When you’re setting up or changing the structure of your business, there is a lot to think about. There are many forms of business structure to chose from, such as:
- Sole Proprietorships & General Partnerships
- Limited Liability Companies (LLCs)
- S-Corporations
- LLC with S-Corp Tax Election
- C-Corporations
In Part I we looked at sole proprietorships and general partnerships. Now, let’s consider limited liability companies.
Limited Liability Companies
At Lion Legal, we are big believers in giving people the same advice that we use ourselves, and we are fans of the limited liability business concept. Limited Liability Companies are relatively new forms of business structure that combine the best of both worlds of corporations and partnerships.
According to the IRS, an LLC is “designed to provide the limited liability feature of a corporation and the tax efficiencies and operational flexibility of a partnership.” This combination allows members to participate in the management and operation of the business, with the asset-shielding features of corporations.
LLC Ownership
An LLC may have an unlimited number of members, and also allow for special allocation of the profits of the business pro-rata to the members’ ownership. In other words, the larger your ownership share, the larger your share of profits.
Membership in an LLC is not limited to individuals; corporations can be members as well. The contribution of a member can be a capital investment, the donation of vehicles, tools, materials, real estate or other assets to the LLC. A member may also loan funds to the LLC, and have the loan repaid with interest, ownership shares or a guaranteed payment (subject to the assets of the LLC). Sweat equity is also a valuable contribution.
Allocation of Ownership and Profits
It’s up to members to decide how to allocate shares among themselves, considering the contributions of each member.
There are very few restrictions on how profits are shared among members. Typically, the profits might be shared in proportion to the percentage of ownership of each member.
Protection Against The Liabilities
Members enjoy limited liability as well, which means that members are not personally responsible for the debts and liabilities of the company. If everything goes wrong, a member may lose what they invested in the business, but no more. There are some exceptions* but this is one of the biggest benefits of an LLC.
(*The limitation does not necessarily apply to employee tort actions, including accidents.)
Compare that to a sole proprietorships or general partnership. The sole proprietor is liable for everything, and partners are liable for business debts even if they were incurred by another partner without approval.
Taxes
By default, an LLC is a “pass-through” entity for tax purposes. In other words, the profits or losses of the business pass through directly to each member/owner’s personal tax return, just as they would in a sole proprietorship or a partnership. Since the member’s share of profits is reported as income on that member’s Form 1040, it is subject to self-employment tax.
The IRS allows an LLC to choose to be taxed as an S-corporation, providing the same corporate tax benefits for an LLC. However, each member’s pro rata share of profits is taxable income, whether or not it is distributed to that member in that taxable year. LLC taxation is also allowed as a sole proprietorship, partnership, or C-corporation too. The pass-through taxation is not double taxation like a corporation, but could deter investors in an LLC-structured start-up business.
LLCs are effective estate planning tools for business partners, if designed correctly, avoiding probate when members die.
Less Paperwork and Organizational Overhead
An LLC is governed by its operating agreement, and is not saddled with detailed corporate requirements to maintain its status as a limited liability company. LLCs are considered corporations, and are required to file Articles of Incorporation with the Secretary of State’s office, but are allowed extreme flexibility by members to tailor the day-to-day structure through an Operating Agreement. LLCs also enjoy no annual meeting requirement, and are not forced to establish and maintain a Board of Directors. The paperwork and recordkeeping is much reduced when operating as an LLC.
If the LLC has more than one member, the operating agreement is critical. It needs to address day to day operations, how money and capital goes in and how money and capital comes out, who handles the books, the taxation style, and what happens when a member dies. It should also address the eventual dissolution of the LLC.
Start-up Costs
Some states, including Arkansas, charge an additional franchise tax. This is a minimal cost of $150 annually. The lack of clear corporate structure requires a detailed operating agreement, which can also increase start-up costs, including attorney’s fees. Overall, the start-up costs for an LLC versus any other business entity (save for sole proprietorships) is much less.
Are you a “do it yourself-er”? It is totally possible to create your own LLC directly through the Secretary of State and handle your own taxes, particularly if you are a single member LLC. The benefit of involving legal and tax counsel on the front end is to answer your questions, make sure you understand the process, and to draft your operating agreement to address all possible scenarios with your co-members.
Talk To Your Lawyer & Accountant
Consult with your lawyer and your accountant. They have worked with many business owners and have a good idea of what can happen, and how to forestall the worst consequences. An ounce of prevention is worth a pound of cure, as the saying goes, and it couldn’t be more true than in this context.
In addition to formation, dissolution, and the daily operations of the business, the tax implications need to be carefully considered. Self-employment tax is high, and if you are making or think you might make more than a specific annual cut-off, you will be responsible for estimated quarterly taxes, unemployment tax, and excise tax.
Do I Need An LLC? – Part I
Do I Need An LLC? – Part III
We Can Help
Our attorneys are experts, and are here for you with straight talk, predictable cost, and superior services. We promise to tell you what the most likely outcome is up front, and to be open and transparent in our communications with you until your case is resolved.
Our approach to practicing law is revolutionizing the way law firms deliver legal services. Case evaluations are completely free. Call Lion Legal today at (501) 227-7627 or Email Us to set up a free consultation.