Adding a member to a Texas Limited Liability Company (LLC) is a vital step in many developing organizations, and there are various reasons to do so, such as:
- having a new business partner,
- recognizing an employee for their hard work and loyalty, and
- adding capital for expansion
Yet, there are many things to consider for this business decision.
Aside from acquiring a unanimous vote by current members, you must also consider the tax consequences.
In this guide, we share the tax consequences of adding a member to an LLC. Keep reading until the end to get helpful tips on adding a member to an LLC in 7 easy steps.
What is an LLC?
An LLC is an organizational structure that provides limited liability protection and pass-through taxation, where tax is “passed through” the business owner’s personal tax return.
It means that LLCs protect a business owner’s personal assets from business debts and in case of a lawsuit. Furthermore, an LLC can be taxed as a sole proprietorship, a partnership, or an S-corporation.
LLCs are typically highly advantageous for business owners. They offer the same liability protection as corporations without the need for tedious paperwork and events, corporate recordkeeping, and board meetings.
Courtesy of Canva/ mediaphotos
How are LLCs taxed?
An LLC is typically treated as a pass-through entity for income tax purposes. This means that the LLC doesn’t pay taxes on its business income, but the members pay taxes based on their share of profits.
Members may opt for the LLC to be taxed as a pass-through entity or a corporation. Depending on whether the LLC employs anyone or on what you sell, you may likewise be responsible for paying sales taxes and payroll taxes.
The Two Ownership Options
- Single-Member LLC Ownership
This type of LLC ownership has one member (owner) who has full control of the company. The LLC is a legal entity that is independent of its owner.
- Multi-member LLC Ownership
This type of LLC ownership has two or more members (owners), sharing control of the company. The LLC is a legal entity independent of its owners.
Yet, a few exceptions when owners may be held personally liable are the following:
- When a member committed illegal business activities or fraud, a member has not managed the LLC, the parties agreed in their operating agreement, and
- A member has done something that compromised the separation between personal and business transactions.
Both single-member LLCs and multi-member LLCs protect the business owner's personal assets.
The Tax Consequences of Adding a Member to an LLC
By default, the Internal Revenue Service considers a single-member LLC as a disregarded entity for income tax purposes, meaning it is not required to file a separate income tax return to disclose income and expenses. It will just go directly on the member’s tax return.
When you add a member to an LLC, the business will be considered as a pass-through entity for income tax purposes. And just like a single-member LLC, a multi-member LLC will still not pay its own taxes.
The difference is that the LLC tax rate will now be based on each member’s income tax bracket.
For instance, if two members have a 50-50 ownership split, each will pay half of the business’ profits and claim half of the tax credit or deduction for which the LLC is eligible. Its taxation works like a partnership.
If the LLC opts for a C corporation tax status, it must report all income and expenses on IRS Form 1120, a separate return, and is subject to corporate tax. This option will result in the LLC being taxed twice.
Other Consequences of Adding a Member to an LLC
A new member can help the LLC grow, but their presence can also reduce the profit proportion of the current owners.
When someone becomes a part business owner, removing them can be quite tough if their presence is no longer advantageous to the business.
In addition, a new member in a member-managed LLC adds another voice that needs to be heard, potentially complicating or slowing the operation.
7 Easy Steps to Add a Member to an LLC
Courtesy: Canva/ mbpteerapat
1. Review the Existing Operating Agreement
First, you must check the provisions in your existing operating agreement. LLCs will often have one or more provisions in the operating agreement pertaining to adding or changing members of the LLC.
It may also include details of transferring rights and membership interest, such as restrictions on sales to non-LLC members.
If your LLC has such an existing provision, it will outline the process you’ll follow. But if your operating agreement doesn’t have rules on how to add a member, use the default rules in Texas.
2. Seek Consent from the Current Member/s to Add a New Member
The Texas Business Organization Code Section 101.105 requires the approval of all company members to add a new member to the LLC. [1]
Obtaining consent from an existing single member to add a member and change the LLC to a multi-member LLC structure may involve negotiations, discussions, or getting written agreement or consent from a single member.
