Consultant’s Corner: Tax Consequences of Adding a Member to an LLC

Q. I have a Single Member LLC. I am in the process of adding a partner, and want to know how the IRS will view this change relative to potential tax consequences. What would be the best entity selection for the new two-partner business?

An LLC is unique in that it can be taxed as a disregarded entity, partnership, C corp or an S corp. A single member or owner LLC can be taxed as a disregarded entity, C corp or S corp. A multi-member or owner LLC can be taxed as a partnership, C corp or S corp. Unless an LLC elects corporate tax classification by filing Federal Form 8832 (C corp) or Federal Form 2553 (S corp) with the IRS when it is formed, a single member or owner LLC is taxed as a disregarded entity and a multi-member or owner LLC is taxed as a partnership.

Adding a member to your LLC will change the LLC from a single member to a multi-member LLC which will effectively change the LLC’s tax status from a disregarded entity to a general partnership unless the LLC is currently taxed as a corporation (C or S type). Assuming your LLC is currently taxed as a disregarded entity (sole proprietorship), the LLC’s accounting books and records will need to close as of the date the new member joins the LLC. The LLC will also need to file short year tax returns for the current tax year if the new member joins the LLC during the tax year. The first short year return will cover the period the LLC is a single member LLC taxed as a disregarded entity. The second short year return will cover the period the LLC is a multi-member LLC taxed as a general partnership (or corporation if the LLC elects corporate tax status after adding the new member).

However, if your LLC was formed within the last 75 days and you would prefer corporate tax status (C or S corp) for the LLC when it becomes a multi-member LLC, you may be able to retroactively elect corporate tax status to the date the LLC was formed which would eliminate the need for multiple short year tax returns. For consideration with your local tax advisor or CPA, you can review the following discussions on LLC taxation and short tax years:

Short tax years:

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Tax-Years

Forms 8832 and 2553 and instructions:

http://www.irs.gov/uac/Form-8832,-Entity-Classification-Election

http://www.irs.gov/uac/Form-2553,-Election-by-a-Small-Business-Corporation

To develop a better understanding of the differences in tax treatment and owner distributions/compensation for partnerships, C corps, S corps and similarly taxed LLCs, you can review the following basic guidelines:

1. Partnership and LLC taxed as a partnership. A partnership is a pass-through entity for tax purposes. The partnership reports all of its income and expense on a separate tax return, Form 1065, and pays no tax on its net profit. A partnership passes through its net profit or loss to the partners based on their ownership interest in the partnership. Each partner’s share of the partnership’s net profit or loss is reported by the partnership on Schedule K-1. Each partner reports the amounts from their respective Schedule K-1 on Schedule E of their personal Form 1040. Partners do not take a W-2 salary but may take guaranteed payments, which the partnership deducts as a business expense, and or periodic cash draws of their share of the partnership’s net profits, which the partnership cannot deduct as a business expense. However, partners are taxed on their entire share of the partnership’s net profit regardless of whether they ever take profit distributions. Partners are not required to withhold payroll taxes from their guaranteed payments or periodic cash draws, but they may need to make personal estimated income tax payments depending on their personal income tax situation. Generally, a partner’s guaranteed payments and share of the partnership’s net profit will be subject to both federal and state personal income tax and, if net self-employment earnings are $400 or more, the SE Tax.
2. C corporation and LLC taxed as a C corporation. A C corp pays tax on its net income. The corporation reports all of its income and expense on a separate tax return, Form 1120. In a C corp, business owners who perform services for the corporation are generally required to take a W-2 salary, which is subject to payroll tax withholding and deducted as a business expense by the corporation. The owners generally take distributions of the business after-tax profits in the form of dividend distributions, which are not deducted as a business expense by the corporation. Both W-2 salary and dividend distributions are considered personal taxable income to the business owner.
3. S corporation and LLC taxed as an S corporation. An S corp is also a pass-through entity for tax purposes. The S corp reports all of its income and expense on a separate tax return, Form 1120S, and pays no tax on its net income. An S corp passes through its net profit or loss to the business owners based on their stock ownership interest in the corporation. Each owner’s share of the S corp’s net profit or loss is reported by the S corp on Schedule K-1. Each owner reports the amounts from their respective Schedule K-1 on Schedule E of their personal Form 1040. Owners who perform services for the S corp are also required to take a W-2 salary, which is subject to payroll tax withholding and deducted as a business expense by the S corp. Owners can also take periodic cash draws of their share of S corp net profit; however, they will be taxed on their share of S corp net profit regardless of whether they ever take profit distributions. Both the owner’s W-2 salary and share of S corp net profit are considered personal taxable income. Owners are not required to withhold payroll taxes from their periodic cash draws, which are not deductible as a business expense by the S corp, but they may need to make personal estimated income tax payments depending on their personal income tax situation. While the owners will be subject to both federal and state personal income tax on their share of S corp net profit, they will not be subject to the SE Tax. Therefore, the S corp structure can offer the advantage of less overall SE Tax compared to a sole proprietorship or partnership in situations where it is reasonable to pay a salary amount that is less than the Social Security limit ($118,500 in 2015) while distributing the remainder as profits to the owners.