Wealthy & Wise: LLC Tax Elections Decoded

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About the Video

LLC tax elections can be confusing until you know what your options are and why. Cort Christie and Bryan Hawley help take the mystery out of that election to help you decide which one is best for your business.

Prefer to read? A full transcript is provided below.

Cort:

Hello and welcome to another edition of Wealthy and Wise. I’m your host, Cort Christie, founder of NCH. Today, we’re going to be talking about the different ways that an LLC or a limited liability company can be taxed. And there’s various ways that you get to choose from, depending on the type of business that you’re in, depending on what stage of business, the amount of profit that you might have. And there’s various things that you want to look at when choosing how you want to be taxed as an LLC. And I think I know that sounds confusing, but I brought an expert to help me out today to make sure that we get things right. We have Bryan Hawley, who’s one of our top business advisors at NCH. He’s been supporting our clients in many different ways on the development of their business and more specifically on identifying the right type of taxation and then helping them get over to our fantastic tax support team. So, with that, Bryan, welcome to the program today.

Bryan:

Thanks for having me.

Cort:

Absolutely. And I’m excited about this because there’s always a lot of confusion around the taxation of the business entities and specifically LLCs, because that’s like 90% of what we tend to register people as today. And they have choices in the matter, and they don’t recognize that they have choices up front, but they do. And I think this is where I want you to shed some light on this for us. And so I’m going to just turn it over to you for a bit here, and we can have a few questions after you kind of start to break it down for us.

Bryan:

Sure. Yeah. It can be rather confusing. And mostly, like you were saying, 90% of business entities are LLCs. And I think it’s like 80 if you count all the large businesses and everything too, I think you were saying. However, you know, the LLC is about 45, 50 years old having 1977 as the day one of the states looked at some stuff in Europe and said, oh, hey, look, partnerships that have a corporate veil for everybody, not just a particular type of partner. So Congress brought them over or allowed them to be in the States, but they didn’t want to vote on or make the IRS interpret the vote and write new tax code. So they said, pick whatever tax code you want, essentially. A lot of people call this like a check the box solution.

Cort:

Okay.

Bryan:

So, if you set up an LLC, if one sets up an LLC and they say nothing to the IRS except for may I please have my EIN number right, your employer identification number. And then for 75 days, two and half months, if you’re doing the math, you don’t say boo to the IRS. They’re going to go. How many owners did they say they had when applying for the EIN number? And if it’s one owner and again, you didn’t say anything, you didn’t make any additional decisions regarding taxation, right? Which they call an election. I decide, I elect same word in this arena, right? They will choose for you. Right? If you know your Rush lyrics, if you fail to make a choice, you still have made one, right? So, they’ll say oh, one owner. If one owner is disregarded for tax purposes, which mean that they would be taxed as a sole proprietor, just the person out there with an EIN hanging a shingle, no business entity as far as taxation, no difference. You know, the proper schedule, schedule E, C, whatever, that’s… We’ll get into that a little bit later. But they get the corporate veil from the limited liability company because the limited liability company, if we turn that into a sentence, it limits the liability to fall only on the company. Right? So, this way you get the limited liability without any change in taxation. And there’s reasons why one would want to do that, like passive income, for instance. Yet if there are two or more owners, right, then they go, oh, and they, and you haven’t said boo to the IRS, right? I’m going to keep using that word. Then they go, oh, partnership. Right? Because if two entities, be it people or two corporations or two LLCs for that matter, two anything, get together in business, two or more, they could form a partnership. But if it’s just two owners within an LLC, then and you don’t say anything to the IRS, you don’t make an election, the IRS will make that for you. And they call that a partnership. And then you do taxes as if a partnership would.

Cort:

And so, for clarity for the audience to the first one, right, is like a single person who runs the company that the IRS just says, hey, you didn’t tell us what you wanted. And so, it’s on their personal tax return. 1040.

Bryan:

Yeah. So here I kind of glazed over that answer, drilling down.

