By Yigang Xu, CPA
XU CPA, LLC
A limited liability company (LLC), in the plainest language, is a hybrid entity sharing elements of a regular corporation (for limited liability) and a partnership or a sole proprietorship (for income flow through). It is not to be confused with a regular corporation, because it is not incorporated, but a form of union or association of persons for carrying on an enterprise.
A LLC is relatively easy to form than a corporation, and it is very flexible for federal income tax purpose. Since it is a hybrid entity, it can actually be taxed as 1) a sole proprietorship, 2) a partnership, and a 3) regular corporation, which further can be taxed as an S corporation. There are just a lots of flexibility.
If domestic LLC does not make any federal tax classification by filing Form 8832, it is by default:
1. A partnership, if there are more than two members;
2. Disregarded as an entity separate from its owner if there is only one member.
A partnership files tax Form 1065, its income or loss flows to its members, and members are subject to self-employment tax. A disregarded entity does not have its own tax return, but the owner reports the activities on Schedule C of his or her own Form 1040, like a regular Schedule C, income is subject to self-employment tax.
8832 Classification and 2553 Election:
Or an LLC can file Form 8832 and classify the entity to be taxed as a corporation, once it has elected to be treated as a corporation, it can further file Form 2553 to elect to be treated as a subchapter S corporation. An S corporationfiles tax Form 1120S, its income or loss flows to its members, but the income is not subject to self-employment tax nor the additional Medicare tax of 2013. This is a huge advantage illustrated below:
• If your business generates a net income of $100,000, and you do not make the S corporation election, this flow through income will be subject to an SE tax of $ 15,300 (12.4% for FICA and 2.9% for Medicare), but if the entity is an S corporation, you will not be subject to SE tax, which is a $15,300 saving in this scenario. Further, an additional Medicare tax of .9% is levied on certain income over various threshold starting in 2013, but S corporation income is not subject to this new Medicare tax.
An LLC is a very flexible business entity that is relatively easy to start, with or without an operating agreement, it is not to be confused with a corporation, as it is not an incorporated entity. It has various options regarding to federal taxation, entity can make election to be taxed as an S corporation or just follow the default treatment. But an S corporation election has its unique feature of having its income not subject to self-employment tax. If this particular feature is very important to taxpayer, an S corporation election is a choice tax election for many small business owners.
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