A perfect match for small businesses looking for flexibility and limited liability

Are you planning to start a business sometime soon? Maybe you’re a current business owner who started an enterprise sometime in the last 20 years?

If you’re a current or soon-to-be small business owner in the United States, chances are you’ve heard about or considered becoming a Limited Liability Company (LLC).

Before LLCs, C corporations used to be your only option if you wanted limited liability for your business. The C corporation structure, however, was not a good fit for all small businesses because it subjected the business owner(s) to two layers of federal tax – one at the corporate level and a second at the individual level.

S corporations were eventually created to provide relief from double taxation, preserving the C corporation benefit of limited liability while adding the feature of passthrough taxation. There were still limitations, however, as discussed later in this article.

There was still a need for a business entity that features the limited liability protections of a corporation with taxation principles of partnerships. At the prodding of Denver-based Hamilton Brothers Oil Company, the Wyoming legislature passed the first LLC Act in the U.S. in March 1977. It wasn’t until September 2, 1988, however, that the IRS finally gave the ok to tax LLCs under partnership taxation rules.

After the IRS’s 1988 ruling, other states began to introduce their own LLC provisions.

This article, the third in our series exploring different types of business entities, examines the benefits, as well as the drawbacks, to organizing your business as an LLC. The first two articles explored C corporations and S corporations.

Offers limited liability, no ownership restrictions

As its name implies, an LLC offers limited liability to all its members. Similar to an S corporation, the owners (members) of an LLC are not personally liable for the company’s debts or liabilities. LLCs also have no ownership restrictions like an S corporation. Anyone can become a member of an LLC, including corporations, foreign individuals and other LLCs.

By contrast, S corporation ownership is limited to U.S. citizens who are natural persons. Corporations, partnerships and non-resident aliens are not permitted to be an S corporation shareholder.

LLCs can have one or more members

While the terms LLC and partnerships are sometimes used interchangeably, LLCs can exist with only one member. The IRS considers an LLC with one member to be a “disregarded entity.” This means that the IRS “disregards” the LLC entity and treats the business like a sole proprietorship for tax purposes. LLCs with one member are also referred to as “single-member LLCs” or SMLLCs.

Where does an LLC come from?

Similar to corporations, which are formed by filing Articles of Incorporation with the state in which the business will be located, LLCs are also formed by filing Articles of Organization at the state level. To file the Articles of Organization, you’ll need the LLC’s name, name and mailing address of the registered agent and possibly other identification information. Here are some of the other common requirements for forming an LLC:

  • Identify Registered Agent – A “registered agent” is an individual that your business designates to receive official papers for your organization, such as tax and lawsuit notices. LLCs are required to have a registered agent in each state it is registered in to conduct business.
  • Choose type of management – Most LLCs are managed by its members. In this arrangement, all members take part in the decision-making process of the business. Each member is an agent of the LLC and has a vote in all business decisions. In a manager-managed LLC, the members turn over control of the business to a manager, which becomes the agent of the company. A member-managed structure is the default status in most states. If the LLC wants to be managed by a 3rd-party manager, it must be designated as such in the operating agreement.
  • Operating agreement (see more below) – The operating agreement is an internal document that spells out how the LLC will operate and be run. While most states do not require an LLC to have an operating agreement for registration purposes, it is often a good idea to have one. In the absence of an operating agreement, state law will govern how the LLC operates.
  • Employee Identification Number (EIN) – If the LLC has more than one member, it must get an EIN number from the IRS.
  • Out-of-State Registration – LLCs are required to register in each state where it conducts business, including appointing a registered agent for each state.

State of formation vs. state of operations

There are two types of LLCs: “Domestic” and “Foreign.” A domestic LLC only conducts business in the state where it is formed. A foreign LLC conducts business in a state other than where the business was formed and initially registered. A U.S.-based LLC, for example, would be registered as a domestic LLC in one state and registered as a foreign LLC in all 49 other states that they might operate in.

Because of the additional administrative and compliance work required to register and operate a business as a foreign LLC, smaller businesses should consider registering in the state where you expect to conduct most or all of your business. As you obtain customers in additional states, you can then register your business as a foreign LLC in additional states.

Operating agreement governs the operations of the business, enforced by the members/managers

Does your LLC legally need an operating agreement? No, it does not. But every tax and legal advisor will probably tell you that you should.

An operating agreement is the primary governing document of the LLC and is very similar to a partnership agreement. It spells out the company’s interests, activities, management and provisions governing the rights and obligations of its members.

Here are some of the more common sections of an operating agreement to be aware of:

  • Equity Structure – This section details ownership percentages of each member. Initial capital contributions, which can be either cash or non-cash contributions, are detailed. Other rules governing future contributions and distributions would also be included in this section, along with whether members are allowed to carry a negative capital balance.
  • Profit and Loss Allocations – Default allocations according to state law are made proportionately according to capital accounts. Non-proportionate allocations may be made if included in the operating agreement. For example, a member who has a 25% interest in the LLC can be allocated 50% of the LLC’s profits or losses in a particular year if this is disclosed in the operating agreement.
  • Management – Do the members of the LLC manage the day-to-day operations of the business, or will a non-member manager be appointed? How are non-member managers appointed and what authorities are they granted?
  • Voting – The default rule for LLCs is one vote per member, regardless of ownership percentage. If an LLC wants to have voting based on ownership percentages, this option must be identified in the operating agreement.
  • Different Membership Interests – Various membership interests can be formed. Examples include non-voting interests, preferred interested and profits-only interests.
  • Anti-Dilution Protections – Every time a new member is admitted to an LLC, the ownership percentages of the existing partners decrease. Anti-dilution provisions prevent ownership percentages of existing members from decreasing by permitting one or more existing member(s) to keep his original ownership interest percentage whenever the LLC votes to add new members.
  • Restrictions on Transfers – Can membership interests be assigned to individuals outside the LLC? Do membership transfers require unanimous approval from all members or only a certain percentage of members? Does the LLC have the “right of first refusal” when a member wants to sell his interest? Is there a buyout clause that describes the steps of how a buyout will take place?
  • Liquidation and Dissolution – When members are ready to dissolve the business, this section details how an LLC’s assets will be liquidated. A typical liquidation begins with paying off the LLC’s liabilities, followed by distributions to members according to their capital accounts. Lastly, any remaining assets are distributed to members according to their percentage interests.

