Income Tax Issues

Income Tax Issues

The IRS has taken the position that a corporation cannot legitimately operate without at least one employee. (i.e. that one cannot set up a corporation and then use the corporation to issue 1099 independent contractor tax forms to the owner).  This has created a situation thus requiring that the owner of the corporation pay himself using W-2 formulations when his income may be uncertain and he may not able to always take the specific amount on each “payday”.

On the other hand, the IRS has always been willing to treat an LLC owner differently.  If, upon formation of the LLC, the owner does not file the IRS 8832 form, he will be defaulted as a “pass-through” taxpayer, meaning that he will be taxed as a sole proprietor and can disregard the LLC, simply putting the income and expenses of the LLC on Schedule C of his 1040 personal tax return.  This choice will, of course, require quarterly tax payments and will still require that he pay the FICA or self-employment taxes on his income.

Further, the IRS allows the LLC owner to be taxed as a C-corporation rather than as a “pass-through” taxpayer by the filing of the 8832 form checking off the box relating to corporation taxation choice.

This choice given the taxpayer does not change the fundamental nature of the LLC, but simply allows the LLC to be taxed as a corporation.  In other words, the entity is still an LLC with all of its other attributes and is not a corporation.  That being the case, there is a strong argument to be made that a taxpayer who chooses to be taxed as a corporation should not be required to be paid as a W-2 employee from the LLC, but should be able to act as an independent contractor and file quarterly payments for his personal income taxation.  In other words, it would seem that the legitimacy of the LLC organization should not be challenged by the IRS where the owner does not declare himself a W-2 employee.  We are unaware of any cases wherein this issue has been litigated but we only raise this as one of the issues to be considered when  contemplating the formation of a business entity.

Last, an issue often arises regarding the necessity of registering the corporation in the state of the residence of the owner.  If the LLC treats the owner as an employee, then it will most likely be required to register the LLC in the state of residence of the employee owner.  If the LLC is not required to hire the owner as an employee, there is some justification for not requiring the registration of the company in the residence state of the owner.  California, for example, does not require that a foreign company register if the business done in the state is conducted by independent contractors if the company sells products as opposed to offering services..