C-Corporation Tax Election
After forming your LLC, you have four options on how your LLC will be taxed:
- Sole Proprietorship;
- Sub-S Corporation; or
The first three options are called pass-through elections. The fourth, the C-Corporation election, results in the tax being imposed on the LLC.
Before making your decision, you need to consult with your tax advisor and determine what works best for you. In many instances we have counseled individuals who chose the C-Corporation alternative without professional advice solely because the maximum corporate tax is 21%, while your maximum tax rate on the other alternatives is 37%. They assume that there is a 16% tax benefit to the choice; however, the “benefit” is illusory. The problem is that once the tax is imposed at the LLC level, you are subject to a 37% additional tax (called double taxation) when you distribute the money out of the LLC to yourself.
Many clients have just assumed there is some sort of magical way to avoid this double taxation. There is not. This is why you must be fully advised on your tax election.
There are several ways to reduce or possibly eliminate the problems of double taxation with the C corporation election:
Retained Earnings: Retain your taxed earnings in the LLC. Retention without distribution to members avoids the second layer of taxation. This will not work, however, if you will be relying on the LLC’s cash flow for your personal expenses.
Salary Distributions: Alternatively, you can distribute LLC income as salaries or bonus. These are taxable to recipients but are a deductible expense to the LLC. The difficulty with this is that you will have FICA matching of approximately 7.65%; thus, you will withhold and match approximately 15.30% of the salaries paid.
Income Splitting: Income splitting results when a business owner withdraws as much of the LLC’s profits as he or she needs to support their lifestyle and leaves the rest inside the LLC. Since our tax rates are progressive, income splitting may minimize the effects of double taxation. By taking only a portion of your LLC’s profits as salary, and leaving the rest in the LLC for reinvestment, your and the LLC’s gross income and taxable income are reduced, which, in turn, reduces the tax.
501(c)(3): Form a 501(c)(3) organization and use it to meet your charitable inclinations. First, you register the organization with the IRS. You then contribute cash and/or real or personal property using, in the case of property, the fair market value, not your tax basis, as a write-off against your taxes. Remember, however, that the income from the contributed assets belongs to the 501(c)(3) and must be used for charitable purposes, after deducting legitimate operating expenses such as salaries to your family members for running the charity.
Captive Insurance: This is an exceptionally complicated area of the law. Essentially, you can form your own insurance company or operate in conjunction an insurance company with others for the purpose of insuring various risks you have in your business. The insurance premiums are tax deductible and the money received by the captive would, at least initially, go into a loan loss reserve and not be income. Eventually, on distribution, the loan loss reserve could be construed as income.
Pensions: Contributing the maximum allowable each year allows you to put money away for retirement and receive a tax deduction; presumably, you would withdraw the money when you are at a much lower tax rate than the 37% maximum tax.
There are risks in retaining your earnings after the C corporation election:
Alternative Minimum Tax: LLCs taxed as C-corporations are subject to the AMT when they gain the benefit of too many tax incentives. The tax rate is 20 percent (the rate is reduced to 15 percent for certain specific items.)
Accumulated Earnings Tax: LLCs under a C-Corporation election that accumulate and do not distribute after tax profits are subject to an accumulated earnings tax. An LLC may accumulate earnings of up to $250,000 without incurring this tax. Any amount over this construed by the IRS to be beyond the reasonable needs of the business. The accumulated tax rate is 20% of the accumulated earnings. Personal service companies have a $150,000 threshold.
There are exceptions:
- Specific, definite, and feasible plans for the use of the earnings accumulation; and
- Product liability loss where the accumulated amount is needed for the payment of reasonably anticipated product liability losses.
We hope this helps. Good luck out there.