership-like taxation, and (4) disregarded status for tax purposes, applied to single-member LLCs.
Known as Foreign Qualification, this process allows a company formed in Delaware or any other state to legally transact business in Indiana.
When an LLC is formed, it will be taxed as a partnership by default if it does not elect to be taxed in a different manner by filing a Form with the Internal Revenue Services. Partnership taxation is, then, the most common form of LLC taxation. Under this default taxation, the LLC itself is not subject to federal taxation on its income or loss. Instead, each member is allocated his, her, or its distributive share of the LLC’s income or loss. Each member declares their share of the LLC’s income or loss on their personal taxes, and pays self-employment tax at their own personal income rate, taking into account the character of the income or loss passed through to the member (owner) (e.g., capital gains taxation rate, etc.).
Management of an LLC can elect to be taxed under Subchapter C (C-Corp taxation) at the entity level in the same manner as a corporation is taxed (unless the corporation elects otherwise), by filing IRS form 8832. An LLC may be automatically subject to C-Corp taxation if it is treated as a “publicly-traded partnership” or “PTP” for tax purposes.
An LLC electing C-Corp taxation is subject to what is commonly referred to as “double taxation,” meaning the LLC is taxed on its income and loss at the LLC level, and the members (owners) are also taxed on distributions made by the LLC. The LLC is taxed on its income at the then-current corporate tax rate (currently 21%). Unlike in partnership taxation, the character of the LLC’s income is not passed through in distributions from an LLC to its members. Instead, distributions from an LLC electing C-Corp taxation are taxed as ordinary income to the members (owners) or are treated as qualifying dividends (0%, 15%, or 20% depending on the tax bracket of the receiving member), if the distribution qualifies for such treatment.
However, the members (owners) of an LLC electing C-Corp taxation have many options for reducing the effect of “double taxation.” If taxed as a C-Corp, an LLC is able to deduct all business expenses, interest payments, reasonable salaries paid to owners, employee fringe benefits (such as health and disability insurance), and more, thereby lowering the amount of tax owed. In addition, an LLC electing C-Corp taxation pays lower tax rates on earnings retained for use in improving the company, a benefit that is unique to C-Corp taxation.
In addition, an LLC electing C-Corp taxation can fully deduct state and local income tax and property taxes from its taxable income. On the other hand, an individual's deductions for state and local income taxes and property taxes are capped at $10,000 (or $5,000 for married couples filing separately). Therefore, a member loses the full benefit of this deduction if it invests in a pass-through entity, such as an LLC subject to partnership taxation (or S-Corp taxation, discussed below).
An LLC can elect to be treated as a pass-through entity by filing Form 2553, electing to be taxed under Subchapter S (S-Corp taxation). S-Corp taxation is very similar to the LLC default partnership taxation in that, under each, the LLC itself is not taxed as an entity; instead, the members take all items of income and loss onto their own tax filings and the character of the income is passed through from the LLC to the members.
There are certain differences between S-Corp taxation and partnership taxation. In some cases, LLCs subject to S-Corp taxation can engage in tax planning techniques that an LLC taxed as a partnership cannot, particularly in the area of self-employment taxes and claiming the 20% “qualified business income” deduction available in some cases.
Note that electing S-Corp taxation imposes significant restrictions on the ownership and operations of an LLC. For example, in order to qualify for S-Corp taxation, an LLC must (1) (a) have no more than 100 beneficial owners, (b) all of whom must be natural persons (no entities, save for certain trusts and estates), (c) that are U.S. persons (no non-US members), and (2) issue only one class of membership interests. These requirements are very restrictive and limit the size and investor base of the LLC significantly.
An LLC with only a single member is automatically classified as a “disregarded entity” by the U.S. Internal Revenue Service, unless it elects C-Corp or S-Corp taxation. As a disregarded entity, for purposes of taxation, the LLC is ignored (and does not prepare or file a tax return) and LLC items of gain and loss are treated as those of the sole member directly. Any income must be claimed on the single member’s tax return as self-employment earnings.
A single-member LLC which adds on another member automatically becomes taxed as a partnership, and the conversion to partnership taxation may have tax consequences to the original member. Also, a single member LLC can elect C-Corp taxation or, if it meets the eligibility requirements, S-Corp taxation and status.
It is important to note that Harvard Business Services is not an accounting firm or a law firm, and cannot provide accounting, tax, or related legal advice. Nothing herein is, or should be taken as, such advice, and we recommend that a reader speak with an accountant or other tax professional for more information, particularly as it relates to the tax election and status that may suit the reader’s, and his or her business entity’s, needs, goals, and tax circumstances.
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