Whether you’re just starting or you have an existing company, you may be considering forming an LLC. Here’s what you need to consider before you do: 1. Corporate Gymnastics LLCs are a flexible form of business entity with fewer mandatory rules than apply to LLCs than to corporations or partnerships. However, this flexibility means that all of the details governing each LLC must be spelled out in long, complicated Operating Agreements. 2. Limited Liability Like corporations and (some) partnerships, LLCs offer their members limited liability. Each member of an LLC may lose his or her investment in the company, but the member’s other property should not be subject to the LLC’s liabilities. Of course, creditors know this too, so members are often required to personally guarantee loans and other obligations of the LLC. 3. The Rule Book An LLC and its members are governed by the Operating Agreement. The Operating Agreement should cover such topics as management of the LLC, capital contributions from the members, distributions of net profits, and ultimate liquidation of the company. 4. Upper Management An LLC can either be managed by its members or managed by one or more managers who might or might not be members. Even where an LLC is manager-managed, there are usually some decisions that must be made by the members (such as a sale of the LLC). LLCs do not usually have traditional corporate officers (like president, treasurer), but they can. 5. Ante Up The investments members make in the LLC are called capital contributions. Capital contributions can be cash or anything of value. A key term of the Operating Agreement is whether existing members can be required to make additional capital contributions. 6. Pride of Ownership Unlike corporations, in which ownership is evidenced by stock, ownership in LLCs may be denominated and evidenced in many different ways. A member might simply own a percentage interest recorded only on the LLC’s books, or a member might own membership units or shares that are represented by certificates. 7. Returns on Investment Net profits of the LLC are generally paid to some or all of the members in the form of distributions. When and how distributions are made should be addressed in the Operating Agreement. Members can divvy up the profits in almost any way imaginable. 8. Pick Your Poison By default, LLCs (those with more than one member) are treated like partnerships for income tax purposes, but they can instead elect to be treated like corporations (even S corporations). LLCs with only one owner are completely ignored for income tax purposes, meaning that they are lumped together with their owners. 9. Taxing Calculations The taxation of partnerships, and therefore most LLCs, is very complicated. The LLCs do not pay taxes themselves (in most cases), but they do have to file tax returns. Net income passes through to the LLC’s members in the form of allocations to member capital accounts, which must comply with very detailed tax rules. Bottom line: have a good CPA. 9. Charge! When a corporate shareholder is sued, it’s possible that a judgment creditor could end up controlling the shareholder’s stock, including the right to vote. In an LLC, the judgment creditor of a member is only entitled to a charging order, which is the right to receive distributions when and if paid. The judgment creditor of an LLC member cannot participate in the management of the LLC.
Though you can be in business without setting up a legal entity, we don’t recommend it. The following points will help you decide on the best entity for your operation. 1. Human Error Carrying on business without a business entity means that each of the owners is 100% personally responsible for all of the business’s liabilities. That isn’t good. A business entity [corporation, limited liability company (LLC), or limited liability partnership (LLP)] protects the owners from personal liabilities, except professional liabilities and personal wrongdoing. 2. Pass the Buck The tax code divides corporations into C corporations and S corporations. The main difference is that with C corporations, the corporation pays income tax on its net income and the shareholders also pay income tax on dividends. With S corporations, such as LLCs and LLPs, only the shareholders pay income tax on the corporation’s net income. 3. Exclusive Owners’ Club S corporations have strict rules about who can be shareholders: no C corporations, LLCs, or LLPs; no trusts (with a few exceptions); no non-US residents. S corporations may have a maximum of 100 shareholders. Even if you’re not planning to have these types of owners, the S corporation owner restrictions can limit (or make more costly) future opportunities to sell stock to new investors or take advantage of common estate planning techniques. 4. Charge! It is possible for creditors of a corporation’s shareholder to take the corporate stock in satisfaction of their debts. Generally, the same is not possible for interests in LLCs or LLPs. Creditors of an LLC member or LLP partner are limited to a charging order, which means that creditors can receive distributions from the LLC or LLP, but they do not get control. 5. Head of the Class For C corporations, LLCs, and LLPs, it is possible to create different classes of stock or interest that entitle the owners to different rights. For instance, classes can differ on distributions, participation in management, and liquidation rights. S corporations cannot have different classes of stock, other than voting and non-voting stock. 6. All Good Things Every partner in a partnership (whether LLP or general partnership) has the right to withdraw from the partnership at any time. It may be a breach of the partnership agreement, but a partner’s withdrawal might still result in the dissolution of the partnership. Corporation shareholders and LLCs members do not have the right to withdraw unless this right is provided in an owners’ agreement. 7. Gainful Employment Profit distributions from an S corporation are not subject to employment taxes, provided owners who work in the business are also paid a reasonable (taxable) wage. Profit distributions to the working owners of an LLC or an LLP are subject to employment taxes, whether or not the owners also receive wages. 8. Healthy, Wealthy and Wise Payments for health insurance and other fringe benefits are generally deductible by a C corporation, regardless of the recipients. Health insurance and fringe benefits provided to the owners of an S corporation, LLC, or LLP are not deductible generally. 9. Keep it Simple A separate income tax return must be filed for each separate business (except a sole proprietorship or 100% subsidiary), even though S corporations, LLCs, and LLPs generally do not pay taxes themselves. The corporate income tax returns are relatively simpler than the LLC and LLP income tax returns because LLCs and LLPs are governed by complicated rules about the allocation of profits and losses. 10. Changing Course If circumstances require a change in the choice of entity, it’s almost always possible, at a price. The laws in most states now have simple filing procedures for converting from one type of entity to another. That’s the easy part. But conversion might trigger taxes, especially when converting from a corporation to another entity. No matter what business entity you choose, it’s a good idea to consult with an attorney. You can contact us online or by calling 407-660-2964.