How is income of the members of a LLC treated by the IRS?
When an entity is taxable as a partnership in connection with your estate or business planning, the income of the members may be treated as self employment income if the LLC ("limited liability company') is engaged in business. In a LLC, all members may be considered to be general partners if the LLC is member-managed. The problem is that the pass through of profits from the LLC to the partners who have management authority, even those profits generated as a return on investment capital, will be subject to self employment taxes if they were earned through the labor of the members.
The taxes associated with a member's distributive share of profits total 15.3% on the first $137,700 of self employment income, and above that amount the Medicare tax component (2.9%) of the employment taxes continues to be imposed, and an additional 0.9% Medicare tax kicks in above $200,000 of income for single filers and $250,000 for married filed jointly.
How does a "S" corporation fit in?
A somewhat simple solution is that a "S" corporation is useful to provide more certainty regarding the avoidance of self employment tax on income that is a return on a capital investment. The pass-through taxation of the profits of a "S" corporation to shareholders does not include self employment taxes. You may benefit by transferring your LLC membership interest to a "S" corporation and having the corporation pay the client compensation, with proper withholding and payment of the employee and employer shares of the employment taxes, for any actual services rendered by the client.
Employee owners of corporations can control to some degree the amount of compensation paid to themselves, which must be "reasonable" in order to be in compliance with the IRS requirements. If you are receiving a distributive share of LLC income, you can assign your membership to a "S" corporation and then you can pay yourself an amount of reasonable compensation from the corporation, which might be less than the amount of taxable income flowing through from the LLC to the "S" corporation.
How does this affect nonresidents of Wyoming?
Very often there are business entities like LLCs, trusts or entire families that wish to move to Wyoming in order to escape the tax authorities in the state of their former residence.
For nonresident individuals who wish to subject some or all of their income to taxation at Wyoming tax rates, there are limited opportunities. Pass through taxation of partnership type entitles, like LLCs and grantor trusts thwart any benefit of having the entities or trusts domiciled in Wyoming. So--what can a non-Wyoming resident do?
One alternative is the establishment of a Wyoming Incomplete Non-Grantor Trust. This type of trust will permit the earnings produced by the trust assets to be taxed at Wyoming rates, provided that the earnings are not distributed to a non-Wyoming beneficiary. Some states have a look-back rules that will tax the beneficiaries if there are distributed earnings in a later year. The "WING" trust needs to be in the form of a domestic asset protection trust. If the trust assets are subject to the claims of the settlor's creditors, then grantor trust status for income tax reporting will be applicable. (Treas. Reg 1.677(a)-1(d) states that a trust will be a grantor trust if the grantor's creditors may satisfy claims against the grantor out of the trust's assets).
A second, more broad approach to avoidance of state income tax by an individual tax payer is to change the deemed situs of the income from the state that taxes income to a state, such as Wyoming, that does not tax income. The question then is how to change the "situs" of the trust, which means changing the "residency" of the maker.
What is required for residency?
Income taxation in many states, for example, Colorado, is applicable to all income earned by the "resident individual" which has been defined as a person domiciled in that state, or a person who maintains a permanent place of abode within that state and spends in the aggregate more than six months of the taxable year within the state. The key is that, for example that the individual be absent from Colorado more than six months. Even in such a case, Colorado law would still tax the income of an individual, regardless or where and how such income was earned, if the individual has a "domicile" in Colorado. The difference between domicile and residency is slight but critical under the tax laws of most states. The terms are sometimes used interchangeably, but for our purposes we are interested in establishing residency.
Individuals can establish residency by acts of habitation in a particular place.
Courts look at many factors for residency, and change of driver's license and voter registration is less important than the more real day-to-day aspects of life and the apparent involvement of a person in the new community, which includes having a "local" Wyoming attorney.
Please note the article on this site regarding the double protection of a LLC and a trust in Wyoming.
Please be sure to contact your tax preparer for tax advice and for preparation of your personal income tax returns.
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