Which LLC?

Most people establishing a business have heard of the limited liability company, or “LLC,” and its ability to act as a shield for personal assets against claims by creditors.  But there are several types of LLCs, each with its own uses, pros and cons.  While not an exhaustive list, this note describes the main features of the most prominent ones. 

The LLC is a relatively recent creature of law in most states and is established by statute. The LLC laws of each state vary slightly from one to the other, so it’s important to get legal advice particular to your jurisdiction and circumstances.[1]  For present purposes, though, we’re not going to focus on the particulars of any one state’s laws.

Single-Member LLC.

The most basic LLC is the single-member LLC.  This is an attractive alternative to a sole proprietorship and is chosen primarily for the protection against personal liability it offers.  A “sole proprietor” conducts business under his or her own name (or under a “dba”), and creditors and those who obtain court judgments against the proprietor have access to the proprietor’s personal assets; an LLC provides a legal shield between business and personal property by limiting the business’ liability to the assets of the LLC. 

To maintain this liability protection, however, one has to “walk the walk and talk the talk:” the business must be distinct from personal affairs and not a “mere alter ego” of the owner.  It is important to keep separate books, records and bank accounts, to make it easy to distinguish what belongs to the business as opposed to the person.  If, for example, the owner contributes money or other assets to the LLC, this should be recorded either as a capital contribution or as a loan and documented.  Likewise, if the LLC is reimbursing the owner for expenses incurred on behalf of the LLC, a bill of sale or other receipt should be issued. 

The consequences of not maintaining this separation is to make it possible to “pierce the corporate veil” and reach the owner’s personal assets, by showing there is no distinction between the business and the person, and thus that the personal assets should be available to creditors.  This is the downfall of many single-member LLCs.

The single-member LLC is a pass-through or “disregarded” entity, meaning that profits and losses are treated as ordinary income on the owner’s tax return and taxed accordingly.  Also, as with a sole proprietor, the owner of a single-member LLC is responsible for self-employment taxes in lieu of the payroll taxes withheld if the owner were a wage earner.

Multi-Member LLC Taxed as Partnership. 

In a multi-member LLC two or more people come together to own and run a business. Typically, such an LLC will have an Operating Agreement among the company and its owners, regulating important issues concerning the operations of the company and the rights and obligations of the owners, such as the relative ownership interests of the parties, their capital contributions, their obligation (or lack thereof) to make additional capital contributions, their right to distributions, the management and decision-making process, and indemnification of individual members, although the list of possible topics is long.[2]Note, though, that unless the Operating Agreement says otherwise – and most do – each member has the power to bind the LLC and the other members, much like partners in a general partnership; for this reason, usually one or more members are designated managers or expressly given the authority to act on behalf of the LLC, with the other members having only internal decision-making power through their voting rights.Unless there is a piercing of the corporate veil – much more difficult to do than with a single-member LLC – the liability of the members of the LLC is limited to their respective capital contributions.

Multi-member LLCs are flexible, and can have multiple classes of membership with some members accorded voting rights and some just along to share in the profits.And new members can be admitted to the LLC, either through the sale of existing membership interests or by issuing new membership interests, which makes this type of LLC a simple yet very attractive investment vehicle.

A multi-member LLC is taxed as if it were a partnership, with each member receiving a K-1 return and net profits or losses are taxed at ordinary income rates.Also, as an owner of the business, each member may be responsible for self-employment tax, depending on the member’s activities on behalf of the LLC.[3]

LLC taxed as an S-Corporation.

Another variation is the LLC taxed as an S-Corporation (an “S-Corp”).  If the LLC elects S-Corp status, the LLC becomes a cross between a corporation and a pass-through entity, though with certain restrictions: an LLC electing S-Corp taxation can have no more than 100 members, none of whom may be non-resident aliens, partnerships or corporations.  Like a multi-member LLC but unlike a full-fledged corporation (a “C-Corp”), an LLC making the S-Corp election does not pay corporate taxes but passes profits and the tax burden to its members; the avoidance of the “double taxation” to which shareholders of C-Corps are subject (i.e., taxation at the corporate level plus taxation at the individual level) is perhaps its greatest attraction.  