Cort:

Then the partnership would be if you had two or more partners and you didn’t elect or didn’t say Boo, then it would be a 1065?

Bryan:

Yes. So you and I, as people and the viewers here, as people, unless there’s any robots viewing, I don’t know. But we do, we all do a 1040, right?

Cort:

Yes.

Bryan:

And either 1040EZ, and if you’re a business owner EZ is out the window, you’re doing a 1040, right? And yes, so if nothing right, if no decision single owner, it’s going to be on your 1040 with an additional schedule. So, imagine a motorcycle having a sidecar, right? So, if you’re doing a particular type of income, we’ll drill down in a minute. You’d have a schedule C. If you have a different type, like maybe you own a farm, it’d be a schedule F. If you have dividends from a stock portfolio, schedule D and it goes on and on to rentals a Schedule E, some other things. So, the appropriate schedule one could say in short, right? This is where you could see kind of how deep this goes. So, this is where the real value of once you become a client being assigned a business specialist like myself or any of my colleagues within my department, especially, you do have those 75 days, right? That’s two and a half months to make that decision, that election. So even if you’re like, well, I know I need an LLC because I want to limit my liability to only fall on a company. So, what else am I going to use in a limited liability company? Right? Corporation might be too heavy of a situation for most, which is kind of the situation how it’s become now. Then, you get to decide to not decide or decide to go corporately, which we’ll talk about in a moment. So, yes, then to tie up what you had said, if two or more, then it does go into a 1065 and that’s the same exact return. This is the interesting part. So, if you and I formed a partnership, an actual just partnership, we would do a 1065, whether it’s a limited partnership or a general partnership or a couple others. So, an LLC with two, since it doesn’t have its own tax classification, it would say, Oh, I’m a partnership for tax wise, right? There’s two sides of the coin, legal, taxation. So, for the legal, for the taxation side of things, it would be taxed as a partnership. Now, let’s say one does make a choice. So, it’s like I want to be taxed corporately, right? So, to divide this up to make it easy for everybody, let’s talk about non corporate and corporate. So non-corporate we’ve learned, right, is sole proprietorship with the appropriate schedule on your 1040.

Cort:

Yes.

Bryan:

A partnership, whether it’s two or ten or 50,000 people, you could do a partnership 1065, being hyperbolic. Now corporately, Right? So corporately, you have two choices. Now corporations can be taxes as not for profits but LLCs can’t. That’s like the one limitation. Otherwise, it’s a free for all. One could say, so what do you have left? You have a regular old C Corp, which is how every C is born. If you imagine this corporation, here it is right here. Right? Imagine it. You see it right there. There’s a little switch right here. It says taxation, right? And it’s default mode. It’s taxed as a C corp, which means that there’s, if you imagine this corporate record, I mean, this tax code book. It’s as big as a pool table when you open it and all this dust right? So, in there somewhere and thank God you don’t have to find it. It’s a CPA’s job, is chapter C and in there are rules just like there’s rules to Major League Baseball. Right? And so, it’s a game and you want to play by the rules and you might want to find out which game is best for you. Maybe minor league baseball is good for you, right? So that would be a subchapter S. So, if you ever heard somebody say S Corp or Sub S or subchapter S, they’re all talking about a subchapter Under C called Subchapter S down this huge book.

Cort:

Okay.

Bryan:

So those are your two versions of corporate tax, non-corporate, corporate. So, which one is right for me? Right? Which one’s right for my neighbor? Which one’s right for Bob down the street? It depends who you are, what you’re doing. At the top of the show, you had mentioned what stage of business, how much money you’re making, all of these things. So, these are what one has to look at and C corps still have their place. They’re just rarely used, because I don’t know how deep you want me to go, because this can be quite a rabbit hole. So I’ll take your lead on this. With a C corp, a lot of people say, oh, that’s double taxation. So, we’re going to start from the more complicated one, we’re going to work our way back. Okay?

Cort:

And double taxation just for our viewers is you have a tax rate…

Bryan:

Yes.