These are just several of many different provisions that can be included in an operating agreement. Having a team of advisors who are experts in LLCs, including CPAs and attorneys, is critical to not omitting important sections of the agreement.

Must file annual report each year to remain in good standing

Many states require LLCs to file an annual report to remain in good standing. These reports usually require the business to provide the state with identification information, such as the names and addresses of directors along with the LLCs registered agent’s name and mailing address.

Some of these annual reports, such as Texas’s franchise tax report, only require an annual filing and no corresponding fee unless tax is owed. Other annual reports, such as California’s franchise tax report, requires an annual minimum fee of $800 regardless of whether or not the LLC reported a profit.

Taxation of LLCs

Similar to S corporations, LLCs (and partnerships) are considered “passthrough” entities where a business’s income and expenses flow through to the partners and are reported on the partners’ personal income tax returns.

The most significant tax difference between LLCs and S corporations is the treatment of self-employment taxes. In an LLC, each member’s share of profit is subject to self-employment tax. In an S corporation, each shareholder’s share of profit is NOT subject to self-employment tax. The IRS does, however, require S corporations to pay shareholders who contribute substantial services a “reasonable” salary. This salary is subject to payroll taxes.

Here are several other significant areas of LLC taxation:

State Taxation – Partners need to be aware that some states require LLCs to withhold taxes on behalf of the partners. This withholding is oftentimes mandated using the state’s highest marginal rate.

Partnership Audit Rules – Legislation in 2015 instituted new procedures for federal audits of partnerships. Audits will now be conducted, and any additional taxes will be levied, at the partnership level. Partnerships and LLCs have the option to elect out of these new audit rules. Under the old rules, the IRS would be forced to collect any additional taxes levied from the partnership’s partners, not the partnership itself. This election to opt out of the new audit rules must be made annually.

Special Allocations – Another tax-related advantage that partnerships have over S corporations is being able to implement special allocations. As an example, let’s consider an LLC which has four members, each of whom owns 25% of the LLC. The LLC isn’t required to allocate 25% of the LLC’s profits and losses to each member. If agreed on by all the members and documented in the operating agreement, one of the members can be allocated 50% of the LLC’s profits and losses while the other three members split the remaining 50%. There are guidelines and limitations for how an LLC can structure special allocations. Please consult your tax advisor for more information.

Complicated Annual Reporting – While special allocations are what has partially made LLCs a popular business entity, special allocations can also cause tax compliance to become expensive and time consuming for the LLC itself and its members. Complex tax consequences shouldn’t deter you from at least considering the LLC structure for your business with your team of advisers. The benefits of having an LLC may be greater than the time and money resources required to comply with state and federal tax laws.

Flexibility – An LLC always has the option of choosing to be taxed as an S corporation instead of a partnership. The LLC files Form 2553 with the IRS to make the election to be taxed as an S corporation. This is the same form used by a C corporation who elects to be taxed as an S corporation.

Investors prefer C corporations over LLCs

For all the aforementioned reasons why LLCs make sense to use as the entity of choice for the majority of businesses formed today, LLCs are still frowned upon by institutional investors for the following reasons:

  • Taxes – First, investors don’t want to be burdened with the compliance requirements of being a member of an LLC. U.S. federal partnership taxation can get complicated and expensive. Investors don’t want their individual taxes to be either complicated or expensive. There are also potential state reporting requirements if the LLC is considered to have an active trade or business in one or more states. While members of an LLC have annual tax reporting obligations, investors in a C corporation only deal with tax reporting requirements when they sell their shares in that C corporation.
  • Legally can’t invest – Certain investors, such as venture capital funds, are unable to invest in partnerships if the VC fund has tax-exempt partners. These partners can’t accept active trade or business income due to their tax-exempt status.
  • Delaware C corporation is the standard – Many investors and venture capitalists prefer businesses they invest in to be Delaware C corporations for several reasons. First, the Delaware Court of Chancery hears numerous corporate cases every year and makes it easy to research prior court cases and precedents. The court also features judges instead of juries. These judges are subject-matter experts in C corporations. Second, Delaware makes it easy to form a C corporation and offers flexibility regarding how to structure the business and its board members.

Can an LLC be converted to a C corporation?

“Can’t I just start my business as an LLC and covert it to a C corporation at a later date?” Yes, you can start your business as an LLC and incorporate at some point in the future.

There are 3 different ways to convert your LLC to a C corporation:

  • Statutory conversion – A “certificate of conversion” is filed with your particular state that converts LLC members to stockholders of your new corporation, and transfers assets and liabilities from the LLC to your new corporation. The LLC then ceases to exist. This option is usually the quickest and least expensive way to convert an LLC to a corporation.
  • Statutory merger – Similar to a statutory conversion, except there are more steps and paperwork involved.
  • Non-statutory conversion – This is the most complicated and expensive way to convert an LLC to a corporation. You should usually be able to avoid using this type of conversion.

Please discuss which conversion option is right for you with your tax and legal advisors, as there can also be potential tax consequences with each conversion method.

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