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To Form An Llc, Or Not To Form An Llc; That Is The Question

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  • Posted on: Feb 15 2017

New business owners have many decisions to make when they start a business. Many of these decisions will impact the business for years to come. Among them is the correct type of business to form.

One of the most common business forms used by entrepreneurs is the Limited Liability Company (“LLC”). While LLCs share many of the same attributes as an S-Corporation or C-Corporation, they are more flexible and require less formalities and paperwork.

An S-Corporation (formerly known as a “Sub section S corporation,” and commonly called an “S-Corp.”) is a corporation that elects to pass corporate income, losses, deductions, and credits through to its shareholders for federal tax purposes. Shareholders of an S-Corp. report the flow-through of income and losses on their personal tax returns and are assessed a tax at their individual income tax rates. This allows an S-Corp. to avoid double taxation on the corporate income. An S-Corp. is responsible for the tax on certain built-in gains and passive income at the entity level.

The S-Corp. must be a domestic corporation, and must have fewer than 100 shareholders and only one class of stock. Individuals, specific trusts and estates may be shareholders, but partnerships, corporations and non-resident aliens may not be. Additionally, specific financial institutions, insurance companies and domestic international sales companies may not file as S-corporations.

A C-Corporation (sometimes called a “C-Corp.”) is a standard corporation that conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders. A C-Corp. is a separate taxpaying entity. Thus, the profits of the corporation are taxed to the corporation when earned, and then are taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any of the corporation’s losses.

The legal existence of a C-Corp. is separate and distinct from its owners (i.e., the shareholders). This means that when the corporation is sued, shareholders are only liable to the extent of their investments in the corporation. Their personal assets are not at risk, as they would be if the business was a partnership or sole proprietorship. Any debts acquired by the corporation are considered to be the corporation’s responsibility.

An LLC is a hybrid type of legal structure that provides the limited liability features of a standard corporation and the tax efficiencies and operational flexibility of a sole proprietorship or  partnership. The “owners” of an LLC are referred to as “members.” An LLC can consist of a single individual, two or more individuals, corporations or other LLCs.

Forming an LLC

Each state has its own requirements for the formation of an LLC. While there are differences, they all share some common principles:

Name the Business. When choosing a name, new business owners should follow three general rules: (1) they cannot duplicate the name of an existing LLC in the state of incorporation; (2) they must indicate that the business is an LLC (e.g., “LLC” or “Limited Liability Company”); and (3) they must not use words restricted by the state of incorporation (e.g., “bank” and “insurance”).

File the Articles of Organization. The “articles of organization” is a document that includes information about the business, such as the name, address, and the names of its members, and how the LLC will be treated for tax purposes. In most states, the articles of organization are filed with the Secretary of State. However, in other states, the articles are filed with a different office.

Create an Operating Agreement. Although most states do not require an operating agreement, many lawyers strongly recommend one, especially for multi-member LLCs, because it identifies the LLC’s finances and organization, and provides the rules and regulations for the company’s operation. The operating agreement typically includes, among other things, member interests, the allocation of profits and losses, and member rights and responsibilities.

Obtain Licenses and Permits. Once the business owner registers the business, he/she must obtain all required licenses and permits.

Publish the Formation of the Business. Some states, such as Arizona and New York, require the business owner to publish a statement in a local newspaper about the LLC’s formation. These states have maintained this requirement, notwithstanding the availability of the information on the internet (e.g., the Secretary of State’s website), to put the public on notice that an entity has been formed to do business within a corporate structure that shields its owners from personal liability for the debts, obligations and liabilities of the business.

Advantages

Tax Benefits:

The IRS does not consider an LLC to be a separate entity for tax purposes. This means that the business itself is not taxed. Instead, the LLC’s members will be taxed for the company’s profits and losses – that is the LLC receives “pass through” treatment allowing allocated profits to be taxed only once on each member’s individual income tax return (as opposed to the double tax incurred in a C-Corp.). Although the federal government does not tax the income of the entity directly, some states do.  Therefore, it is important for members to check with their accountants or their state’s income tax agency.

