Howdy, this is David Groce, your Texas Tax and Law Man, continuing our conversation about LLCs. Remember that LLCs are legal entities created under state law with certain powers, duties, and responsibilities. That’s the nuts and bolts of the LLC. But on top of the basic legal structure of the company, an LLC also has to tell the IRS how it wants to report and pay tax. Today’s let’s look at an LLC that chooses to pay tax as a C corporation.
Think of the LLC Corp like an old-fashioned stake truck. It’s great for a particular purpose, like stacking hay or carrying appliances, but it’s not the typical truck you want to go zipping around town.
Before we dive into the tax reasons why an LLC would choose to pay tax as a C Corp, let’s refresh ourselves on a corporation and remind ourselves why an LLC is NOT a C corp.
To begin, a corporation is the oldest form of shared ownership that offered the owners limited liability. The Dutch first started using the corporate structure when the wealthy merchants invested in ships and sent them around the world to trade. Imagine that you, me, and your best buddy are all rich merchants. You buy a ship and send it out to trade. I do the same and so does your buddy. The bad news is one ship sinks and the other two make it back. If that one ship was your ship, you just went broke. To limit that risk, the Dutch said let’s all three own one-third of each ship. If one ship goes down, then each of us only loses a little, instead of one of us losing everything. Thus, the corporation was born.
Because the corporation is so old, the rules governing a corporation are well-established and formal. Every corporation has to have shares, shareholders, a board of directors, and officers. And, a corporation has to have meetings, notices of meetings, and keep records of the meetings. That is a lot of paperwork and technicality. And, if you don’t do all of that just right, your corporation can be subject to a number of legal arguments that weaken the limited liability shield and may expose the shareholder investors to personal risk.
So, to avoid all of that, the good old boys in Wyoming invented the LLC that bypasses all the red tape and allows us to have a simple easy to operate entity, which also lets you choose how it is taxed with the IRS which is our main point today.
For an LLC - C Corp, we create our entity with the state and then elect to be taxed as a corporation on our SS-4 application or on Form 8832. C Corp status means now that the LLC pays tax on its earnings.
In all the others structures we have discussed, the earnings of the LLC pass-through to the owners - the LLC members. In the case of an LLC C Corp, the LLC actually files and pays tax on its earnings on a corporate tax return - Form 1120.
The draw back of a corporate taxation is that it actually creates double-taxation. The corporation pays tax on its earnings. To pay these earnings to the owners, we have to either pay it as salary or pay it as a dividend. Both a salary and a dividend are taxable to the recipient. So, why would anyone want to pay double taxation?
There are a couple of scenarios:
First, the new Tax Cuts and Jobs Act created a new flat tax of twenty-one percent on C Corps. If a client has a higher effective tax rate than 21%, like in a trust or a high-income earner, there may be advantages to run a business through a C Corp and let the C-Corp pay its own tax at the lower 21% rate.
Second, this strategy works best when the C-Corp can keep its earnings and reinvest them without having to pay them to the owner. This avoids the double taxation problem, because the money is NOT paid to the owner and thus not taxed twice.
While this is not the most common structure for an LLC, electing C Corp status can provide the owners some specific benefits - mainly a 21 percent tax break.
So like the guy with the old stake bed truck, we may have a specific need to justify this structure. If not, maybe we need to look at another more popular model of LLC to meet your needs.
Until next time, adios.
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