S-Corps must follow corporate formalities similar to those of C-Corps, holding formal board and shareholder meetings, having by-laws, etc. 

Unlike single-member and other multi-member LLCs, however, members can be employees of the S-Corp, and thus earn wages, taxable at ordinary income rates with employment taxes withheld, eliminating the self-employment tax; such wages must be fair under industry standards.  But shareholders can also take profits in the form of qualified dividends (i.e., dividends that meet certain holding requirements) that are taxed at lower capital gains rates. Indeed, at year’s end any cash profits must be distributed as dividends and are considered passive investment income and taxed at the lower capital gains rate.  This combination of wages and distributions can under the right circumstances yield a lower overall tax rate than the “plain vanilla” multi-member LLC.

The S-Corp is thus ideally suited for taking the profits out of the business, but this comes at a price: the restrictions on the number and kinds of shareholders make it less suitable for raising capital than other forms.

LLC taxed as a C-Corporation.

Finally, an LLC can opt to be taxed as a C-Corp.The main advantage of such an LLC is that it facilitates investment by entities that may not invest in pass-through entities, such as pension funds.Like a full-fledged C-Corp, there are no restrictions on the number or kinds of shareholders, which this makes it more suitable for raising capital than an LLC taxed as an S-Corp.An LLC/C-Corp can go public and have its shares traded on stock exchanges.The variety of expenses that can be deducted from income is broader than those permitted as S-Corp, including full deductibility of health insurance.

However, C-Corp status brings with it disadvantages, chief among them being “double taxation” of income, which is taxed once at the corporate level and, once distributed, again at the individual level.While, unlike an S-Corp, there is no obligation to distribute all profits annually, an “accumulated earnings tax” is levied where the earnings retained by the LLC exceeds the company’s “reasonable needs,” as determined by the IRS.Unlike single-member LLCs and LLCs taxed as partnerships, losses can only offset income at the corporate level and can’t be used to offset personal income taxes.Similarly, the entity’s capital gains are taxed at the corporate rate, not the more favorable individual rates.Moreover, there are ownership and income threshold tests, under which an LLC taxed as a C-Corp can be considered a “personal holding company”, which causes the imposition of an additional tax burden on the LLC if it doesn’t distribute passive income earnings to its shareholders.Speaking generally, it is often the case that an individual member is likely to have a smaller tax burden with an S-Corp than with an LLC taxed as a C-Corp.[4]

Full corporate formalities must be observed, including board and shareholder meetings, and record-keeping requirements.

There is little reason for an LLC to elect C-Corp taxation rather than going whole-hog and setting up shop as a C-Corp in the first place although, as always, an attorney and/or an accountant should be consulted.

Summary.

LLCs are flexible entities that can serve a variety of purposes, including protection from personal liability, regulating the business affairs of the company, raising capital and reducing taxes, and choosing the right form of LLC is an important step in achieving the goals of the company’s owners.LLCs, as hybrid creatures of state law, can embody the best attributes of other forms of organization, such as sole proprietorships, partnerships, limited partnerships and/or corporations, but with caveats and limitations that may trip up the unwary.Of course, consult an attorney before deciding whether and which kind of LLC might be right for your business.It is not a decision to be taken lightly, but if done correctly, substantial liability protections and advantageous tax treatment can be achieved.

[1] Note that the state LLC laws do not necessarily run parallel the state’s business corporation law, and thus one must be aware of the differences, particularly with the LLC/corporation hybrids discussed below.

[2] Form documents from companies that provide formation services or are downloaded from government websites usually ignore most of these topics and, accordingly, are useless.

[3] It is a common misconception is that one can both be a member of a multi-member LLC and be paid a salary as an employee.  However, owners of LLC interests cannot simultaneously be employees of themselves; they can, however, receive fees for services as directors or officers of the company.  The question of whether self-employment tax applies is more complicated, with the IRS taking the position that any member who participates in the management of the LLC or provides meaningful services to the LLC is liable for self-employment tax; it is unclear whether the IRS takes this position with regard to distributions to non-voting or “profits-interest” members.

[4] Your mileage may vary.