Business Taxation. When establishing a new business or growing an existing business, determining the method by which your Arkansas LLC will be taxed can be one of the most important decisions affecting your bottom line.
The three most predominant methods of taxation for an Arkansas LLC are pass-through taxation, partnership taxation, and s-corp taxation. This article will give you a brief overview of these three methods of LLC income taxation.
Pass-Through Taxation
The majority of small businesses formed as a limited liability company (LLC) are taxed as a pass-through entity otherwise referred to as a “disregarded entity.” This means the business itself does not pay federal income tax. Instead, profits and losses pass through to the owner who reports the income on their individual tax returns, and the owner pays FICA taxes (known as “self-employment taxes”). This is the most common tax structure for single member (single owner) Arkansas LLCs. One of the primary points of pass-through taxation is that the owner is not on the payroll (W-2) and, therefore, will pay self-employment taxes.
Partnership Taxation
Arkansas LLCs that have multiple members (owners) are often times taxed as a partnership. Similar to pass-through taxation, when taxed as a partnership the LLC does not pay federal income taxes, rather, the profits and losses are passed through to the owners based upon the structure of the partnership. The profits and losses are reported on the owners’ tax return, and the company will issue K-1s to the owners reflecting the breakdown of the profits and losses allocated to each owner. One of the primary points of partnership taxation is that the owner is not on the payroll (W-2) and, therefore, will pay self-employment taxes.
S-Corp Taxation
Arkansas LLCs (either single member or multiple members) can elect to be taxed as an s-corp. whereby the owner(s) must be on the company payroll as a W-2 employee, and the LLC must pay the owner a “reasonable” salary based upon industry standards. A general rule of thumb is that the owner(s) should be paid a salary in the amount of at least 60% of the net profit received by the company. In the s-corp tax structure, the owner will receive a salary which will be subject to payroll taxes and taxed as ordinary income. The benefit is that any profit distribution to the owner in excess of that salary is exempt from self-employment taxes and payroll taxes, but it will be taxed as ordinary income. The avoidance of paying self-employment taxes and payroll taxes on these profit distributions to the owner can result in significant tax savings to the owner. For example, if an LLC generates regular annual profits of $100,000, then the owner should receive at least $60,000 in salary which will be taxed as a standard employee. However, any profit distribution to the owner will avoid the self-employment taxes and payroll taxes, but it will be taxed as ordinary income. This can result in the owner saving several thousand dollars in taxes owed. Also, the LLC will still be eligible for the qualified business income deduction.
Required Filing and Other S-Corp Taxation Requirements
Even though S corporations typically don’t pay income tax at the corporate level, they still have important filing requirements. The business must file Form 2553 to elect s-corp tax status. The LLC must also file a tax return as Form 1120-S.
A few other requirements to qualify for s-corp taxation are that the LLC can only have individuals as members or certain types of trusts, it cannot have other entities (LLCs or corporations) as members, and the LLC operating agreement must be structured in a way that preserves s-corp tax status. Also, the LLC can only have one class of membership interests to qualify for s-corp taxation.
Potential Tax Advantages
One of the main benefits of an S corporation is the ability to reduce self-employment taxes. Owners who work in the business must receive a reasonable salary, which is subject to payroll taxes, but additional profits may be distributed without being subject to Social Security and Medicare taxes known as FICA taxes (“self-employment taxes”). Losses may also pass through to owners, depending on IRS rules.
Hiring Family Members, Including Children
Some business owners consider hiring their children to help with the business. While wages paid to children must still be reasonable and for legitimate work, this approach can offer tax and education benefits when done correctly. Employment laws and payroll taxes still apply, and the rules can differ depending on the child’s age and type of business entity.
Arkansas Tax Considerations
Arkansas and Federal tax rules affect whether an S corporation is the right choice. Some businesses may also benefit from state-level passthrough entity tax elections, depending on their structure.
Is an S Corporation Right for You?
While S corporations can offer meaningful tax benefits, they are not the right fit for every business. Ownership rules, compliance requirements, filing a tax return for the LLC, and long-term goals should all be considered before making an election. Generally, an s-corp tax structure is a viable option only for businesses that have a good operating history, predictable revenues and profits, generate profits that are in excess of the owner’s salary, and that can firmly commit to paying the owner’s salary. Generally, s-corp taxation may not be a viable option for new and start-up businesses because they may not yet generate the profits necessary to justify s-corp tax status.
Located in Batesville, Melbourne, and Heber Springs, Arkansas, and serving all of Arkansas, Reeves Law Firm stands ready to handle any civil, estate, family law, guardianship, personal injury, probate, or any other litigation matters that may arise.
Reeves Law Firm primarily serves Independence County (Batesville), Jackson County (Newport), Sharp County (Ash Flat, Highland, Cherokee Village), Lawrence County (Walnut Ridge), Cleburne County (Heber Springs, Greers Ferry, Fairfield Bay), Izard County (Melbourne), Stone County (Mountain View), White County (Searcy), and Baxter County (Mountain Home).
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