How an LLC can elect to be taxed like a C-Corporation with the IRS:
The IRS doesn’t have a specific tax classification for LLCs. Instead, they look at how many owners – (called Members) – an LLC has to determine how the LLC will be treated for federal income tax purposes.
An LLC with 1 Member is taxed as a Disregarded Entity. Meaning, if the LLC owner is an individual person, the LLC will be taxed like a Sole Proprietorship. If the LLC owner is another company, the LLC will be taxed like a branch/division of the parent company.
An LLC with 2 or more Members is taxed as a Partnership.
Alternatively, you can ask the IRS to tax your LLC like a Corporation. There are two types of corporate taxation available for an LLC:
• An LLC taxed as a C-Corporation, or more technically known as an LLC taxed under Subchapter C of the Internal Revenue Code.
• An LLC taxed as an S-Corporation, or more technically known as an LLC taxed under Subchapter S of the Internal Revenue Code.
In this article, we will discuss an LLC being taxed as a C-Corporation.
Please note, the following sections are brief overviews and are not exhaustive. As mentioned earlier, you will need to speak with an accountant and/or tax attorney to discuss the details that are unique to your business.
Disadvantages of an LLC taxed as a C-Corp
Disadvantage: Double Taxation
This is the most commonly known disadvantage. Owners (shareholders) of an LLC/C-Corp pay taxes on two levels:
- corporate
- and individual
The LLC/C-Corp pays corporate taxes (current nominal rate is 21%) on its taxable earnings and then distributes money to its owners either by a dividend or a salary.
Either way, in addition to the LLC/C-Corp paying corporate taxes, the owners then pay taxes again at the individual level:
-
- A dividend is considered ordinary income and is taxed at 10% to 37%, depending on the owner’s tax bracket.
- If the owners take a salary, they pay a 15.3% self-employment tax for Social Security and Medicare (also known as FICA).
Notes:
– There are other direct means of taking money out of an LLC/C-Corp (like a loan to shareholders) and indirect means (like expenses and leases), but these are too detailed for the scope of this article.
Disadvantage: Accumulated Earnings Tax
Over time, business owners and tax professionals used different methods of avoiding double taxation, one of which is by just leaving the profits in the LLC/C-Corp’s bank account and letting the cash pile up.
To combat this, Congress passed new laws and enacted the Accumulated Earnings Tax (see IRS: Publication 542), which is a 20% tax on money that is left in the corporate bank account that is in excess of the company’s “reasonable needs”. Usually, if an LLC/C-Corp accumulates more than $250,000 in earnings (or $150,000 for Personal Service Corporations), it crosses the “reasonable” line and can trigger the 20% tax.
Note:
An LLC/C-Corp that accumulates more than $250,000 (or $150,000 in a Personal Service Corporation) may be able to avoid the Accumulated Earnings Tax if they are able to prove they have a realistic plan for the use of those earnings. For example: expansion, construction, new equipment, new factory, acquisition, etc.
Disadvantage: “Zeroing out”
The other method to offset double taxation is referred to as “zeroing out” the LLC/C-Corp. This means that the LLC/C-Corp doesn’t keep earnings in the corporate bank account, and instead issues a certain percentage as dividends and the rest as salary (emptying out the corporate bank account).
So while the S-Corporation avoids corporate tax, the owners still pay ordinary income tax or self-employment tax. However, for most small business owners, they will most likely get better tax savings by having their LLC taxed as an S-Corp.
Disadvantage: Personal Service Corporations & Accumulated Earnings Tax
As mentioned above, if a Personal Service Corporation accumulates more than $150,000 in earnings, it crosses the “reasonable” line and can trigger the 20% Accumulated Earnings Tax.
The IRS considers an LLC/C-Corp to be a Personal Service Corporation if it passes both the following tests:
1. The LLC/C-Corp’s primary business activities are services offered in the following fields:
accounting, actuarial science, architecture, consulting, engineering, health, law, performing arts, or veterinary services.
2. At least 95% of the LLC/C-Corp’s stock/membership interests are directly (or indirectly) owned by employees performing the above services.
Additionally, the 95% ownership can be held by the following:
- retired employees,
- an estate of an employee,
- an estate of a retiree described above, or
- anyone who acquired the stock of the LLC/C-Corp as a result of an employee or retiree’s death
Disadvantage: Personal Holding Company Tax
The IRS considers an LLC/C-Corp to be a Personal Holding Company if it passes both the
Income Test
and the
Stock Ownership Test
Income Test:
60% of the LLC/C-Corp’s adjusted ordinary gross income is from passive income, such as annuities, dividends, interest, rent, and royalties.
Stock Ownership Test:
At any time during the last 1/2 of the tax year, more than 50% of the value of the LLC/C-Corp outstanding stock is owned (directly or indirectly) by (or for) 1, 2, 3, 4, or 5 people (but no more than 5 people).