Cort:

At the company level called the corporate tax rate. And that taxes your profits.

Bryan:

Yes.

Cort:

And then if you decide to pay out those profits in the traditional form, which is called a dividend like for publicly traded companies. Then you get taxed again and dividend tax rates are actually, as we call them, ordinary income tax rates, which go up to 37% currently.

Bryan:

It’s your bracket.

Cort:

So, you kind of have, you have a 20% top corporate tax rate. I think it might be higher than that now.

Bryan:

21.

Cort:

21?

Bryan:

Yeah.

Cort:

And a 37% personal and you first take a bite out of the apple with corporate tax rate and then that same dollar can get taxed again when it hits your 1040 as a dividend and so that’s the double taxation model, which can be incredibly punitive, but there’s ways of managing it,

Bryan:

Right. Just like there’s a way in, in through management. It could actually work out best for some businesses.

Cort:

Yes.

Bryan:

Any time that a dollar, the same dollar is taxed twice for the made in one way, you made this dollar by selling this pop boom dollar. So, it’s taxed in two different ways. That’s referred to as double taxation. So just like play out the chess game a little bit. Let’s say you do have a corporation, it’s tax like a C, right? And then it has revenue and it has expenses. Let’s say the revenue is higher than the expenses. So that’s profit, right? What’s left over quite simply, that’s after payroll and widget materials and everything and rent and utilities and internet and everything. So, whatever’s left over would be profit and then the feds, let’s just talk about the feds, it’s state, too. But feds go, oh, hey, that’s profit. That’s 21%, thank you. Right? So 21% right? Now, the owners say there’s three guys, right? Three people. The owners say, oh, well, we want some of that profit. We’ll take that as a dividend, like you said, it’s called different things depending on what different entities you have for a C Corp, it is called a dividend. And then they accept that dividend. Maybe it’s on their schedule D on their 1040, like I mentioned before. And they’re going to get nailed. They’re going to get hit again on that same dollar. So, it’s already been whittled down once. But yes, larger businesses, you have a number of employees. It’s different for everybody in different you’ve got, you know, different arenas in which you’re operating and all these kinds of different things. But where, yes, you can manage that taxation and come out ahead, otherwise C corps wouldn’t exist anymore. They’d be antiquated, right? So, because they exist, somebody found them useful somewhere, especially publicly traded companies. And it’s not just for those folks. But S right? S Corp, subchapter S. A lot of people also say that it stands for Small Business Corporation, whether it does or not it works. and actually on the form to become a subchapter S entity. And I say entity because we’re talking about LLCs and they may do this too. We’ll circle back to that. Right across the application 2553, there’s no test on this, but it says application for Small Business Corporation. Right? So a lot of people just assume S means that, whatever floats your boat and makes it easy to think about. You do that. But Subchapter S mitigates that double taxation. And how does it do that? Quite simply, you get all the corporate write offs, right? You get your employees, if you have any, you get yourself as an employee and we’ll get to that. You’ve got all of your expenses, anything above the revenue that you would consider profit. Anything below that that you wouldn’t consider profit, expenses, you get all the corporate write offs, all the same stuff. However, when there is money left over, there is no, oh hey, that’s corporate profit. Because the main difference we’ll just sum this up real quick. The main difference between an S Corp and a C Corp is a C Corp may retain its own corporate earnings. And if there some left over, it’s taxed. And then what you do after that, you disperse it, whatever, if you want to or you hold on, you hold on to it for that Wheat Thrasher buying that costs $8 million dollars. You know what I mean? So, it may retain its own earnings. So, since it gets earnings, it’s taxed on it as corporate tax. An S Corp may not retain its own earnings. And this is where it gets fun. So, if it can’t retain its own earnings Cort, what does it do? So, well It’s got to do something with it, right? So, let’s imagine some like imaginary tax return like, oh, here’s the income, here’s the write-offs or whatever. There’s a black number at the end. They didn’t end in the red. They ended in the black here’s a positive number. It may not retain its own earnings. Well, how does that work? Well, it’s got to give it to its owners. So, let’s say that you and I own this S election, right? This S election, this Subchapter S Comma, LLC. Let’s say that’s even its name. Right? So, this LLC, if there’s money left over, what do I do with it? Well, I’ve got two owners. I’ve got Cort at 60% and Bryan at 40 and you got me again. And so it’s got to disperse it. I’ll say there’s 100 bucks in there for math, for easy math, right? Then you get a little note from mom, right? Essentially you get a little note from the tax return, which is an 1120s for those taking notes and it’s called a K-1 distribution. Just imagine, it’s like a little paper airplane right stuffed with 60 bucks in it and it goes and it lands right next to your 1040 and mine with 40 bucks in it lands right next to my 1040. And so, like if, if one imagines they’re doing their taxes by themselves on their, which they shouldn’t do if they own a business. But they’re doing their taxes by themselves on you know, let’s do your taxes dot com or something and it says, do you own a business? Yes, or are they a partnership or an S corp? Yeah. Okay. Go grab your K-1. The same is, are you a W-2 employee? Yes. Okay. Go grab your W-2. Same as are you an independent contractor? Yes. Okay. Go grab your 1099. Right? It’s just a piece of paper where all the hard math has already been done and it’s the result of the S corp tax return called the 1120s. It all comes down. What do I do with the extra? All the hard parts, corporate write-offs and all that is there. The easy part is writing down the 60 and the 40 on the K-1 and handing them to the appropriate party. Now, I say if you own 60% and I own 40%, the distribution is tied to the amount of ownership. So, that’s a difference that I’ll distinguish here in a moment. So, with a C corp that’s a whole other thing it’s taxed once may retain its own corporate earnings, S corp may not retain its corporate earnings. So, and then it must disperse that profit to the owners. Now here’s the linchpin of the whole thing and why there are so many S elections with small businesses. Because not only the double taxation thing, but we’ve got active and passive income. Let’s jump into it really quickly. So, if you’ve got active income, let’s say any time you make something you’re manufacturing and you’re selling something, you’re providing a service, that’s active income. Any time a pile of money or an item is making money for you, you know, dividends from stocks that you hold, long term rentals you hold long term or cash I lent to my friend Joe for more than a year. I charge him interest because he’s Joe and that’s all passive. So that is not subject to self-employment tax. A moment ago I said there’s reasons why you might want to install the asset protection, but not have any kind of corporate taxation. Right? Because if it’s not subject to something that you want to get rid of, it’s just going to come to you and the best place for it is on your personal. You leave it where it needs to be. But making something, providing a service, selling something, improving something and selling it, all that is active income and that is subject to self-employment tax. So if you’re a sole proprietor or even in a partnership and it’s active income, it’s going to be 15.3% just off the top right? That’s on every dollar that you keep. So, if we’re in a partnership and we divide up our money, that’s left over however we do, let’s say, you know, there’s profit left. Partnerships also may not keep their own earnings, their own partnership earnings. They must be given to the partners.

