III. Non-Tax Benefits of Forming an LLC.

There a number of non-tax benefits that stem from formation of an LLC. Chief among these non-tax benefits are the following:

• . LLC members are shielded from personal liability. This is an advantage enjoyed by corporate shareholders and limited partners in a limited partnership. However, unlike in a limited partnership, where one general partner has to be designated to be personally liable for partnership debts and obligations, no such restriction exists in an LLC.
• . LLCs may be managed and directed in their day-to-day operations by their members or owners. This provides great governance and control flexibility and eliminates the need for a board of directors. Management may be concentrated or decentralized.
• . LLCs are not as formal as corporations. For example, LLCs are allowed to dispense with annual meetings which are often required for corporations.
• . LLCs may have an unlimited number of members. For example, S corporations may have no more than seventy-five shareholders. Further, an S corporation may not have any foreign shareholders or investors. Additionally, shareholders in S corporations may only be individuals or certain types of trusts. LLC members may be individuals, trusts, corporations, or partnerships.
• . LLCs may issue multiple classes and series of stock and equity. S corporations are limited to the issuance of a single class or series of stock.
• . In a number of states one person may form an LLC. This is much like a sole proprietorship, but with limited liability. A partnership requires two or more individuals.
• . Employee benefits programs otherwise unavailable to a sole proprietor or partnership may be available to the LLC to attract and retain the services of key employees.

IV. Tax Treatment.

State law plays a large role in determining how an LLC will be taxed. In the 1990s, the Internal Revenue Service (IRS) adopted so-called check-the-box regulations that govern the tax treatment of LLCs. If state law does not require classification and treatment like a corporation, an LLC with two or more members may elect to be treated as either a corporation or a partnership. Where corporate status is chosen, the LLC prepares a separate entity tax return and is taxed like a corporation. If partnership status is chosen, the LLC is treated like a pass-through entity and taxes are reported on the individual owners tax returns. In states that allow single member LLCs, the LLC may be treated as a corporation or a pass-through entity and taxed like a sole proprietorship. As a default rule, if the LLC does not elect how it wants to be taxed (as a corporation or partnership) IRS regulations mandate tax treatment as a partnership.

The ability to elect partnership taxation is a great benefit to LLCs. Corporations are subject to double taxation. The corporation pays separate entity taxes. Shareholders pay individual taxes on dividends and distributions. However, when taxed as a partnership, with pass-through treatment, the LLC avoids the double taxation problem corporations present.

V. Tax Benefits Associated with LLCs.

A number of tax benefits are associated with the formation and operation of an LLC. Chief among these tax benefits are the following:

• . LLCs may allocate profits and losses on a basis other than ownership percentages.
• . According to § 754 of the Internal Revenue Code (IRC) an LLC may make an election to adjust the tax basis of assets after a change in ownership. Further, § 754 allows for the use of debt to increase the basis in determining an owners share of ownership.
• . Where restrictions are placed on LLC membership alienability, marketability discounts may be available to offset the basis of member ownership. Marketability discounts are based on the availability, or lack thereof, of a market in which to liquidate the assets and interests of the LLC.
• . Key person discounts may be available for estate planning purposes in order to account for the lack of performance of services of a key member of the LLC who has been rendered disabled, incapacitated, or dead.
• . Minority discounts may be available for LLCs where the minority-interest holding members, if any exist, lack the ability to manage the LLC.

VI. Family and Estate Planning Guidance: Using LLCs to Benefit the Small Business Owner.

Due to their flexibility and non-tax and tax advantages, LLCs can be useful tools in the hands of wise estate planners to assist in answering business continuity and succession planning issues long before they become problematic and potentially catastrophic. In general, LLCs are useful in diminishing family dramas and rivalries if care is taken in their formation and structuring. The LLCs Articles of Organization or Bylaws hold the key in merging family and estate planning into business planning. The Articles of Organization should and must definitively speak to the issues of disability, incapacity, resignation, retirement, death, divorce or other domestic disturbance, debt, and creditors and bankruptcy. In terms of planning guidance, the Articles of Organization should outline and provide procedures and protocol to address the following issues as they arise:

• . Resignation or retirement of members or key employees;
• . The distribution of LLC assets upon the settlement of a legal separation, divorce or dissolution;
• . The effect of a foreclosure of debt and the personal bankruptcy of a member;
• . Qualifications to hold LLC offices; and
• . The disability, incapacity, retirement, and death of an LLC member.