Personal Holding Company Tax (20%):
The IRS imposes a 20% “Personal Holding Company Tax” on an LLC/C-Corp if it doesn’t distribute passive income earnings to its shareholders.
How did this come about?
People attempted to shelter passive income (get a reduced tax rate) via Corporations (or LLCs taxed as Corporations) because the highest corporate tax rates have been lower than individual tax brackets. The IRS eventually caught on and they weren’t big fans. Instead, the IRS wants to tax income at the highest rate possible (in this case, individual rates instead of corporate rates).
The thinking was that Corporations should be operating businesses, not scheming to shelter and reduce taxes.
So Congress enacted a penalty to tax these “holding companies”. And thus the Personal Holding Company Tax was born.
Bottom line:
• If you don’t distribute passive income earnings to the LLC/C-Corp shareholders, you receive an extra tax by the IRS in addition to corporate income tax.
• Any income splitting strategies are rendered useless.
Disadvantage: No Personal Deductions on Corporate Losses
Unlike an LLC that is taxed as a Sole Proprietorship or a Partnership where the owners can offset their taxable income by writing off business expenses, an LLC/C-Corp can’t do this.
Instead, corporate losses can only be used to offset the taxable income on the corporate tax return (Form 1120), not to offset the taxable income on the owners’ personal tax return (Form 1040).
Disadvantage: Capital Gains Tax
Corporate capital gains tax rates may be higher than personal capital gains tax rates.
Unlike individuals, which pay different capital gains tax based on whether an asset is held for more than a year or less than a year, LLC/C-Corps cannot classify their capital gains tax.
Earnings from the sale of an asset are taxed at the corporate tax rate.
For that reason, a pass-through entity (LLC taxed as Sole Proprietorship, Partnership, or S-Corporation) may be more beneficial for capital gains tax since they are taxed at personal rates, not corporate rates.
Disadvantage: Reverting from C-Corp Tax Qualification Back to Default Tax Classification
Converting your LLC taxation from a C-Corp back to its default status (Sole Proprietorship taxation or Partnership taxation) will likely have tax consequences. Even though you are only changing the tax classification of the LLC, the IRS treats this action like you’re liquidating the company and as a result, there will be a tax liability.
Disadvantage: Registering with the U.S. SEC
This isn’t really a “disadvantage” because if you’re registering with the SEC, it’s in the hope that you will soon be raising more capital; however, we wanted to mention it since it is an extra step.
An LLC/C-Corp is required to register with the U.S. Securities and Exchange Commission (SEC) if it has over 500 shareholders and more than $10 million in assets.
Disadvantage: Strict Record-Keeping Requirements
LLC/C-Corps must maintain more corporate and financial records than that of pass-through LLCs (LLCs taxed as Sole Proprietorships, Partnerships, or S-Corporations).
Advantages of an LLC taxed as a C-Corp
Note: Many of the advantages listed below are for companies looking to raise substantial capital and/or go public. In many cases, it may be more beneficial to have the state entity be a Corporation instead of an LLC that elects C-Corporation tax treatment by the IRS. If this is applicable to you, we strongly recommend having a conversation with your legal and tax advisors.
Advantage: Unlimited Number of Owners (Shareholders)
Unlike an S-Corporation which is limited to 100 shareholders, an LLC taxed as a C-Corporation is allowed to have an unlimited number of shareholders.
This is beneficial for companies looking to raise money and/or go public.
Additionally, there is more acceptance in the capital marketplace (venture capital, angel investors, etc.) towards the issuance of shares vs. the issuance of LLC membership interest.
Advantage: No restrictions on who can hold shares
Unlike an S-Corporation which has restrictions on its shareholders (ex: non-US residents), an LLC taxed as a C-Corporation faces no restrictions on who can own shares in the company.
This is also beneficial for companies looking to raise money and/or go public.
Advantage: Raising Money and Going Public
For the reasons mentioned above, if you’re looking to raise a lot of capital and/or take your company public, a Corporation (or an LLC taxed as a C-Corporation) is often the best choice.
Advantage: Widest Range of Tax Deductions
For businesses with a large number of applicable write-offs (see fringe benefits below), C-Corporation taxation has the widest range of tax deductions.
Advantage: Ease of Stock Transfers
Transferring stock/ownership in a C-Corporation is often far easier than transferring LLC membership interests/stock in a pass-through LLC, such as an LLC taxed as a Sole Proprietorship, Partnership, or S-Corporation.
Advantage: Qualified Small Business Stock
As per Section 1202 of the IRS Code, C-Corporations can get a reduced capital gains tax on Qualified Small Business Stock, aka QSBS.
