Using a limited liability company (LLC) as the legal structure for your business has the advantage of providing you and your partners with limited liability protection. But it's important also to understand how you will be paid as a member or partner in a multi-member LLC.
Under federal tax laws, LLCs are viewed as "pass-through" entities. In other words, the LLC is not viewed as a taxable entity in its own right, and its profit and losses are instead passed through to its members.
By default, a multi-member LLC is taxed as a partnership. That means that, while you will still get the limited liability protection of being a member of an LLC, you and your partners also bear the full brunt of the taxes payable on your LLC's income.
Your Income as a Partner in an LLC
In this standard, default scenario, the members of a multi-member LLC can't be paid on a salaried basis. Instead, the profits generated in the year are distributed to each member, who is then required to report this income to the IRS using Schedule K1 (form), Partner's Share of Income, Deductions, and Credits.
One important thing to note is that you will be required to pay taxes on these profits even if you don't physically withdraw your share of the profits. Members of an LLC might choose to leave profits inside the company for a number of reasons, including providing required cash for future expansion purposes. Even though you don't draw on your share of the profits, however, you will still be taxed on the amount that constitutes your share.
Special Allocation of Profits
Distributions of profits are generally based on each member's proportional ownership interest, which should be set out in your LLC's operating agreement. In some situations, however, members might decide to distribute profits based on something other than each member's percentage ownership interest in the LLC.
For example, John, Jack, and Mary have decided to form a multi-member LLC. Their total investment in the LLC is $100,000, but while John and Jack have contributed $25,000 each, Mary contributes $50,000. Rather than giving John and Jack a 25 percent ownership interest and Mary a 50 percent interest, the members decide to give each member a one-third ownership interest and distribute a higher proportion of the LLC's profits in the first five years to Mary in order to compensate her for her higher investment in the company.
This is called a special allocation, and care must be taken to ensure that the IRS won't reject such special allocations as inappropriate. Because special allocations have the propensity to be abused, the IRS tends to scrutinize the reasons for such allocation. For example, if the member with the lowest personal tax bracket is given a larger share of profits for no other reason than because they have the lowest tax bracket, there is a possibility that the IRS will reject the special allocation being made and tax the partnership income according to each member's actual ownership interests.
Taxation as a Corporation
While taxation according to partnership rules is the default tax classification for a multi-member LLC, the LLC has the option of electing to be taxed as either a C Corporation or an S Corporation. In the case of opting to be taxed as a C Corporation, the LLC becomes a taxable entity in its own right, while opting to pay taxes as an S Corporation means the LLC remains a pass-through entity.
However, electing to be taxed as either a C Corporation or an S Corporation means the LLC is able to treat members like employees and pay them salaries. Payroll taxes are withheld from these payments, and at tax time, members will be treated as employees when it comes to this income. Because of this, the election to be taxed as an LLC can be an attractive option, particularly if members anticipate that profits will be left within the LLC rather than distributed.
When setting up a multi-member LLC, one important thing to consider is how the profits generated by the LLC will be taxed in the hands of the LLC's individual members. In some cases, it may be a good idea to consult with a tax adviser to see if electing to be taxed as a corporation might be more advantageous overall from a tax perspective.
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