Finally, with an LLC in place, the small business owner is wise to consider the stand-alone adoption of a Buy-Sell agreement. Legally, a Buy-Sell agreement is a contractual agreement that would speak to the sale of LLC membership interests upon the happening of a specified condition or event. In essence, it would bind the LLC interest holder and the LLC itself to repurchase interests in the LLC upon the occurrence of a triggering event. This triggering event could be the disability, incapacity, resignation, retirement, or death of an LLC member. Offers by outsiders or others to purchase assets or interests in the LLC could very well trigger such an agreement. The Buy-Sell agreement would assure that all LLC interests are accounted for and are being used properly. The Buy-Sell agreement provides a further crutch to ensure that the LLC is not crippled further by the disability, incapacity, resignation, retirement, and death of a member or other specified events.

Disability, incapacity, retirement, and death most certainly make business continuity and succession planning difficult or impossible. Families are often faced with the seminal question: Is it worth keeping this business in the family, or should we just let it go? The next question is often the following: If we decide to keep the business going who is going to manage the business? Establishment of an LLC long before these issues arise gives the small business owner time to groom and train replacements within the family. If this effort fails, the LLC may serve as a useful vehicle to look outside the family to attract and retain key leaders to carry on the business and legacy. Employee benefits and opportunities to own equity in the LLC may go a long way towards attracting the leaders to guide the business beyond the capabilities or earthly limitations (i.e., sickness and death) of the founding member(s).

VII. Conclusion.

Some people say that sometimes business and family do not mix. Sometimes this is true. Business and family can mix quite well if thought and planning take place on the business side of the equation. LLCs as outlined above hold special appeal to small business owners concerned about business continuity and succession planning. LLCs offer many non-tax and tax advantages over other forms of business that small business owners and their advisors alike should strongly consider. LLCs are excellent entity choices to address the recurring issues of risk and liability, capital formation and financing, governance and control, and business continuity and succession planning. Finally, the tax benefits and impact of LLC ownership, due to the hybrid nature of an LLC, are tremendous.

6. I understand that if I organize my business as an LLC, I will not be able to provide my employees with options or some other form of equity participation. Is that correct?

No. LLCs and partnerships can offer equity-based compensation plans. Indeed, the flexibility associated with LLCs and partnerships permits tailoring of compensation plans that can reduce or eliminate current income tax at the time of a grant.

7. If I am setting up an LLC, is there any reason to form it under the laws of one state rather than another?

In most instances there is no reason for a business to organize in another state rather than the one in which is operates.

8. Should you ever form a general partnership?

Not in today’s world, no.

The general rule is that all partners in a partnership are liable jointly and severally for all obligations of the partnership.  Limited liability partnerships are a type of general partnership that provides its general partners with limited liability for certain obligations of the partnership.  It has the benefits of a partnership and limitations on liabilities.  For example, partners in LLPs are not liable for the debts caused by the negligence of other partners.

9. I have heard about LLCs and LLPs, but what in the world is an LLLP?

Investment vehicles have traditionally been structured as limited partnerships. A limited partnership must have at least one general partner. Promoters have often minimized liability exposure by using an adequately (but not robustly) capitalized corporation as the general partner. Some states, such as Delaware, now expressly authorize limited partnerships to file a statement of qualification and become “limited liability limited partnerships,” or LLLPs. In these states, even the general partner is shielded from partnership liabilities.

10. If the Secretary of State allows me to reserve a name for a new entity, do I need to worry about any further name searches?

Maybe. Typically, Secretaries of State will reserve a name for anyone who wishes to form a new business entity. By reserving the name prior to organizing the entity, one can be assured that the Secretary of State’s office has checked its database and determined that the name is available for use.

The Secretary of State’s office, however, usually does not determine whether the chosen name may infringe upon federally registered or common law trademarks. If a new business anticipates building a broad identity around its entity name (think, for example, about Ben & Jerry’s Homemade, Inc., or Amazon.com, Inc.), then it should consider performing trademark searches before committing to a name. It may be cheaper to analyze the trademark issues now than to adopt a new corporate identity later.

Naturally, I have heard many more questions all over the map.  The ones we’ve just discussed are the ones I hear the most often.

I.          Introduction.

For small business owners, a number of factors come into play in deciding what type of entity to choose for conducting their business. Entity choice is often one of the key initial decisions a business owner must make. Often, this is a critical decision that must be made before the first goods are manufactured and sold, or the first services are provided to patrons or clients. In order to make the proper entity choice, the business owner must consider a number of non-tax and tax factors. In terms of the non-tax considerations that come to mind, four primary considerations affect the calculus of entity choice: (1) risk and liability issues; (2) capital formation and financing options; (3) governance and control of the entity; and (4) continuity and succession planning.