3. Identify Potential New Members
The next step is to determine and bring in potential new members who will join the LLC. Choosing entities or individuals that align with the LLC’s objectives and goals is ideal.
4. Amend the Operating Agreement
Add new members by amending the operating agreement to reflect the changes in the LLC membership. This outlines the responsibilities, rights, and obligations of each member.
Ensure the amended operating agreement complies with Texas laws and is legally binding.
5. File the Paperwork
Once the operating agreement and other legal documents are updated, file these with the state agency to reflect your new member structure.
File a Texas certificate Form 427 and pay the associated fee. This document can be sent by mail, in person, or through fax and should be submitted in duplicate. [2]
6. Inform Relevant Agencies
Notify relevant agencies, including the Internal Revenue Service (IRS), about the change in the LLC structure. Update forms and tax filings to reflect the change from a single-member to a multiple-member LLC.
Furthermore, if your LLC has managers, you must notify the Secretary of State of the management changes. It can be done through any of the following:
By filing an amendment to update the LLC’s management information and
Updating management details on the Public Information Report
7. Revise the LLC’s Taxation
The last step is to update taxation and financial records to accommodate the new member or LLC structure. You may have to update the Employer Identification Number (EIN) with the IRS if necessary.
You can open an LLC business bank account for the new ownership structure from a single-member LLC to a multi-member LLC. Doing so will ensure separate financial management.
Reverting to a Single-Member LLC from a Multi-Member LLC
Courtesy of Canva/Pixelfit
If you’ve reached an informed decision and believe that going back to a single-member LLC would work best for your business, you can revert your business entity to a single-member type.
To convert a multi-member LLC to a single-member LLC, simply file Form 8832. Once you revert into such classification, the business entity will be reported on the single member’s personal tax return.
Accounting Support to Add a Member to an LLC
If you’re mindful of the tax consequences of adding a member to an LLC, having the right accounting support will be an asset.
As someone with specialized knowledge in tax compliance and financial management, they can help you stay up to date with the best practices and changing regulations in the industry.
Moreover, by delegating the task to someone more knowledgeable in the field, you can focus your energy and time more on core business operations. This allows you and other LLC members to focus on strategic growth.
FAQs to Adding a Member to an LLC and Its Tax Consequences
What happens to taxes when you add a spouse to an LLC?
When you add a spouse to an LLC, you will pay federal and state income taxes on your company’s profits.
Your business entity will still offer the tax structure of a partnership with limited liability protection.
How is income from an LLC taxed?
The LLC itself isn’t taxed, but the profits and losses are passed to the LLC owners, referred to as members and reflect on their individual returns.
How do I add a member to a single-member LLC with the IRS?
To add a member to a single-member LLC with the IRS to protect personal assets from personal liabilities and enjoy tax benefits, check the procedure in your Texas LLC Operating Agreement.
Can LLC members reduce or avoid self-employment tax?
Yes, LLC members can lessen the burden of a self-employment tax by opting to be treated as a corporation for taxation purposes. Most LLCs choose to be classified as an S corporation because it remains a pass-through entity.
Alternatively, members can opt for the entity to be taxed as a C-Corporation, which is required to report and pay income tax on its profits.
Key Takeaway
As you now know, adding members to an LLC has tax consequences.
Similar to the single-member LLC, a muti-member LLC will be treated as a pass-through entity with regard to tax issues. It means that profits and losses of the business pass through the percent of the members’ ownership.
And because each LLC member is not treated as an employee in terms of taxation, they are considered self-employed business owners.
So, all LLC members become responsible for paying the income tax that the LLC earns, and their LLC tax rate depends on each member’s individual income tax bracket.
Contact Hall Accounting Compay today to learn more about what we can do to help your business stay in compliance with Texas regulatory requirements when adding a new member to the LLC.
Related Articles:
Resources
[1] https://statutes.capitol.texas.gov/Docs/BO/htm/BO.101.htm