Limited liability companies are most often established and used as tools to protect assets and limit liability. Generally, an LLC can require a client to prepare an extra “tax schedule” or “tax return” each year. However, if organized properly, LLC owners’ net taxes are not typically increased or decreased because of the introduction and use of LLCs. However, there are exceptions.
Taxpayers can decide to have their LLCs taxed like corporations, specifically “S corporations,” which are slightly less cumbersome in tax administration than “C corporations.” S corporations also have requirements on the quantity and identities of ownership in those entities.
Alternatively, taxpayers can decide to have their LLCs taxed like partnerships if there is more than one owner (LLC owners are called “members”). Similarly, if the LLC has only one member, the LLC can be taxed as a sole proprietorship. Taxing an LLC as a partnership or sole proprietorship means that net income or loss essentially “flows through” the LLC directly to the LLC’s members, who report that information on their individual 1040 returns. Most people decide to tax their LLCs as partnerships or sole proprietorships.
Nevertheless, most business attorneys will consult with clients’ tax preparation professionals before advising clients on how their LLCs should be taxed. The wrong decision on this topic can cause the LLC’s ownership to pay more tax than necessary.
However, conversely, sometimes LLCs can help decrease tax liability. In these instances, tax savings can be icing on the cake for LLCs that are already justified due to liability and asset protection concerns. One of the most common potential tax savings possibilities in this context deals with LLCs that own investment property, particularly in farming, and usually consisting of farmland.
Generally, passive income (income that is not “earned” under the tax code) is only subject to income tax. If income is earned (as defined in the tax code), the income is subject to income tax, and the income may also be subject to what is called “self-employment tax.” Self-employment tax is essentially a Social Security premium/tax and Medicare tax that collectively is usually calculated at a rate of around 15 percent.
Landlords who rent farmland to tenants generally treat that rental income as passive income. The IRS has contended that a landlord entity that shares an owner with another entity that is the tenant should treat the rental income as non-passive income. However, a careful reading of several IRS publications leads many tax professionals to conclude that such rent is the type of non-passive income that is not subject to self-employment tax.
What this means is that farmers may be able to avoid some self-employment tax on some rental income paid from a farming tenant LLC to separate landlord LLC, within which the farmer also has some ownership interest.
Because of the complexity of this analysis, tax professionals can reach different conclusions on this topic. Nonetheless, for many farmers, even the possibility of any tax savings can convince those farmers to organize LLCs, even if LLCs are independently justified.
Lee R. Schroeder is an Ohio licensed attorney at Schroeder Law LLC in Putnam County. He limits his practice to business, real estate, estate planning and agriculture issues in northwest Ohio. He can be reached at Lee@LeeSchroeder.com or at 419-659-2058. This article is not intended to serve as legal advice, and specific advice should be sought from the licensed attorney of your choice based upon the specific facts and circumstances that you face.