Cort:

So, you have self-employment tax on top of all of it.

Bryan:

Your regular on top of your bracket. Right?

Cort:

Just like any independent contractor would have…

Bryan:

Any Sole-Proprietor.

Cort:

Would have to pay that 15.3%.

Bryan:

On top. Yes, you nailed it.

Cort:

So if I, so with an S elected entity, the profits that are distributed, as you said on this form K-1 is the notification form that doesn’t require then that you have to pay that self-employment tax?

Bryan:

Bingo because it’s here owner, here’s some profit. Good job. Right? So that isn’t the only way the owner of an S elected entity gets paid though. So, I promised circling back to something a bit ago when I said that different ways to pay yourself. So, there’s like, let’s call it a test. You have to pass a test if you want a corporation or an LLC, and we’re talking about LLCs today, but it’s identical. If you want an LLC to have an election, the tests are as follows. You have to have 100 or less owners right, check, it’s you and I. Right? All right. All the owners have to work in the company. You’re not a silent partner. We’re both grinding away. Check. Right? You have to make a profit two years out of any five-year period. Right? Or sorry. You have to make a profit three years out of it. You can lose, you can not make a profit the two years out of the five years. So those are the tests, including all the owners have to make a reasonable salary. Now, every once in a while tax code puts some wiggle words in there. And this is much like that, reasonable salary.

