Tax Tips Blog

Reed asks: I have a question about LLCs and federal taxes. I know that if you create an LLC and don’t file an 1120 (i.e. you don’t pay yourself as a W2 employee of your own business), then whatever income you make in the LLC just flows through to your personal taxes. What I don’t know is how your taxes and deductions change when you do file an 1120. Do you end up with an extra level of federal taxes? Here is what I suspect, and am hoping to find some confirmation for… For anything you do pay yourself as a W2, since that is an expense of the business, your W2 tax situation is all that is relevant. In other words, if the income to the LLC was $100, and you paid yourself $100, then effectively the LLC made a $0 profit and you calculate your federal taxes the way you would if you weren’t incorporated. I’m doing some big hand-waving there to simplify the question, since (for example) self-employment taxes are something I believe is deductable for an 1120′d LLC.

My reply: If your LLC has just one member, the default position is to ignore it for tax purposes. So if you were conducting a business, you’d file schedule C for the LLC. If the LLC was renting real estate, you’d file schedule E. If it was operating a farm, schedule F. And so on.

If the LLC has more than one member, it’s treated like a partnership by default, and would file form 1065.

However, either kind of LLC (single- or multi-member) can elect to be taxed like a corporation. And if the LLC makes that election, it can further elect to be taxed like an S Corporation. These are positive elections - you need to make them and file the election with the IRS. And there are time frames on these elections.

You need to file these elections before certain dates to make them effective for a particular year. Once you make one of these elections, it remains in effect for all future years.

So if an LLC elects to be taxed like a corporation (a regular or C corp), it would file form 1120. The corp would normally pay a wage to its members and/or officers and deduct that wage (and related payroll taxes) from it’s income. The member would report the W-2 income and pay tax on their personal return. Any income left would be taxable to the LLC at standard corporate rates. And the corp could also pay dividends, which would be taxable to the members, but not deductible to the corp.

If the LLC elects to be an S corp, it would file form 1120S. It still needs to pay a wage to it’s members. And it would still deduct that wage and payroll taxes. But the net income of the LLC taxed as an S Corp would flow through to the member(s) and be taxed on their personal return along with the W-2 income. That pass through income is not subject to Self-employment tax.

Several of my clients are concerned about how the new Texas Franchise Tax will affect their business. This new tax is a major revision and adds a lot of complexity.

Entities will no longer be taxed based on their modified net income or taxable capital, but instead on their profit margin. There are still a few rules to iron out, but Texas has issued temporary guidelines.

In general, although more entities will be reporting their income to Texas, many small businesses stand to reduce or avoid this tax completely.

Currently, Texas assesses a franchise tax on all businesses EXCEPT:

• sole proprietors (who are not single member LLCs)
• general partnerships
• limited partnerships
• professional associations (physicians, dentists, and other medical professionals) and
• non-profit entities.

For tax years beginning January 1, 2007, all for-profit entities who are seeking state liability protection will be subject to the tax. The two groups that will be subject to this tax for the first time are physicians and other medical professionals who organized as a professional association and limited partnerships.

All taxable entities must file a report, even if no tax is due. Currently, the Texas Franchise tax provides for a dual calculation, but most of my clients and most entities who are subject to this franchise tax, the tax is based off their modified net income.

Currently, the Texas franchise tax kicks in if your entity has “receipts” (or revenues) of $150,000 or more. Once you trigger the Texas franchise tax, all net income is subject to a tax rate of 4.5%. You can reduce the tax with expenses, including guaranteed payments or salaries to owners.

Beginning with 2007 tax years (reported in 2008), the hurdle (receipts) rate is raised to $300,000 from $150,000, so fewer companies will trigger this tax. The franchise tax rate also is reduced to 1% for most taxpayers and 0.5% for wholesales and retailers. This rate will be applied to the companies taxable margin, not net income.

Let’s take a look at how this might affect two of my clients. The first client we will look at is a physician, who has never been subject to the Texas Franchise Tax as he incorporated under the Texas Professional Association Act. He is anticipating gross revenues of $600,000. Medical professionals are allowed to reduce this amount by revenues received from:

• Medicaid
• Medicare
• CHIPs
• Workers Compensation Claims
• TRICARE and
• the actual cost of uncompensated care.

My client had to revise their general ledger to easily separate all these payments in order to make things more efficient come tax time. The hardest part is obviously determining the actual cost of uncompensated care. After my client deducts all these exempt revenues his Texas Revenues totaled approximately $480,000.

Service providers get to elect each year, if they would like to reduce this amount by either the W-2 wages they paid to themselves and all their employees (not to exceed $300,000 per person) or 30% of their Texas Revenues.

My client estimates paying W-2 wages of approximately $390,000 and employee benefits of $15,000. This would reduce my client’s taxable margin to $75,000 and Texas Franchise tax is computed at $750, but no tax is due if you owe less than $1,000. My client will still have to file this form, but he will still not be subject to the Texas Franchise Tax.

The second client we will look at is a retailer. He is anticipating gross sales of approximately $2 millions with a cost of goods of nearly $1 million, making his margin approximately $1 million. Since he is a statutory retailer he will be paying tax at 0.5% of this amount or $5,000. Although this sounds like a lot of tax, under the current Texas Franchise Tax System he will be paying on his net income, which is almost twice as much tax owed.

Both of these clients anticipate saving tax dollars under the new Texas Franchise Tax system. Just remember this won’t take affect until your report your 2007 income.