There is also a possibility that an LLC’s member can request that the company be taxed as an S-Corp. There are advantages and disadvantages with making such an election, which are best explored with an attorney and/or an accountant. If this course is taken, the LLC remains a limited liability company from a legal standpoint, but for tax purposes it can be treated as an S-Corp.

Limited Liability:

An LLC is considered a legal entity separate from its individual members.  Like a standard corporation, an LLC provides its members protection from liability. This means that members are not personally liable for the LLC’s debts and judgments, unless there is no functional/operational difference between the LLC and its member(s). (This Blog discussed the consequences of this course of conduct here). Consequently, vendors and creditors are foreclosed from pursuing the personal assets (such as a home or an individual bank account) of the LLC’s members. Individuals who form a traditional partnership or a sole proprietorship do not enjoy this protection.

More Flexibility and Time to Devote to the Business:

One of the benefits of creating an LLC is the time new business owners can devote to growing their business. Forming and maintaining an LLC requires less paperwork and compliance with corporate formalities than other entities.  Once registered, an LLC is not required to conform to many of the formalities of a standard corporation (e.g., hold an organizational meeting to elect corporate officers and draft and enact bylaws that detail the company’s internal management; hold regular meetings of the board of the board of directors; and convene an annual shareholders meeting), though compliance with some of the formalities will reduce the risk of creditors piercing the corporate veil (such as by drafting an operating agreement).

Members of an LLC retain the flexibility to determine how to allocate profits under the terms of their operating agreement (members are not permitted to pay themselves a wage).  They are not limited to their percentage ownership or capital contribution.  However, whatever the agreed-upon allocation, profits may not be distributed when it endangers the LLC’s solvency or when the LLC’s liabilities are equal to or exceed its assets. Additionally, the LLC may not make a special allocation that is predicated on obtaining a tax advantage for the LLC’s members; a special allocation must be based on ownership interests and reflect a legitimate economic circumstance.

Silent Investors:

Like a limited partnership, members of an LLC do not have to be managers; they can be investors only, having little or no input into the company’s day-to-day operations. Under this circumstance, however, the operating agreement must provide for such investors.

No Ownership Restrictions:

Unlike an S-Corp., an LLC has no restriction on the domicile or number of members that can own the company.

Disadvantages

Limited Duration:

In many states, when a member leaves an LLC, unless the operating agreement provides otherwise, the business is dissolved and the remaining members must wind down the business, decide if they want to start a new business, or part ways.

Self-Employment and Other Taxes:

LLC members are considered self-employed and, therefore, must pay Medicare and Social Security taxes. Many states, such as California, New York, and Texas require LLCs to pay a franchise tax or “capital values tax.” Moreover, members can be personally liable for payroll taxes that are not paid by the company.

Undefined Management Roles:

Unless there is an operating agreement that identifies the roles and responsibilities of the members, LLCs do not have specific managerial roles, unlike a standard corporation, which has a hierarchal management structure (e.g., officers, directors, managers and employees). The absence of a management structure can make it difficult for the company and creditors to know who has the authority to bind the company (e.g., who can enter transactions, sign checks, encumber the company, etc.).  It can also make it difficult to attract new investor money.

Takeaway:

Until recently, the standard corporation provided the only protection to new business owners from the risks of unlimited personal liability. With an LLC, new business owners could obtain the limited liability features of a corporation and the operational flexibility and tax efficiencies of a sole proprietorship or partnership. For these reasons, among others, millions of new business owners have registered their companies as LLCs each year.

Notwithstanding, it is important for new business owners to understand how LLCs are taxed and operate in comparison to other corporate or business forms. By doing so, entrepreneurs can choose the business structure that is right for them at startup and in the future. It is important, therefore, that new business owners consult with an attorney to discuss the various formation options available to them at the early stage of their business.

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