Bar News - February 18, 2011
Tax Law: LLC Tax – Six Things You Need to Know
By: John M. Cunningham
You are a New Hampshire lawyer with a good working knowledge of NH LLC law, and you form New Hampshire single- and multi-member LLCs for your clients frequently. However, although your knowledge of tax is limited, you’d like to obtain at least a basic, plain-English understanding of LLC tax.
Here are the six things you need to know:
1. The Taxes. NH LLCs and their members are subject to three main types of taxes—federal income taxes, Social Security Taxes and NH state taxes. The relevant NH taxes principally include the Business Profits Tax (the BPT), the Interest and Dividends Tax (the I&D Tax) and the Business Enterprise Tax (the BET). (Social Security Taxes are called FICA taxes in the case of C and S corporations and Self-Employment Taxes in the case of sole proprietorships and entities taxable as partnerships.)
2. The Check-the-Box Regulations. For federal tax purposes, the LLC bible is a set of US Treasury regulations called the "Check-the-Box Regulations." As applicable to LLCs, these regulations and related provisions of the Internal Revenue Code provide basically as follows:
3. The BPT. Regardless of whether they are single- or multi-member LLCs and regardless of their federal income tax regimen, the BPT applies at an 8.5 percent rate to the net profits of NH LLCs apportionable to NH. However, the BPT does not apply to LLCs and other business organizations whose gross receipts for a given taxable year are $50,000 or less. By careful structuring, it is often possible to use this BPT "$50,000 floor rule" to substantially reduce an LLC’s BPT liabilities even if its aggregate gross receipts exceed $50,000.
- Single-Member LLCs Owned by Individuals. Single-member LLCs owned by individuals can be subject to federal income taxation either as sole proprietorships; as S corporations under Internal Revenue Code ("IRC") Subchapter S; or as C corporations under IRC Subchapter C. For these LLCs and their members, sole proprietorship taxation is generally best for federal income tax purposes, but Subchapter S will often be best for avoiding Social Security Taxes.
- Single-member LLCs Owned by Entities. Single-member LLCs owned by entities can be subject to federal income taxation as "disregarded entities" (in which case their profits and losses will be treated as those of their owners); or as C corporations. For these LLCs and their owners, disregarded entity taxation will almost always be best for all tax purposes.
- Multi-Member LLCs. Multi-member LLCs can be subject to federal income taxation as partnerships under IRC Subchapter K; or as S or C corporations. For multi-member LLCs, partnership taxation is usually best for federal income tax purposes, but for Social Security Tax purposes, Subchapter S is often best. However, if individuals who are members of multi-member LLCs need partnership taxation for federal income tax purposes but also want to minimize their Social Security Tax liability on their shares of LLC income, they can often achieve these potentially conflicting results under a little known but powerful IRS proposed regulation known as Prop. Reg. § 1.1402(a)-2 (the "Prop. Reg.").
4. The BET. The rate of the BET is so low that this tax needs no discussion here.
5. The I&D Tax. Members of LLCs who reside in NH are generally subject to the I&D Tax at a rate of 5 percent on LLC distributions of profits to them if these LLCs have "transferable shares." However, with skillful drafting, it is often possible to structure both single- and multi-member LLCs to have non-transferable shares for I&D Tax purposes. (However, there is at least a small question whether distributions to NH residents from LLCs taxable as S corporations are subject to the I&D Tax. I think they’re not. Some tax people may disagree.)
6. How to Choose the Right Tax Expert for Your Clients. Whenever you are forming a single- or multi-member LLC, you should first of all make clear to your client that you lack tax expertise and that you can take no responsibility for tax issues relevant to the LLC and its members. However, you should help your clients to find an individual who possesses this expertise. This individual must be able to ensure (i) that your clients’ LLC has the right federal tax regimen for federal income tax and Social Security Tax purposes; and (ii) that their LLC’s certificate of formation and LLC agreement contain provisions that will maximize federal and state tax savings and minimize the risk of adverse tax audits.
Even though you yourself lack tax expertise, you can help your clients evaluate individuals who claim to possess this expertise by asking them these four questions:
If any individual to whom you put these questions hesitates in answering them, find your client another tax expert.
- What are the key points of comparison for federal income tax purposes between sole proprietorship taxation and Subchapter S? (These are the two main federal income tax regimens likely to be useful to individuals forming single-member LLCs.)
- What are the key points of comparison for federal income tax purposes between Subchapter K and Subchapter S? (These are the two main federal income tax regimens likely to be useful to multi-member LLCs.)
- What provisions should be included in the certificates of formation and LLC agreements of LLCs taxable as partnerships to minimize their members’ Social Security Tax liability?
- What provisions should be included in certificates of formation and LLC agreements of, respectively, single- and multi-member LLCs to protect their members from the I&D Tax?
John M. Cunningham is with McLane Graf Raulerson & Middleton in Manchester. He has been a NH Bar member since 1990.