The limited liability company (“LLC”) is a new type of entity which is now available in almost every state in the U.S. It has a combination of features which is not found in any of the other available business forms.
The LLC is very desirable for situations in which 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 which 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 organization – the S corporation or LLC – shows the profits and losses, but the tax consequences of that informational return are prorated among the shareholders (or “members” in an LLC).
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 LLC’s
Until recently, 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 both adopted a “check the box” system of allowing entities to select the type of tax treatment they wish to be subject to. As a result, it is no longer necessary for federal or California tax purposes to limit the number of corporate features an LLC has.
However, an LLC subject to tax in states which still look to the features of the LLC to determine whether it is subject to tax as a corporation or as a partnership, must still meet the tests in those states in order to obtain the desired flow-through tax treatment.
The old rule, which may affect taxation in some states, would require that an LLC have no more than two of the following four corporate characteristics in order to receive partnership tax treatment:
1. limited liability
2. continuity of life
3. centralization of management
4. free transferability of interests
Since the LLC form is usually desired in order to provide the participants with limited liability, it is two of the other three corporate characteristics which are usually given up in structuring an LLC in order to qualify for state partnership tax treatment.
If S corporations and LLC’s are taxed as partnerships, are there tax differences between the two forms? Yes, there are differences, but they may or may not be significant to a particular business since that depends upon the tax circumstances of the business.
Unlike the shareholders in an S corporation, but like partners in a partnership, the LLC 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 are prohibited from making such special allocations because special allocations are considered a second class of stock, which is prohibited under the S corporation rules.
LLC tax treatment is better than S corporation tax treatment in other ways. LLC’s are not subject to the built-in gains tax or tax on excessive passive income that can apply to S corporations. S corporations which converted from C corporation status with certain tax circumstances are subject to built-in gains taxes on gains existing prior to the conversion and on passive income in excess of 25% of gross income.
Another difference that may not be meaningful to all businesses 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, a date for its organization, a statement of purpose, the agent for service of process and a statement indicating whether the LLC is to be managed by managers and not by all of its members or managed by only one manager.
The Operating Agreement is not a legal requirement under California law, but it is a necessity since the parties will find it necessary to define all the rights, privileges and obligations of the members of the LLC. The Operating Agreement should contain provisions addressing at least the following topics:
- The rights and duties of members;
- Contribution of cash, property, or services by members and other issues relating to capital structure;
- Maintenance of capital accounts, accounting records and financial information, and delivery of financial reports and tax information to the members;
- Distributions to the members;
- Allocations of profits and losses and other tax consequences of the LLC;
- How the LLC is to be managed, whether by the members, by a management group of members, or by hired management;
- Meetings of members, meetings of managers, and voting requirements;
- Disposition of interests of members, termination of memberships, assignment of membership interests, admission of additional members, and withdrawal of members;
- Rights of the LLC or other members to buy out the interest of a deceased member;
- Rights of the LLC or other members to buy out the interest of a member under specified circumstances;
- Dissolution of the LLC; and
- Procedures for amending the operating agreement.
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 LLC’s 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 and reluctant to do business with an LLC. Similarly, the participants in an LLC will likely 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. Foreign investors must not assume that the LLC is the way to go, since an S corporation may not have shareholders who are non-resident aliens.
Under U.S. tax law, the income distributed to members from small LLC’s will often be regarded as earned income. 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 include all the features desired by the members.
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 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 operating a business. It may be even more frequently the best choice for real estate partnerships, estate planning 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.
Contact Johnson & Associates to further discuss the advantages of having an LLC.