There are primarily four main choices to pick from in operating a business and choosing an entity: (1) a sole proprietorship; (2) a partnership (whether general or with limited liability); (3) a corporation (whether a subchapter C or S corporation); and (4) a limited liability company. The decision to choose one of these types of entities over another creates a whole host of considerations geared around liability and risk aversion, capital formation, governance and control, and continuity and succession. Especially, for small business owners, these core considerations are highly magnified and take on great significance. As their small businesses succeed and grow, becoming large businesses, business owners and key executives/employees become most worried and concerned about disability and incapacity planning, retirement, and death. Certainly, where business owners and key executives/employees are concerned, disability, incapacity, retirement, and death can ravage and destroy even the best businesses virtually overnight.

II. Limited Liability Companies.

Sole proprietorships, partnerships, and corporations all address the issues of risk and liability, capital formation and financing, governance and control, and continuity and succession in varying ways. Indeed, sole proprietorships and partnerships (particularly general partnerships) generally are not the best choices where business owners run a high risk of being sued as they do not shield their owners from personal liability. Corporations are excellent in high-risk situations where owners seek limited liability. Sole proprietorships and general partnerships are limited in capital formation and financing by their owners creditworthiness. Corporations allow greater options for capital formation through the sale of shares of stock and other equity. Sole proprietorships and general partnerships allow for direct control and management by owners. Corporations are formal and bureaucratic in that officers and agents have to answer to shareholders and boards of directors. Sole proprietorships and general partnerships die and cease to exist when their owners die. Corporations are advantageous in that they have perpetual life and existence.

In the not so distant past, those wishing to start a business essentially had only three options for the form of that business sole proprietorship, general partnership, or corporation. As demonstrated, each of these business types brought with it a number of factors to be weighed and considered when viewing risk and liability, ease of capital formation, internal control and governance, and continuity. There existed very little room for the proverbial happy medium. However, in the 1970s, this changed when Wyoming enacted the first limited liability company (LLC) statute, creating a business form that blended features of sole proprietorships, general partnerships, and corporations. Essentially, LLCs are hybrid entities that limit personal liability, have equity features like corporations that assist in capital formation, provide flexibility in governance and control structure, and exhibit almost unlimited life and duration. Currently, all fifty states and the District of Columbia have LLC statutes in place. LLCs are formed quite easily through filings of forms with the appropriate state official, usually the Secretary of State.

1.  I understand the difference between an S and a regular C corporation, but what is a close corporation and how is it different?

There is a distinction between the classifying a business entity for state law purposes (which deals with issues like limited liability and requirements for running and maintaining the business) and the company’s federal tax classification.  Virtually all states permit the formation of “close corporations.” A close corporation has a limited number of shareholders typically no more than thirty-five, can operate without a board of directors, does not need to adopt bylaws, and generally operated with less formality than a “regular” corporation—without loosing any of the liability protection offered by “regular corporations.”  If you ran a entity without a board of directors, bylaws or failed to follow any of the required “corporate formalities,” you may be subject to personal liability.  By statue, statutory close corporations are exempted from taking such factors into account if the question of piercing the corporate veil ever arises.

For tax purposes, a close corporation’s status is an independent question.  A close corporation will be treated as a C corporation unless it qualifies for treatment as an S corporation and timely elects the “pass-through” treatment available under Subchapter S of the Internal Revenue Code (“IRC”).

2. With the drop in individual income tax rates does it make sense to organize my business as a regular C corporation?

When the top marginal rate for individuals was 39.6% and the top marginal rate for corporations was 35%, it was frequently advantageous to organize a business as a C corporation as long as the entity did not hold assets expected to appreciate in value and the business plan called for retaining earnings for capital investment. When the top tax bracket was reduced to 35% in 2006 many of the reasons were lost.  There are, however, still some attributes of a C corporation that are attractive, such as the availability of tax-advantaged fringe benefits for owners of the business and the potential 50% capital gains exclusion. The reduction in individual tax rates, however, makes entities that offer pass-through taxation more attractive than ever.

3. Why do the venture capital providers prefer funding C corporations?

I hear this one a lot.  For start-up businesses generating losses, a flow-through entity such as an LLC generally provides tax benefits that make it preferable to a C corporation.  A profitable C corporation may distribute after-tax earnings to shareholders in the form of dividends. In computing their tax liability, however, shareholders must generally include C corporation distributions in income, and cannot use C corporation losses as deductions.  Since LLCs can have multiple classes of equity interests and it is possible to fashion an LLC membership interest comparable to convertible preferred stock, one might think that the LLC form would be attractive to investors.

