We have discussed what an LLC (limited liability company) is and how to form an LLC, but how is it taxed at the federal level?
The simple question has a somewhat complicated answer. The LLC is a relatively new form of business entity that combines features of both partnerships and corporate structure. In 1997, the IRS clarified how an LLC would be taxed. This is known as “check-the-box” taxation, as the LLC checks a box on a form.
A single-member LLC may elect to be taxed as either a C corporation or a sole proprietorship. A multiple-member LLC may elect to be taxed as either a partnership or a C corporation. So, in order to determine how an LLC is taxed, we need to discuss sole proprietorships, partnerships, and C corporations.
A sole proprietorship is a business owned by a single, sole individual and is treated as the individual owner for tax purposes. There is no tax return specific to the business entity. The only tax return is the individual’s tax return with the income of the sole proprietorship reported on Schedule C. The business income is then taxed at the individual’s tax rate. Note that business income includes distributed net profits and retained earnings. Finally, keep in mind that a sole proprietorship is responsible for paying self-employment tax.
A partnership is, in its most simplest form, two or more people work together to advance their business interest(s). The partners share profits, losses, deductions, credits etc. A partnership is not taxed; rather, income, losses, deductions, credits etc. “pass through” to the partners. The partnership reports each partner’s share of income, losses, deductions, credits etc. to the IRS and each partner in accordance with the partnership agreement. The partners then report their share on their own tax return, regardless if there was an actual distribution of income to the partner.
Note that along with the potential distributions of profits and losses, partners may also be provided guaranteed payments for their services or capital contribution to the partnership. These guaranteed payments are ordinary income for the partner and deducted by the partnership as an ordinary business expense. However, if the guaranteed payment is for personal services, the partner is liable for self-employment tax.
A C corporation is what a person typically thinks of when the word ‘corporation’ is used. A C corporation is so called because it is governed by Subchapter C of the Internal Revenue Code.
Unlike a sole proprietorship and partnership, a C corporation is a taxable entity. In other words, the C corporation files its own tax returns separate from its shareholders. Taxable income is calculated by the C corporation and the corporation pays tax. There are various tax strategies in C corporation’s that this blog post will not address. What a farmer or rancher should be aware of is that the C corporation is taxed as an entity, unlike the other business entities discussed in this post.
All in all, this post is a very small look at the considerations in selecting a business entity for your farm or ranch operation. If you want a more detailed discussion of various business entities, feel free to contact us. And don’t forget, also contact your financial professional — they know taxes, after all!