1. Reason #1: The tax advantages of the LLC versus the corporation;
2. Reason #2: The extremely flexible nature of the LLC, allowing wide-latitude in structuring the rights and obligations of the members (i.e., the partners);
3. Reason #3: The user friendly nature of an LLC.
Reason One: Why Start-Ups often Prefer an LLC over a Corporation: No Double Taxation.
As a quick primer on business entities, there essentially four types of entities most businesses consider utilizing: (a) a corporation, (b) a limited partnership, (c) an S Corp or (d) an LLC. As a simple explanation, a limited partnership is generally not as popular for start ups because it requires at least one partner have the status of a General Partner, meaning that partner has unlimited liability (which most entrepreneurs do not want to risk for obvious reasons). An S Corp is formed as corporation but is taxed like a partnership, and thus the business entity is not subject to a separate tax (discussed more fully below); however, there are restrictions on S Corps (including that they are limited to 100 shareholders, none of which can be foreigners, and there is no ability to create separate classes of shares), which may restrict the ability to bring in additional shareholders. Essentially, then, that leaves the corporation and the LLC as the popular choices for structuring a business.
1. Taxation of a Corporation: A corporation is taxed on any net income (profit) at the corporate entity level, and if there is a distribution to the shareholders (of net profit), each shareholder is then taxed on this distribution (a dividend). The result, is a double taxation:
(a) corporate level: 15% to as high as 35% depending on level of net income, and
(b) shareholder level 15% on the dividend distributions to shareholder.
The double taxation arises from the fact that the entity itself and the shareholders each have a separate taxable identity and each are required to file a tax return and pay taxes on net income (as to a corporation) or dividends/distributions (as to a shareholder). Of course, the corporation generally does not have to make a distribution to shareholders, but that may not be a satisfactory solution for a closely held company where the shareholders are expecting distributions of profits.
(b) shareholder level 15% on the dividend distributions to shareholder.
The double taxation arises from the fact that the entity itself and the shareholders each have a separate taxable identity and each are required to file a tax return and pay taxes on net income (as to a corporation) or dividends/distributions (as to a shareholder). Of course, the corporation generally does not have to make a distribution to shareholders, but that may not be a satisfactory solution for a closely held company where the shareholders are expecting distributions of profits.
2. Taxation of a Limited Liability Company: LLC’s provide all the protection of a corporation (thus unlike a partnership, the members of an LLC have limited personal liability for the LLC’s debts). But, in contrast to a corporation, an LLC is not classified for tax purposes as a separate entity, rather it is a “pass through”.
(a) Single-Member LLCs:
(i) Unless the member makes a different tax election, single member LLCs are classified as a disregarded entity. As such, the LLC entity is not subject to a tax separate from the member and all income or deductions of the LLC go on the owner's tax return. For LLCs that operate an active trade or business, this means the income and deductions are listed on "Schedule C Profit or Loss From Sole Proprietorship" of the sole member. If rental property is held through the LLC, then the owner would include income and deductions on the owner's "Schedule E Supplemental Income and Loss."
(ii) Self-Employment Tax: As a single member LLC, the owner also must pay self employment tax consisting of FICA and Medicare at a rate of 13.3% for 2011 and 15.3% for 2012. While self employment tax is an additional burden that corporation shareholders don't pay, the single-member gets a deduction on their income of fifty percent of the self employment tax. However, often a shareholder in closely held/small companies will be paid a salary for services provided to the corporation. While the corporation will pay part of FICA and Medicare, there may ultimately no real savings as compared to the LLC because the owner is responsible for the taxes, whether it is paid through the business (as with a corporation), or directly by the owner (for a single member LLC). One common thought is to avoid any payroll tax in a corporation by not paying the sole shareholder a salary; however, this defeats the tax benefit gained from reducing the taxable net income of the corporation itself.
(b) Multiple Member LLC:
(i) An LLC with more than one member is by default classified as a partnership. Like single-member LLCs, co-owned LLCs do not pay taxes on business income. Instead, the income and deductions of the LLC are reported on a partnership return. However, the LLC still does not pay a separate entity tax. The limited liability company itself files an informational LLC tax return (Form 1065) and issues a K-1 to each member. Instead, the income and deductions are divided among the members based on the economic terms set forth in the Operating Agreement (or, if there is no operating agreement, in accordance with each membership percentage in the LLC). The members in turn receive a K-1 from the LLC, which shows the allocation of the member's share of the income and deductions of the LLC.
(ii) Self Employment Taxes. A member in a multi-member LLC also pays self-employment taxes. LLC taxes are paid by each member according to his/her share of the profits and losses. Like in a single-member LLC, each member files a Schedule C and calculates self-employment tax on Schedule SE.
(c) Non-resident Alien: Unlike an S Corp, a non-resident alien can be the member of an LLC, and therefore it is worth noting that non-resident alien LLC members do not have to pay self-employment tax.
(d) Minimizing Self Employment Tax: There may be ways to minimize the self employment tax owed by LLC members, including
(i) if a member is a passive owner (i.e., not involved in management of the LLC), the distributions may be exempt from self employment tax, but the tax regulations are complicated and the exemption should be discussed with your tax advisor;
(ii) an owner who receives repayments of a loan and payments on lease from the LLC may be able to avoid self employment tax on such payments.
3. Start Up Expenses and Losses: When starting a business there is an expectation that the partners will have substantial start up expenses, and for most businesses it may be months or years before it shows a profit or can make distributions to its owners. For a corporation, the expenses/losses are deductions from income of the entity for determining the tax liability of the corporation. The LLC has the advantage that, as with the profits, the expenses/losses are similarly allocated to the members individually who thereby benefit from the ability to take these allocated deductions on their individual tax return.
Of course, before deciding the appropriate entity for your business, issues such as taxes and other aspects of the various types of entities should be discussed with your professional advisor. Your particular financial or tax situation may favor choosing one form of entity over another.
The next installment of this Article will discuss how the flexibility of the LLC has made it an attractive business structure for new businesses.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.