Nonetheless, venture capital providers generally make conversion to a C corporation a condition for providing funding. One reason is the non-recognition treatment available to C corporations for mergers and other kinds of reorganizations under IRC § 368.  This non-recognition treatment is not available to LLCs–or to corporations that have converted to C corporations in anticipation of a re-organization. Second, only C corporations can take advantage of the 50% capital gains exclusion under IRC § 1202. Venture capital providers seem willing to sacrifice short term tax benefits in hopes of maximizing the after-tax return to investors when a liquidity event occurs.

The preference for C corporations also appears to be driven by non-tax reasons. Investors, familiar with the structure of corporations, find it easier to get deals closed and manage their investments if all their portfolio companies are organized as corporations.

4. I sometimes get told that it is too expensive to form an LLC as a vehicle to operate hier sole proprietorship. Are they right?

No way! If an LLC is taxed as a partnership under the Internal Revenue Code, then the LLC does not pay any federal income taxes. The LLC, however, would generally be subject to a nominal fee to the state of filing.  If the LLC is a single member LLC, it is a disregarded entity for federal income tax purposes; it is not taxed as a partnership but as a sole proprietor is.

If an individual forms an LLC as a vehicle to operate what would otherwise be a sole proprietor-ship, the activities of the LLC are reported on Schedule C to the individual’s IRS Form 1040. There is no need to prepare and file a separate federal or state tax return for the LLC, or obtain a separate employer identification number.  The benefits of operating through a limited liability entity far outweigh the small formation costs.

5. What is the deal with self-employment tax and LLCs?

This one is murky. Once a determination has been made that a pass-through entity is an appropriate choice advisors have steered clients away from LLCs to S corporations in order to minimize federal payroll taxes.  A shareholder of an S corporation can be an employee of the S corporation, so the shareholder may report some of their share of business income as a shareholder distribution and some as compensation for services as an employee. Only that portion deemed to be compensation is subject to FICA (the contributions for old age, survivors and disability insurance, and hospitalization insurance) and unemployment taxes.

In an LLC taxed as a partnership, a member is considered self-employed rather than employed by the LLC. A member who performs services for the LLC is subject to SECA (the self-employment counterpart of FICA) on “net earnings from self-employment,” which includes (with certain exclusions) the member’s distributive shares of income or loss from any trade or business carried on by the LLC.  Thus, there is no question that a shareholder of an S corporation can shelter some income from employment taxes by taking some of the business income as a shareholder distribution rather than compensation for employment. In contrast, except as noted below, a member’s share of LLC profits will be subject to self employment taxes regardless of whether the member considers herself an “employee” of the LLC.

The next form is a “limited liability company.  An LLC is an entity separate from its owners, so ownership can involve one, two or more owners. As a separate entity, the LLC (not its owners) is responsible for the liabilities of the business.  If the business fails you may lose your investment, but your assets are not at risk. Corporations are the oldest form of business entity and as a result, people are generally at ease with a corporation.

Corporations provide the strongest protection against personal liability but may or may not have the same tax advantages of an LLC.   An “S-Corp.” is made for small business and can’t have more than 100 shareholders; however, it does feature pass-through tax treatment like an LLC.   A “C” corporation has a big disadvantage for start-ups; that is, that the income or loss of a C corporation only taxable to the corporation and does not pass through to shareholders.  Shareholders cannot use start-up or other losses to against income received by sources other than the corporation.  Neither an LLC nor a corporation is the best choice for all businesses.

The form of entity that is appropriate for your business will depend upon your situation.   One would be well advised to seek counsel before starting up a company because the tax and legal ramifications of the choice are significant.

With an LLC you do have several options–First you can divide up the LLC pie (so to speak) into Units–which are the equivalent of shares of stock in a corporation. For instance, Martha Stewards company issued LLC units when it went public . . . well you could have your LLC issue any number of units (say 1,000) and divide them up and for what ever price/consideration you wish as long as it is reasonable. There is also the more traditional way of looking at LLC ownership which is based on a partnership model of allocating percentages to each individual. If you are going to be using the LLC as a vehicle to raise money from third parties, the partnership/percentage method can become a real pain and you are better off simply issuing units. Contact me if you have any additional questions or concerns on these types of matters.