LLC Gives Start Ups Best of Both Worlds

When limited liability companies became a legal choice for entrepreneurs pondering a business entity, the enabling legislation was designed to provide business start ups with the best of both worlds – the liability protection of a corporation, with the tax advantages of a partnership. In this case, the politicians got it right – so right that entities like limited partnerships are rarely used anymore. But there are some narrow circumstances where the LLC is not the best choice for everyone, and if a new venture grows large enough, entrepreneurs eventually consider converting to a corporation.

Before handicapping the various choices of business entities, it's important to understand why this choice needs to be made. Start-up business owners who take a casual approach toward this judgment are setting themselves up for trouble. "If you're cavalier about it and do nothing, you are jointly and severally liable for everything the company does, the actions of your partner, anything that goes wrong in the business. You are jointly and severally liable along with your partner," noted attorney Jeffrey Bartzen of the Murphy Desmond law firm. "So you'd have no liability protection whatsoever."

 

The ABCs of LLCs

As its name suggests, LLC is a form of business whose owners enjoy limited liability, but there are tax advantages and disadvantages. "The great thing about partnerships for tax purposes is that all income and losses of the enterprise flowed through to individuals and no one paid at partnership level," noted attorney Sverre Roang, a shareholder in Whyte Hirschboeck Dudek. "They can be beneficial tax-wise for most small businesses because individual income tax brackets are more favorable than corporate tax brackets."

The disadvantage of an LLC is that income is generally taxable to the members as self-employment income, and the income is added to other income of the member and taxable under the income tax rules at the graduated income tax rates that apply to the individual, according to Ronald Berman, an attorney with Neider & Boucher.

"Some advisors have suggested converting a business to an S corporation to reduce employment taxes," he noted. "The theory is that the owner can receive a relatively small amount in wages, which are subject to employment taxes. The rest of the income is then distributed to the owner through the payment of dividends by the S corp."

Part of the reason LLCs are the most exercised choice is they allow more flexibility than a corporate structure. LLCs do not require a corporate structure with boards of directors and minutes of meetings, and they are taxed the same as partnerships. "They are flexible, easy in, easy out," Bartzen said. "You can take out highly appreciated assets without paying immediate tax, so if a company has intellectual property, we always want them in some kind of partnership-LLC tax structure. If you are going to own real estate, that's real clunky in an S corp."

S Corps and C Corps

S corps get their name from a unique section in the IRS code. By choosing the "S" election, corporations can eliminate the double taxation of corporate income and shareholder dividends. The owners of this business type report profit and loss on their individual tax returns, and they can separate and protect personal assets from judgments against the business.

Among the reasons people gravitate toward S corps is they can save the owner some employment taxes. If you're in a business that has $100,000 a year in profit and you pay yourself reasonable compensation, the IRS will allow you to take the remainder of it as a distribution or a dividend and you avoid employment taxes on it. "The basic gist is that members [owners] of an LLC pay self-employment tax on all income of the LLC, regardless of whether some may be characterized as a 'salary,'" Roang said. "In an S corp, shareholders pay self-employment tax only on the amount they take out as salary. Any earnings of the company beyond salary avoid the self-employment tax."

Berman offers one note of caution. "The IRS is aggressively reviewing such situations in S corps and has been relatively successful in attacking this manipulation of the employment tax," he warned. "The IRS reallocates the payments from dividends to wages and then asserts employment taxes, interest, and penalties."

Among the S corp disadvantages: you can only have a single class of stock, you are limited to 100 shareholders, and you cannot have foreign owners, which makes them problematic for life-science or technology companies spun out of UW-Madison.

Due to the stock restrictions on S corps, and the fact that investors don't like pass-through taxation of LLCs, most of the larger publicly traded companies are all C corps. There are a number of reasons to choose this entity, but the company generally has to be pretty large and have diverse shares: A shares, B shares, voting and non-voting, and some preferred.

C corps also have hundreds of years of case law built up around them, so people know how they are going to be treated. "If I form a corporation in Wisconsin, I pretty much know how California is going to treat me from a liability standpoint," Bartzen said. "With an LLC, there is still some uncertainty. Some of the bankruptcy courts are ignoring the one-person LLCs."

If a company begins as an LLC but intends to grow into a relatively large company, one future decision will be to convert into a C corp. "An LLC is relatively easy to convert to a corporation, whether taxable as a C corp or an S corp, if the situation, as it develops, reflects that a corporate form may be better," Berman noted. "Starting out as a corporation, on the other hand, can restrict the alternatives as it can be very costly for tax purposes to then convert to an LLC."

The "other" entity

Another more narrowly used entity is the limited liability partnership. In an LLP, a partner's liability for the debts of the partnership is limited except in the case of liability for acts of professional negligence or malpractice. This often is the entity chosen by law firms, architectural firms, and accounting firms and other licensed professions. The reason LLPs were created was to provide an alternative to LLCs for large partnerships because it would be nearly impossible for a large partnership like a national CPA firm to get unanimous consent on a vote to form a partnership.

"Let's say you have a national accounting firm and you have 500 partners," Berman said. "To convert that partnership to an LLC requires unanimous consent. To convert to an LLP requires only majority consent. So if you are a national CPA firm, are you going to try to convert to an LLC or to an LLP? It's a lot easier to do an LLP."

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