Determining the Taxable Profits or Losses of an LLC
A limited liability company (“LLC”) shall not be subject to federal income tax. Persons carrying on their business as members shall be liable for income tax only in their separate or individual capacities.
Computing the LLC’s amount of profits or losses is important in determining how much profits or losses should flow through to the members, thus, it is extremely important that every LLC have an LLC Operating Agreement . Once the LLC’s amount of profits or losses has been determined, the profits or losses can then be allocated proportionally to the members according to the allocation determined by the LLC’s Operating Agreement.
In general, LLC taxable income is computed in the same manner as an individual’s taxable income with certain modifications. The most important modification is that items described in Internal Revenue Code Section 702(a) are separately stated. The reason for separately stating these items is that they have special significance to individual members. Internal Revenue Code Section 703(a) also denies two types of deductions that individuals are normally permitted. The first type of deductions are those that are considered inappropriate for LLCs, such as the deduction for personal exemptions and the itemized deductions. The second type are those deductions which the benefits are passed through to the members in their individual capacities, such as certain foreign taxes, charitable contributions, net operating losses, and depletion and of oil and gas wells.
Separately stated items
The taxation of LLCs is based on a blend of entity and aggregate notions of partnership taxation. There are some items that will affect all members the same way, without regard to the members’ tax profits. But there are a number of other items of LLC income and deduction that may affect each member differently depending on the member’s tax profile. For example, consider ABC, LLC whose only tax item is for the year is a $10,000 capital gain, which is allocated equally between its two members, Steve and Jane. If Steve has no other capital gains or losses for the year, and Jane has a $2,000 capital loss for the year, the tax effect of the $5,000 LLC capital gain allocated to each member would be different. Steve would report a $5,000 net capital gain, while Jane would report a $3,000 net capital gain. If the LLC gain was expressed simply as net $4,000 income for the year, without specifying its character as capital, the members would not have the information necessary to adequately report their income for the year. Thus, the LLC information return must separately state this capital gain, as well as other items that can affect the members in different manners. The Internal Revenue Code specifically lists these items in Internal Revenue Code Section 702(a)(1)-(6):
- Short term capital gains and losses
- Long term capital gains and losses
- Gains and losses from the sale, exchanges, or involuntary conversions or property used by the LLC in its trade or business
- Charitable contributions
- Corporate dividends and qualified dividends
- Foreign taxes
- Other items of income, gain, loss, deduction, or credit as required under the Internal Revenue Code