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| The Business Advisor The Limited Liability Company by Mary Hanson |
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The limited liability company ("LLC") is very desirable for situations in which the business owners wish to have partnership-type flow-through tax treatment, along with protection from personal liability. These are the same features which attract business owners to the S corporation, but the S corporation form has many limitations which restrict its use. Many businesses that would like to use the S corporation form are not eligible for S corporation status. In addition, the S corporation rules have many prohibitions and conditions which make it less attractive, even when it is an option.
Since corporations and non-resident aliens cannot be shareholders of an S corporation, the S corporation structure is not an option for enterprises owned by foreigners or for joint ventures involving corporations.
The desirable flow-through tax treatment (passing the tax consequences of losses, investment tax credits, and depreciation through to the individual owners) is regarded as "partnership" tax treatment, as opposed to "corporate" tax treatment. The tax return of the LLC sets out the financial information for the tax year for the LLC, but the tax consequences are prorated among the members of the LLC and taxes are paid by the members.
The key benefits of this flow-through of tax consequences are that profits and gains are taxed only once and taxed at the tax rate of each shareholder or member.
TAX TREATMENT OF LLCs
At one time, in order to obtain the partnership tax treatment for federal tax purposes, an LLC had to be structured so that it did not have too many corporate features. If the entity had more than two corporate features, it would be taxed as a corporation.
Now the IRS and the state of California have a "check the box" system of allowing entities to elect to be taxed as a corporation or as a partnership. As a result, it is no longer necessary that an LLC limit the number of corporate features it has in order to obtain the tax treatment it wants.
The partnership tax treatment is most often the choice for an LLC. When considering the pros and cons of using an LLC or an S corporation, it is important to note that an LLC that has elected partnership tax treatment IS a partnership for tax purposes. An S corporation is subject to tax treatment that on some points is SIMILAR to partnership tax treatment. The differences can be significant, depending on the particular tax circumstances of the entity.
When an LLC has elected to be taxed as a partnership its members get to treat their share of all LLC liabilities as part of their tax basis. In an S corporation, a shareholder may only increase his or her tax basis by such entity debt if that shareholder is personally liable for the debt. In addition, an LLC is permitted to allocate income, gain, loss, and deduction items among the members, provided such special allocations comply with applicable tax rules. S corporations cannot make special allocations that would be considered a second class of stock, which violates the eligibility requirements for an S corporation.
LLC tax treatment is better than S corporation tax treatment in other ways. LLCs are not subject to the built-in gains tax or tax on excessive passive income that can apply to S corporations. S corporations are subject to built-in gains taxes on gains existing prior to a the corporation electing S corporation status and on passive income in excess of 25% of gross income.
Another difference is that the conversion from an LLC to another legal form of entity such as a corporation is not subject to tax. Just as a partnership may be converted into a corporation without triggering taxes on capital gains or causing other taxable events, the LLC may also be converted into a corporation. If, instead, a corporation wishes to convert into an LLC, the corporation must first liquidate, subjecting both the corporation and the shareholders to potential taxes.
FORMATION OF LLC
The creation of an LLC requires the filing of Articles of Organization and execution of an Operating Agreement among the members. The Articles of Organization for an LLC formed under California law must set forth the LLC's name, the agent for service of process, and a statement indicating whether the LLC is to be managed by its members or managed by one or more managers.
The Operating Agreement is not a legal requirement under California law, but it is a necessity for setting out the rights, privileges and obligations of the members of the LLC. The Operating Agreement should contain provisions addressing at least the following topics:
DRAWBACKS OF THE LLC
The LLC is not the perfect entity for any business. All aspects of the LLC must be considered for each business situation.
An important limitation in California is that most licensed occupations are prohibited from using the LLC. If the business must hold any type of state license, check out the potential licensing limitations on the LLC first. The broad prohibition on using an LLC for state licensed activities has been an unwelcome surprise for many business people.
Another concern in California is that LLCs are subject to the minimum franchise tax of $800, plus a gross receipts tax according to a schedule. The gross receipts tax kicks in at $900 on gross receipts of $250,000, and is a tax of $6,000 on gross receipts of $1,000,000 to $4,999,999. The tax on gross income of $5,000,000 or more is $11,790.
Another drawback is that banks, businesses, and other institutions may be unfamiliar with LLC's or reluctant to do business with an LLC. Similarly, the participants in an LLC may be unfamiliar with the entity and may be surprised, disappointed, or uncomfortable with the way the entity operates.
One such surprise may be the personal taxes due on undistributed taxable income of the entity. Partners, members, or shareholders of any entity that is subject to "flow-through" tax treatment are taxed on profits and other taxable items, whether or not any cash has been distributed to them. Profits that are reinvested in a growing company rather than distributed to the investors often boosts taxable income. An LLC member or S corporation shareholder is often surprised by the burden of taxes resulting from a growing business.
The flow-through income from an LLC is often regarded as "earned income" for tax purposes. Any taxpayer who does not want earned income must approach an LLC (and other flow-through entities) with caution.
In particular, non-U.S. citizens must determine whether this earned income presents a tax issue or immigration law issue for them. A non-U.S. citizen who wishes to become an LLC member must make certain that income from the LLC will not be treated as his or her earned income unless he or she has the necessary visa or immigration status to earn such income in the U.S.
Another aspect of the LLC which should be regarded as a drawback is the amount of effort required to create an LLC. The flexibility of the LLC means that it can take a great deal of time and effort to structure the entity to cover all necessary aspects of the operation and structure of the LLC.
If the individuals involved in the business have different tax situations, if the parties wish to take advantage of the ability to allocate tax consequences to different members, or if the individuals disagree on some aspects of the business operation or structure, it can take a great deal of time and effort to work out the details of the LLC.
In conclusion, the pros and cons of using an LLC should be considered for every new entity. It will frequently be the best choice for real estate investments and joint ventures. Nevertheless, because of the flow-through tax treatment, each member must consider the positive and negative aspects of the LLC for that particular member’s financial and tax situation.
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