Cort:

Which then you will pay self-employment taxes, but it’s broken up. You get to expense half of it through the company and half come off your paycheck.

Bryan:

Yeah. And to drill down just a little bit into that. So, let’s just say that you, let’s call this a blended income, right? So I’m taking some as here owner good, here’s some profit I’m taking some as here employee of a company you happen to own. This is where you are truly a business owner and you’re no longer self-employed because you own the business, the business employs you. Sounds like semantics, but it’s a very important distinction. So having said that, when you payroll yourself, there’s payroll tax and FICA. Oddly enough, if you sum those two numbers together, they equal 15.3, which is identical to self-employment tax. Right? So there again blended income, right? To say fifty, let’s just be conservative and say 50/50 rather than 70/30. 50% through payroll W-2. Yes, that means W-2 and 50% as an owner distribution, which is here owner have some profit, owner distribution, K-1 all that stuff, right? It’s all the same thing on our distribution and let’s say it’s 50%, $0.50 on the dollar each way. Well, if you as a sole proprietor, you’re being taxed 15.3 on everything, right? And then as an S corp owner and operator because you have to operate the company, too, that’s one of the tests. You’re paying, an equivalent of 15.3 self-employment tax. So let’s just stop calling it self-employment tax and just call it the 15.3. So, you’re paying the 15.3 on the part that you payroll yourself. And there’s a caveat there. And you’re paying none of the 15.3 on the distribution of your blended income. So, one could easily say that you cut your self-employment tax in half, and that would be a fair statement. Semantics would stop you from saying that that is just the fact you’d want to drill down to be specific and say, well, that’s FICA and in payroll tax. But the company gets to write off part of the payroll tax. Technically, it’s coming out of the company’s pocket before it even gets to your pocket. And then you’re paying the FICA and it’s nearly in half. It’s seven point something and seven point something on either side. So, to keep it simple, here’s your soundbite, right? Because we just went a lot of blah, blah, blah, right. The sound bite is…

Cort:

We’re bringing it all together.

Bryan:

Yeah. The soundbite is this is the takeaway that if for most situations, once you get into certain aspects of your business and whatnot, which anyway, you can take your self-employment tax and essentially cut it in half. If you start going 70/30, the more money that you make in the company and the like, how much would I pay somebody if I own the company, how much would I pay somebody to do the nitty gritty throughout the day? That’s your reasonable salary, typically. That’s just an easy way to talk about it. And then all the rest is here owner, here’s some profit. So, like an airline pilot, right? That is 1099 because maybe they’re just a gun for hire. They’re like, hey, we need you to fly this little thing over there like corporate, right? They make a ton of money and they don’t have a lot of expenses. So, they could, there is averages of how much somebody could be paid If they’re working for a small company. They could pay them that because they are what? They’re a small company. And the rest is an owner because the owner has taken all the risks, making all the decisions, stressing out at night and the operator just flies the plane. Right? Not that that’s not stressful. But as an example. So one could say that you cut it in half. So, just to recap this, the S selection for most small businesses could mitigate and cut in half or more.

Cort:

Your self-employment taxes, which is significant.

Bryan:

Which is corporate, the C Corp, yeah, it’s going to get double taxed in every situation unless you manage that to where the double taxation is lessened. Whatever a large company is going to do.

