An LLC is a distinct type of business, of recent origin, that offers an alternative to partnerships and corporations, by combining (1) the limited liability protection previously afforded only to corporate shareholders and limited partners, and (2) the tax advantages and capital flexibility generally associated with partnerships. Please note that “LLC” does not stand for “Limited Liability Corporation.” An LLC is not a type of corporation at all.
An “S” corporation is a corporation that has made an election with the IRS to be treated for tax purposes as a “pass-through entity.” This means that corporate profits and losses are passed through to the shareholders (owners) who report them on their own personal tax returns and pay the tax at the individual level. The corporation pays no federal income tax at the corporate level.
Both entities offer limited liability protection to the owners and pass-through taxation. LLCs offer greater operating flexibility and impose less restriction than S corporations. For example, there are limitations on the type and number of shareholders permitted in S corporations that are not imposed on the owners of an LLC. LLCs are not required to have annual shareholder and director meetings; LLCs are. On the other hand, shareholder/employees of an S-corporation may pay less taxes overall than owners of an LLC. It is generally less costly to form an S-corporation than an LLC, particularly in California where additional franchise taxes are imposed on LLC’s.
In an “S” corporation, profits and losses pass through to the owners relative to their ownership interests. For example, a 50% shareholder would be allocated 50% of the corporation’s profits and losses.
The LLC is more flexible in structure. LLCs can be structured to divide profits and losses however they wish, irrespective of ownership percentages. For example, you may own 50% of the business, but elect to have only 25% of the profits reflected on your personal 1040, passing the additional income to an owner in a more favorable tax bracket. Also, “S” corporations require all stockholders be US citizens and limit the number of shareholders to 100. LLCs have no such limitations.
LLCs offer numerous advantages. Among them are:
Limited liability. The primary advantage of a limited liability company is limiting the liability of its members. Unless (1) a member personally guarantees a debt; (2) the LLC fails to have a separate bank account and personal funds are commingled with LLC funds; (3) the LLC is undercapitalized; or (4) the LLC fails to pay state taxes or otherwise violates state law, the members are not liable for the debts and obligations of the limited liability company. In a partnership or sole proprietorship, creditors may seize personal assets of the participants to pay debts of the business.
No ownership restrictions. S corporations may not have more than 100 shareholders, and each shareholder must be a natural person who is a resident or a US citizen. LLCs have no such restrictions.
Membership interests may be placed in a living trust. LLC Members may place their membership interests in a living trust. It is difficult to place shares of an S-corporation into a living trust.
Ability to deduct losses. Members who actively participate in the business of an LLC are able to deduct its operating losses against the member’s regular income to the extent permitted by law. S corporation shareholders may also deduct operating losses; however C corporation shareholders may not.
Tax flexibility. LLCs, by default, are treated as “pass-through” entities for tax purposes, much like a sole proprietorship or partnership. This means that LLCs avoid double taxation. Alternatively, an LLC may elect to be treated like a corporation for tax purposes, whether as a C corporation or an S corporation.
Flexible Management Structure and Flexible Ownership is Permitted. The members have greater flexibility in structuring the limited liability company than is ordinarily the case with a
corporation, including the ability to divide ownership and voting rights in unconventional ways while still enjoying the benefits of pass-through taxation.
Fewer Formalities. Corporations are required to keep formal minutes, have meetings, and record resolutions. The LLC business structure requires no corporate minutes or resolutions and is easier to operate.
Self-Employment Tax. LLC members pay self-employment taxes, the Medicare/Social Security tax paid by entrepreneurs; it’s calculated on 15.3 percent of profits. Contrast this with an S corporation – Self-employment tax is due on salary only, not your entire profits.
Gross Receipts Tax. In addition to the minimum franchise tax, a California LLC must pay an annual fee based on the LLC’s total income, which is gross income plus the cost of goods sold. The this “gross-receipts tax” applies to LLCs grossing over $250,000 a year. The tax ranges from $900 (for total income between $250,000-$500,000) to $11,790 (for total income of $5 million or more).
Fewer Incentives. LLCs aren’t ideal for companies wanting to give fringe benefits. C corporations, for example, can provide lucrative employee
benefits that are deductible by the corporation and tax free to the employees.
An LLC can be particularly advantageous in the following situations:
Real estate investments.
LLCs should be particularly attractive for real estate investments because LLCs combine limited liability and flexible
management with the ability to:
- pass through losses and deductions;
- make special allocations; and
- avoid double taxation on the sale of appreciated assets.
Businesses planning to hold property that will appreciate, such as real property.
