How To Report Income Tax With An LLC

Your business structure is set, so you think it’s time to open for business. Not yet. There’s one more issue to resolve before you’re ready to open your doors – self-employment taxes and your limited liability company, or LLC.

Income Tax & An LLC

There is conflicting guidance from the IRS when it comes to reporting income tax of an LLC, so special attention is needed when you consider your course of action.

First, let’s look at the two types of LLC. There is the member-managed LLC, where every member has the authority to act on behalf of the business. In this structure, the members agree on how and when they will vote on certain LLC matters. They also agree that an individual member will not act on behalf of the LLC until the proper votes are obtained. The other type of LLC is manager-managed. This type of LLC includes “passive” members. Passive members, often investors in the LLC, do not actively manage or otherwise operate the business of the LLC. Because the members do not automatically have the authority to manage and operate the business of this type of LLC, they elect managers to carry out these responsibilities.

Initially, most certified public accountants, or CPAs, took the position that if an LLC is member-managed then it would be treated like a general partnership, and every member would pay self-employment tax. Conversely, manager-managed LLCs are treated like a limited partner. Thus, the manager pays self-employment tax, and the member does not.

Member & Manager Problem

But what if the member also happens to be a manager? At this point, the rules start to get blurry. The manager payment is clearly “guaranteed payment” and reported separately on the Form K-1, making it subject to self-employment tax. But there isn’t clear guidance on how to treat the income that flows to the member. Is it subject to self-employment tax or not? Good question.

In one case, the Tax Court agreed with the IRS’s position that a member’s income in a manager-managed LLC should be considered passive. Or rather, in this case, the member’s loss was considered passive and thus not able to be used to offset other income.

IRS Conditions

Yet, the IRS has proposed some regulations that indicate regardless the type of LLC – member-managed or manager-managed – if the member spends more than 500 hours per year in the business, then the income earned is active. And that means self-employment tax.

As you can see, there are not clear steps to follow when it comes to the LLC and self-employment tax. This is something you need to strategize with your CPA before you’re ready to open your doors for business.

About Paul Gaulkin CPA

Paul Gaulkin is a Certified Public Accountant and enrolled with the U.S. Treasury to practice before the IRS. Mr. Gaulkin possesses unique technical knowledge in the process of securing relief for taxpayers nationwide with IRS and State tax problems. With an accounting degree from Florida International University, he is able to transform complex tax and accounting problems into easy to understand solutions.

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