What Non-Tax Lawyers Should Know About LLC Tax

Published: New Hampshire Bar News
February 15, 2023

It is critical that individuals who are forming New Hamp­shire LLCs, whether these are single-member or multi­member LLCs, be aware of the federal and New Hampshire tax issues relevant to their LLCs, and that they ensure that these issues are correctly addressed in their certificates of formation and operating agreements.

Thus, if you are a New Hampshire law­yer who helps clients form LLCs, but you lack tax expertise, you have a stringent ethi­cal duty to advise your clients of this lack and to you help them find LLC tax experts who can assist them.

However, even if you lack tax exper­tise and you so advise your LLC formation clients, you can provide a major service to these clients if you advise them about what you understand to be the main tax issues likely to be important to them. The five main LLC tax issues that, in my view, are likely to be relevant to founders of New Hampshire LLCs are outlined below in this article. You may want to give your New Hampshire LLC formation clients a copy of the article.

Tax choice of entity—single-member LLCs

Most single-member LLCs should be subject to federal taxation as tax sole propri­etorships. However, a small number of them should instead be taxable as S corporations or even as C corporations. The often-com­plex task of choosing among these three fed­eral tax regimens for a single-member LLC in formation is called “tax choice of entity.” No LLC founders should form single-mem­ber LLCs without first having a tax expert provide them with a tax choice of entity.

Tax choice of entity—multi-member LLCs

On tax choice of entity grounds, most multi-member LLCs should be taxable as partnerships under IRC Subchapter K, but a few should, instead, be taxable as C or S cor­porations. Founders of these multi-member LLCs must also retain tax experts to provide them with a tax choice of entity.

Sociality Security Tax liabilities

As partners of a tax partnership, many members of multi-member LLCs may be subject to major federal tax liabilities on their shares of LLC income under the fed­eral Social Security tax known as the Self-Employment Tax (SET). For 2023, the rate of the SET to which these individuals may be subject on the first $160,200 of this in­come will be 12.4 percent, and the rate of the Medicare Tax they will owe on it will be 2.9 percent, for an aggregate tax rate of 15.3 percent and an aggregate 2023 SET and Medicare Tax liability of $24,511.38.

However, a little-known but powerful proposed IRS proposed regulation desig­nated Prop. Reg. § 1.1402(a)-2 (Prop. Reg.) can enable individuals who are members of multi-member LLCs taxable as partnerships to greatly reduce their SET liability on their LLC income. These individuals should con­sult with a tax professional with Prop. Reg. expertise expert on how to structure their operating agreements to take full advantage of this regulation.

Internal Revenue Code Section 199A

In 2017, then President Trump signed into law a major federal tax bill entitled the Tax Cuts and Jobs Act of 2017 (TCJA). The TCJA was designed mainly to benefit large state-law business corporations taxable as C corporations. However, TCJA Section 199A also provides a remarkable 20 percent annu­al federal income tax deduction to individu­als who earn income from “pass-through businesses”—i.e., state-law sole proprietor­ships, LLCs and other businesses taxable as S corporations, and LLCs and other busi­nesses taxable as partnerships.

Section 199A is arguably the most com­plex provision in the TCJA, and, for many LLCs, maximizing the Section 199A deduc­tion may require substantial tax expertise.

For example, to achieve this maximi­zation, individuals who are members of multi-member LLCs taxable as partnerships should not pay themselves for their services to their LLCs in the form of “guaranteed payments” (the partnership tax term for part­nerships). Rather, counterintuitively, they should do so through income distributions; their operating agreements should so pro­vide; and they should take advantage of the extremely flexibility of IRS Section 761(c) to make annual retroactive adjustments of these distributions. No one should form a multi-member LLC taxable as a partnership without first making sure that the governing operating agreement maximizes his or her Section 199A deductions. Maximizing the Section 199A deduction on real estate rental income can be particularly challenging.

New Hampshire taxes; the I&D Tax and the Real Estate Transfer Tax

The main New Hampshire taxes to which members of single-member and multi-member LLCs are likely to be subject are the Business Profits Tax, the Business Enterprise Tax, the Interest and Dividends Tax (I&D Tax), and the Real Estate Transfer Tax (RETT). Every New Hampshire LLC should be structured to minimize all four of these taxes. For example, individuals who reside in New Hampshire and who are LLC members can avoid the I&D Tax on LLC distributions to them by including in their operating agreements a consent or dissolu­tion provision that meets the requirements of the relevant New Hampshire Department of Revenue Administration I&D Tax regula­tions.

However, the New Hampshire tax pos­ing the greatest risk for many New Hamp­shire LLC members is the RETT. The purpose of many New Hampshire LLCs is to acquire and maintain New Hampshire real estate and to rent this real estate to ten­ants. The RETT applies to transfers of New Hampshire real estate at a harsh aggregate rate of 1.5 percent of the current fair market value of the transferred property.

Many New Hampshire real estate own­ers already own their real estate before they form LLCs to hold it. If they don’t follow proper procedures in contributing this real estate to their LLCs after their formation, they may face a brutal RETT liability. How­ever, the RETT statute contains numerous exemptions, of which those most likely to be available to most New Hampshire LLC members are likely to be the RETT exemp­tions called the “testamentary transfer” ex­emption and the “same owners after as be­fore” exemption. Your LLC clients should never transfer real estate into LLCs without first consulting with an RETT expert and taking full advantage of applicable RETT exemptions.

A final note: Even if you do not form LLCs for your clients but do occasionally assist them in handling post-formation is­sues, you should advise them about the above tax issues and, unless they have al­ready done so, you should advise them to consult with tax professionals to ensure that they are addressing these issues correctly.