Limited Liability Companies
When forming a corporation for tax purposes, the question arises as to how and what is more advantageous for the new business owner when forming a new corporation. The latest corporate form, which seems to be all the rage with business owners, is the Limited Liability Corporation, or the LLC. See also Small Business, Small Taxes, Small Problems!
What is an LLC?
An LLC is an organization formed under state law that combines the corporate advantage of limited liability for its owners (called "members") with the income tax advantages of a partnership. Like a corporation, a properly structured LLC protects its owners against personal liability for the debts, liabilities and obligations of the LLC. Like a partnership, an LLC is not subject to federal income tax unless it elects to be taxed as a corporation. The income of an LLC is taxed directly to the LLC's members. In many circumstances, this combination of corporate limited liability and partnership income tax treatment can be very advantageous to both the LLC and its shareholders, (or members, as they are referred to in LLC's).
Who can be a Member of an LLC?
A member may be any person or entity including an individual, corporation partnership, other Limited Liability Company or trust. In most states but not all (for example, not Texas), each member has the authority to manage the business and affairs of the LLC unless the Articles of Organization or Operating Agreement vest such management authority in one or more managers. Members own "membership interests" in an LLC, similar to "partnership interests" owned by partners in a partnership. Members in an LLC have limited liability, i.e., they are not liable by reason of being members, for the debts, obligations or liabilities of the LLC. In contrast, the general partners in a partnership are personally liable for the debts, obligations and liabilities of the partnership unless state law permits and the partnership elects to be a limited liability partnership.
Advantages of an LLC
Without going into a law lecture, I will try to simplify some of the pros and cons of being an LLC. An LLC classified as a partnership for tax purposes has these various advantages over an S Corporation, a regular corporation (a C Corp) or a partnership:
- In a corporation, the articles must be specific in disclosing its purpose and capital structure. An LLC does not have to provide such information.
- An LLC is not required to hold annual stockholders meetings, unlike a corporation.
- Shareholders in an LLC may contribute encumbered property to a corporation in exchange for stock without incurring a taxable gain.
- An LLC may make disproportionate distributions of money and property without regard to shareholder's percentages of stock ownership.This factor alone gives the LLC structure much greater flexibility.
- An LLC is not subject to the federal income tax liability as a C Corporation, as the tax liability is passed onto its shareholders.
- An LLC can use either the cash or accrual basis methods of accounting. A corporation with gross receipts in excess of five million must use the accrual method.
- A closely held C corporation is subject to the passive activity loss limitations imposed by the IRS code. An LLC is only subject to the passive loss rules, if treated as a partnership.
- An LLC can have an unlimited amount of shareholders, while an S Corporation can have no more than 75 shareholders.
- The tax treatment of the income from an LLC is passed onto a partnership return, and then passed onto the shareholders through a K-1 form. Normally, when a partnership incurs income, that income is subject to self-employment taxes. Not the case with an LLC. It has the same advantages and tax pass-thru as an S Corporation, without the hassle of making the S Corp election.
Disadvantages of an LLC
- Each shareholder in an LLC has a voice in the daily operations of the entity, unless it is stated otherwise, specifically in an operating agreement.
- An LLC is automatically terminated if there is a sale or exchange of 50 percent or more of the total interest in the LLC's capital and profits. This is not the case with a C Corp.
- The forming of an LLC can be very expensive, as the filing fees and franchise alone are quadruple the costs of a regular corp. With the legal costs of setting up the LLC, the legal fees can become very costly.
- Any gains recognized by a member of an LLC upon the sale of interest in the assets will be treated as ordinary income, rather than capital gain.
- An LLC is a relatively new entity, and many practitioners, businesspersons and unfortunately, the courts, are unfamiliar with the way LLC's work. There is a lack of legal precedent in the court system. This can be particularly relevant when it comes to determining the scope and extent of the limitation on the liability of members for the debts and obligations of an LLC.
- LLC's are restricted in the election of choosing a tax year for the company. They must choose the December 31st year-end, whereas a corporation can choose any tax year. This is a problem when trying to defer large tax liabilities to shareholders.
There many advantages of electing to do business as an LLC versus a regular corporation, with the limited liability exposures of a such an entity being a big advantage to any new business. But like every other legal entity, an LLC is not for everyone. When making the decision to incorporate, consult your attorney about whether an LLC is the best means of operating your company.