The type of business entity or entities you are using can affect future profits, stability, taxation, and other important matters. Business entities available include corporation / incorporation INC., limited liability companies (LLC), limited partnerships (LP, LLP, or LLLP), or a series or combination of one or more of the above. Running a profitable business is not simply a matter of making a profit; it is also important that you protect what you make, and put it to work in a way most profitable for you and for those who may inherit your business.
One of the most misunderstood areas of tax law is business tax law, especially as it applies to small and medium-sized companies. Many small companies start out as a sole proprietorship, and then later choose to convert to a limited liability company, an S or C corporation or other entity. They type of entity you choose determines the tax treatment of the income.
A C corporation is a corporation whose tax treatment is prescribed in 26 U.S. Code Chapter 1, Subchapter C. Put very simply; a C corporation's income is taxed at the corporate level before there are any profit distributions to the shareholders. C corporations file form 1120, and must file it by March 15 if using a calendar tax year.
An S corporation is a corporation whose tax treatment is prescribed in 26 U.S. Code Chapter 1, Subchapter S. When a corporation is formed, by default the IRS will treat the corporation as a C corporation. To be treated as an S corporation the shareholders and officers must make a Subchapter S election by completing form 2553. This form must be filed before the year in which the corporation wishes to enjoy the benefits of a Sub-S election, but no later than 2 1⁄2 months into the tax year in question. S corporations file form 1120S, and must file it by March 15 if using a calendar tax year.
An S corporation does not pay taxes; instead, its owners pay the tax. At the end of the tax year the tax liability for the net profit (or loss) of the S Corp is attributed to its owners. Each owner is given a form K-1 indicating the amount of income (loss) attributed to that owner. That amount is reported on the individual's federal income tax return.
The tax implications of a limited liability company are often misunderstood. LLC's are often treated one way for federal income tax purposes, another for state income tax purposes, and yet another for legal purposes. It is not uncommon for the IRS to completely disregard an LLC and treat the income of the LLC as if it were a sole proprietorship; yet, for legal purposes it will be treated as a separate entity-maybe. Finally, the state tax authorities will likely treat it as a separate entity unless there is a tax liability issue or dispute: then the owner may find that they are personally liable to the state and possibly criminally liable-regardless of the existence of the LLC.
When you form a limited liability company, if there is only one owner the IRS will disregard the entity and treat the income as ordinary income to the owner. This income should be reported on Schedule C as if it were a sole proprietorship.
When you form a limited liability company, if there is more than one owner, by default the IRS will disregard the LLC laws and treat the entity as a general partnership whose income is taxed as ordinary income to each of the general partners as individuals. Depending on certain facts, this income would be reported either on Schedule C, Schedule E, on form 1040 and in some cases elsewhere.
When you form an LLC one can avoid the default treatment and elect to have the LLC treated as an S Corp or as a partnership. Which election to make would depend on many factors including the relationship between the owners and the number of owners and type of owners, whether they are individuals or some other legal entity.
The entity choice of LLC is not as simple as many think and there are many instances where an audit of an LLC reveals many bad choices and misunderstandings that are very costly to its owners. Relying on advice of a company that merely forms corporations and other legal entities is not wise; one should seek the advice of an attorney and a tax professional when making these decisions.
International treatment of LLC's is even more complicated. An international investor from one country may have their LLC treated by their home country as if it were an ordinary corporation, possibly creating a substantial tax liability. Another international investor could have an entirely different result.
An LLC is often the knee-jerk response of real estate professionals and online corporate formation companies when asked by their clients about how to purchase and hold title to real property.
A great deal of bad advice is given by real estate salespersons, corporate formation companies and other "professionals" regarding this issue. If you need legal and tax advice, look only to experienced legal and tax professionals for advice or you may find yourself in breach of contract (default) with your mortgage lender, if you have one; or, find yourself liable for taxes and fees for which you were not prepared to pay.
The information you obtain at this site is not, nor is it intended to be, legal advice. You should consult an Attorney / Lawyer for individual advice regarding your own situation. Nothing contained on these pages should be interpreted as establishing an attorney-client and/or lawyer-client relationship through Attorney Riverside . com or with the Law Offices of David DL Horton, Esq. & Associates.
As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code. Furthermore, the contents of this website are neither intended to be, nor should be, construed as either legal OR tax advice. Each individual's circumstances are unique. This site contains general and overall discussions, and as such, the content of this site is not intended as definitive legal or tax advice that would apply to any particular person. Those who view this web site should seek advice from an independent tax advisor with respect to their particular transaction or matters that is based on the reader's particular circumstances. You must have your particular financial and tax situation personally reviewed by a tax professional or attorney in order to obtain tax or legal advice upon which you can rely.