Regular corporations and their shareholders are subject to a double tax on this appreciation when assets are sold or liquidated – in other words, taxation occurs at both the corporate and individual level. S corporations that were organized as C corporations prior to making an S corporation tax election also may be subject to a double tax on “built-in gains” from asset appreciation, as well as a penalty tax if their passive income (money from rents, royalties, interest, dividends) gets too high. Because the LLC is a true pass-through tax entity, it allows a business that will hold appreciating assets to avoid double taxation. When the business is sold, generally just the owners, not the entity itself, pay taxes on the profits from the sale.
Business owners desiring to use business debt (money borrowed by the company) to increase their tax basis. The following example emphasizes the problem with using excessive loans in connection with an S corporation: Newman and Conrad started a business named NewCo, Inc., by investing $5,000 each for their stock. NewCo borrowed $40,000 and began the business of selling designer apparel. The first year, NewCo lost $50,000, all of its available cash. Newman and Conrad remained active in the business.
How much were they entitled to deduct on their tax returns as a business loss stemming from the S Corporation? The answer –$5,000 each — their respective bases in their stock, even though the loan to NewCo was probably guaranteed by Newman and Conrad, and they would be required to repay the loan to the lender as guarantors, if the corporation could not pay.
Had Newman and Conrad borrowed the $40,000 and loaned it to NewCo, the basis of their stock would have been $25,000 each and they both could have deducted $25,000 on their tax returns. A loan obtained by the S Corporation does not create basis for Newman and Conrad in their NewCo stock. This technicality has created misery for the shareholders of many failed S corporations.
By contrast, for LLCs, the members can include the company’s loan in their basis. If NewCo had been an LLC, Newman and Conrad could each have deducted the full $50,000 in losses.
As another example, assume each of 10 individuals contribute $100,000 to a newly formed entity to acquire an office building. The entity borrows from a bank an additional $5,000,000 as the balance of the building’s $6,000,000 purchase price. If the entity is taxed as an S corporation, each shareholder’s loss deductions are limited to $100,000. However, if the entity is an LLC taxed as a partnership, each member can deduct losses up to $600,000 ($100,000 basis plus $500,000 share of entity’s debt). These losses may then be used by the individuals to offset other income they may have from other sources.
Start-up businesses The favored tax treatment of the LLC, its limited liability features, and its flexibility for structuring financial and managerial operations make the LLC a form of business organization to be considered for a new business. New businesses generally wish to pass possible early-year losses along to owners to deduct against their other income (usually salary earned via working for another company or income earned from investments). Unless the business requires a particular license, every start-up business should consider the LLC form of organization, whether it is a local market, real estate venture, or corporate high-tech joint venture.
Existing unincorporated businesses. Any existing business that is a partnership and any sole proprietor bringing in a partner should consider converting to LLC form. Only the LLC provides pass-through tax treatment of business income while insulating all owners from personal liability for business debts. Generally, the conversion can be done without triggering income tax.
Anyone thinking of forming an S corporation. Like LLCs, S corporations also provide limited liability protection to all owners. The S corporation tax election comes at a fairly heavy price: S corporations must limit the number and types of shareholders. They are restricted as to how they allocate profits among owners, the types of losses they can pass along to owners to ease their income tax burden, and the kinds of stock they can issue to investors. Even if a business meets the S corporation tax requirements, it can inadvertently lose its eligibility – for example, when a disqualified shareholder inherits or buys the stock – resulting in a big tax bill.
Venture capital investors. Because of the organizational and structural flexibility of LLCs, the ability to engage in management without fear of liability, and the ability to make special allocations and deduct losses, an LLC may be attractive to venture capital investors. An LLC may not be able to attract venture capital, however, if it restricts the right of investors to sell their ownership interests or if the venture capital investor is a partnership that has tax-exempt or foreign partners.
Joint ventures. An LLC can be an attractive alternative to a general partnership or corporation as a means of organizing a joint venture or “strategic alliance.” LLCs are preferable to general partnerships because of the limited liability they provide to members (thus eliminating the need for a venturer to form a special-purpose corporation) and are preferable to corporations because of pass-through tax treatment and the avoidance of double taxation.
Estate planning. The LLC, by virtue of its partnership tax treatment, limited liability, and flexibility of management and financial structures, may prove to be a valuable estate-planning tool for transferring ownership interests in businesses and real estate.
LLCs are particularly attractive entities for real estate investments, because they combine limited liability and flexible management with the ability to pass through losses and deductions, make special allocations, and avoid double taxation on the sale of appreciated assets.