Advantage: Healthcare Fringe Benefits
Health insurance premiums can be written off as a business expense of the C-Corporation. And while you can do the same thing in an S-Corporation, the write-off actually shows back up on your personal tax return as a form of taxable income (if you own 2% or more of the S-Corporation).
Besides the health insurance premiums, there are a number of other healthcare benefits and preferential treatment that C-Corporations receive.
Some examples include write-offs on disability insurance, life insurance, health savings plans, dental care, eye care, and accident plans.
There are far more details and restrictions (such as the need to provide fringe benefits to 70% of their employees, for example) that apply to C-Corporations, but these are in-depth conversations that you’ll need to have with your tax professional.
Advantage: Other Benefits
Besides the information listed above, there may be other tax benefits of an LLC being taxed as a Corporation and they should be discussed with your tax professional.
Other tax benefits include retirement plans, gym memberships, meals provided at work, gift certificates, cash, and other rewards for employee achievement, education assistance, company-owned vehicles, public transportation for employees, and moving and housing benefits.
Consider a corporation instead of an LLC taxed as a C-Corporation
If you are considering having your LLC taxed as a C-Corporation, we recommend speaking with an accountant and/or business lawyer to see if simply forming a Corporation (which is automatically taxed as a C-Corporation) is more beneficial.
State-Level Corporate Taxes
It’s important to keep in mind that everything above is written generally and is in the context of federal taxes.
There are currently more than 40 states which charge corporate income taxes.
Another important thing to note is that a handful of states (Alabama, Iowa, Louisiana, and Missouri) allow for LLCs taxed as C-Corporations to deduct a percentage of their federal taxes, which therefore reduces the LLC’s effective state income tax rate. (source)
Local and Municipal Corporate Taxes
In addition to paying taxes at the federal level and the state level, many LLCs taxed as C-Corporations also have to pay taxes with their local government or municipality.
For example, this means corporate taxes may need to be paid to your county, city, township, or borough; or all, or none of the above.
Your LLC’s requirement will be determined by where you do business and you’ll need to speak with your accountant regarding the details.
Additional Taxes
Furthermore, in addition to the 3 primary levels of income tax (federal, state, and local), LLCs and their owners may be subject to additional taxes based on their industry and whether or not they have employees.
Some examples include payroll tax, federal unemployment tax, state unemployment tax, workers’ compensation tax/insurance, capital gains tax, state franchise tax, gross receipts tax, dividend tax, sales tax, use tax, excise tax, and more.
Takeaways
Electing C-Corporation tax status for an LLC generally makes sense if your company is looking to raise money, go public, or has large healthcare expenses.
Once the LLC makes an election to be taxed as a corporation, it is a hybrid entity. It’s important for the owners to remember that the entity is a corporation for federal tax purposes, but it is still treated as a multimember LLC under state law, which means the governing documents and organization of the LLC must still comply with the state LLC statutes, and not the state statutes governing corporations.
The LLC operating agreement should be tailored for this unique situation. This does not mean the LLC should abandon its LLC operating agreement and replace it will corporate bylaws. The operating agreement should reflect the tax and accounting rules that apply to corporations but still retain the LLC operating and governance provisions as outlined in the state statutes.
There may be other benefits to certain types and sizes of businesses but determining those is a conversation you’ll need to have with your tax accountant.
What do most people do?
Most of our readers are just starting out, so they leave their LLC in its default tax status (Sole Proprietorship or Partnership taxation) until their business becomes more profitable.
Then years down the road, the owners, after speaking with a tax professional, may consider having their LLC taxed as an S-Corp or even a C-Corp. This is done in order to save money on self-employment taxes or give special advantages like QSBS, raise capital, or have deductible fringe benefits.
Important notes:
1. Before changing your LLC’s tax status with the IRS, we recommend speaking with an accountant and/or a tax lawyer. There are far more things to consider than we’ve mentioned in this article.
2. The owners of an LLC are called Members. And the owners of a Corporation are called Shareholders. When an LLC elects to be taxed as a C-Corporation, in the context of discussing taxes, the owners may be referred to as Shareholders. Throughout this article, please know that the words “Members”, “Owners”, and “Shareholders” all mean the same thing.
3. Any time you see the word “Corporation”, “C-Corporation”, or “LLC/C-Corp”, please note that we are referring to an LLC being taxed as a C-Corporation.
4. For the majority of small business owners, an LLC being taxed as a C-Corporation is far less popular than an LLC being taxed as an S-Corporation. (mainly because a C-Corporation has double taxation while an S-Corporation has pass-through taxation).
An LLC being taxed as an S-Corporation can save an LLC owner thousands of dollars per year in self-employment tax (once the LLC’s net income reaches a certain level).
If you need some help or have any questions, feel free to call me at 509-543-7600 or send a request HERE.
February 2022
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