Election of Tax Structure
LLCs are unique in that they offer flexibility in how they are taxed. The IRS will treat an LLC as either a corporation, partnership, or as a disregarded entity. By default, domestic LLCs with at least two members are classified as partnerships and single-member domestic LLCs are treated as entities disregarded from their owners for income tax purposes. A single-member LLC is still treated as a separate entity for purposes of employment taxes and certain excise taxes.
Both partnerships and single member disregarded entities are sometimes called pass-through entities, as the profits and losses of the business “pass through” to the owners, who report them on their personal tax returns. This means that income is only taxed once at the individual level, and subject to the individual tax rates.
If an LLC wants to change its federal tax classification, it needs to file a Form 8832 Entity Classification Election with the IRS. This election cannot take effect more than 75 days prior to the date the election is filed, and it also cannot take effect later than 12 months after the date the election is filed. Once an election is made, the LLC is locked into the chosen classification for 60 months unless there is a change in majority ownership.
If the LLC chooses to be taxed as a corporation, it can elect to be taxed as either a C Corporation or an S Corporation. Opting to be taxed as a C corporation can provide certain benefits, such as fewer limitations on certain deductions (employee benefits and retirement plans), additional flexibility in determining the company’s fiscal year, greater ease in capital raises, and fewer ownership restrictions than LLCs taxed as S Corporations.
Additionally, C corporations are subject to corporate income tax on their profits, which may be lower than the individual rate. Shareholders are taxed on any dividends they receive.
Another option is to elect to be taxed as an S Corporation. Electing to be taxed as an S corporation allows LLC owners to enjoy the limited liability protection of an LLC while also benefiting from pass-through taxation. S corporations do not pay corporate income tax; instead, profits and losses pass through to the owners’ personal tax returns. This can result in potential tax savings, as income is only taxed once at the individual level.
Choosing the right tax structure for your LLC depends on various factors, including the nature of the business, the number of owners, and long-term goals. Consulting with a tax advisor or accountant can help you assess your options and make an informed decision.
Appointment of a Tax Representative
In addition to choosing the appropriate tax structure, LLCs must designate a partnership representative in their operating agreement. The partnership representative is responsible for representing the LLC in tax matters, including audits and other dealings with tax authorities.
The concept of a partnership representative replaced the prior concept of a tax matters partner. This occurred with the establishment of the centralized partnership audit regime (CPAR), under section 1101 of the Bipartisan Budget Act of 2015, which repealed and replaced the Tax Equity and Fiscal Responsibility Act of 1982. Some older operating agreements still identify a tax matters partner, and should be updated to reflect this change.
A partnership representative is a designated point of contact for tax-related issues and can help streamline communication and decision-making. Absent qualifying or limiting language in the operating agreement, the partnership representative has full authority to bind current and former members of an LLC to settlements and agreements with the IRS.
Strategically choosing the right person as the partnership representative is especially important in multi-member LLCs, where there may be multiple owners with differing interests and priorities. It is essential to choose someone who is knowledgeable about tax law and regulations and who can effectively represent the interests of the LLC and its members.
Corporate Transparency Act
The Corporate Transparency Act (CTA), which went into effect January 1, 2024, was enacted with the purported goal of enhancing corporate transparency and combatting money laundering and other illicit activities. The CTA requires certain LLCs to disclose beneficial ownership information to the Financial Crimes Enforcement Network (FinCEN).
With the introduction of the CTA, LLCs falling within the scope of the legislation must now ensure compliance with the new reporting requirements. This entails disclosing detailed information about individuals with significant control or ownership interests in the company, which may necessitate amendments or updates to existing operating agreements.
The CTA imposes additional administrative burdens on LLCs, as they must establish and maintain accurate records of beneficial ownership information, ensuring ongoing compliance with regulatory obligations. Failure to adhere to these requirements can result in severe penalties and legal repercussions, including fines of $591 per day, up to $10,000, or criminal penalties.
In response to the CTA, LLCs may need to revise their operating agreements to incorporate provisions addressing compliance with the new reporting obligations, delineating responsibilities for maintaining accurate records, identifying CTA representatives, and mitigating potential risks associated with non-compliance. Additionally, LLCs may consider implementing internal controls and procedures to facilitate compliance with the CTA and streamline reporting processes.
Kelcie L. Longaker
410-576-4264 • klongaker@gfrlaw.com