Cort:

Sure, and I’ve seen some C elected, you know not elected, C corporations LLCs that are using that corporate tax code. Leave the money in the entity, pay the 21% and then not take it out at all so that they have 79% of the profit left over to grow the business. And so there can be like some interesting caveats, too. And I think, you know, the important point of this, you know, episode today is that when you file an LLC, the most common type of business structure that’s out there, you have four different ways of being taxes, four different tax returns that are impacted by the way that you choose to be taxed. And you know, and there’s a form that you fill out the SS-4 form, you identify what type of business taxation that you want to be. And if you choose to go down the S elected, which by the way for all of you listening today is the most common way for an established business to be taxed today because it’s a way to minimize the amount of taxes that you pay. As Bryan’s pointed out, on self-employment taxes, you can reduce those by potentially 50% or more in some cases depending on the profit of your business. And so that requires an additional form that is submitted to the IRS to let them know that you’ve chosen to be an S elected for tax purposes LLC. It gets so confusing. But I think what’s great here is, we’ve established that, you know, if you choose to be an LLC, now there’s a secondary choice that has to occur after you get that business entity formed and you choose how you want to be taxed.

Bryan:

Now imagine, imagine it was the other way around. Like, let’s flip exactly what you just said. You said you get to choose after. What if you had to make that decision prior, you know, two and a half months. Why two and a half months? Why not two and a half days? Why not two and a half years? Right? Well, you want it to be within the same tax year, right? So, we got that logic. But why not six months? Well, two and a half months, I think somebody thought was fair enough to contemplate. And maybe you actually start the business when you should. And when I say the business, I mean the business entity. A lot of people will create their business and then they’ll create the LLC like they’re putting a roof on it. That’s why I kind of, I twitch a little bit when I hear somebody say under the same umbrella because umbrella is on top, right? And they think that they’re weathering some storms. It’s a concrete slab, right? That’s the very first thing you do when you’re building something.

Cort:

The foundation.

Bryan:

It’s a foundation. It’s a concrete slab. You got to pour that. It’s got to be level. All your plumbing is running through it. The money coming in, the money going out, all of that stuff. And it’s got to fit the floor plan. How many rooms are you going to have? All this stuff. Now, can you add on rooms later? Of course, to a business. A business may what? Grow, but essentially you want to pour that concrete foundation, build your business on top of it. And you know what? While you’re building that first floor or parts of it or sussing things out, some things might change within your business. It might grow faster than you intended it to, might not grow as quickly as you wanted it to. And that’s where the two and a half months comes in. But even after that, every quarter, you could say you have an opportunity to change it from something to something. Now, can you go back and forth? This quarter I want to be that or that quarter, no, the IRS won’t allow it because it’s always an ask. And you don’t want to either, because then you’ll be doing three different tax returns in the same year.

Cort:

Sure, sure. And there’s some flexibility in changing your mind later on. There’s a bunch of rules around that, how to go about changing it. But I think, you know, we’ve established that there’s some decisions to be made after you form your first business structure, and that relates to how you will be taxed, whether it’s your personal tax return, a partnership return, corporate tax return or an S corporation. So, thank you for helping us lay this out, because I think you’ve put it together in a way that people can start to grasp that there’s some optionality that comes with taxation of a small business that you’re just getting started. So, thank you for your time today, Bryan. It’s been great and you’ve kind of dumbed it down for us because it gets complicated. And for our listeners, you know, that are new to business, they’re thinking about, you know, now they’re thinking about even starting a business. These are some of the dynamics that you need to think about. And they can put more money in your pocket ultimately by choosing the best type of way of being taxed. And it can be significant. So, lots of things to think about here. So, thank you for your time. I appreciate it.

Bryan:

Thank you very much.

Cort:

Absolutely, and for all of you listening today, I hope this has been informative for you. I know it’s been informative for me because it’s just good to hear it through. Bryan’s done a great job of breaking it down for us. And if you have any questions yourself or want to talk to one of our representatives like Bryan and just call him up and pick his brain, he’s a wealth of knowledge. Just reach out to us at NCH. We’d love to help you and support you. There’s no charge to talk. You can talk to us as much as you want and kind of brainstorm what’s right for you and your business. So, thanks for tuning in to another episode of Wealthy and Wise. I’m your host, Cort Christie, have a great day!

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