Choosing the form of your business entity: Why most business owners choose LLC’s

The first state to enact a law allowing for the creation of Limited Liability Companies was Wyoming, in 1977. Eleven years later, the IRS brought certainty to how LLC’s would be treated for tax purposes: as a partnership. By 1992, all 50 states and DC had enacted their own LLC statutes.

In 1997, the IRS gave a further boost to the flexibility of LLCs for tax planning purposes by letting owners choose whether they could be treated as a partnership or a corporation (including an S corporation) for tax purposes.

Today two-thirds of all state entity formations are LLCS, as opposed to federal and state corporations including taxing authorities or limited partnerships.

Understanding why most business owners today choose to start businesses as LLC’s offers a window to the different factors that influence “Choice of Entity” decision-making for particular businesses and ownership groups

What are the choices? At a basic level, one choice is no entity at all. A single entrepreneur can operate a business as a sole proprietorship, or two or more entrepreneurs can partner together in operating a business as a general partnership.

Operating as a sole proprietorship or general partnership means there is no entity “shield” preventing one’s business creditors from reaching their broader personal assets. Because sole proprietors and general partners have unlimited personal responsibility to their business creditors, making the “no entity” choice is a bad choice.

State corporate, LLC and limited partnership laws allow business owners to apply to the state to create a separate juridical “person,” namely, a corporation, LLC or limited partnership. That separate legal person is ultimately responsible for the liabilities arising from the running of its business, and an owner’s personal assets are not at risk.

State laws offer a myriad of choices for types of entities that can be formed to provide a liability shield. Maryland, for example, allows for the formation and recognition of corporations, LLCs, limited partnerships, statutory trusts, nonstock corporations, professional service corporations, benefit corporations, and cooperatives, among others.

While officers, directors and employees (including licensed professionals such as lawyers, doctors, CPA’s and architects) can still be sued and found personally responsible (e.g., to the extent of their personal involvement in torts or when they have signed a personal guaranty of the entity’s contractual obligations), the bottom line is that owners choose “entity” over “no entity” for the liability protection.

Before one considers the types of limited liability entities business owners can choose from, a loud confusion alert is warranted: a business that is formed as one type of entity under the state law can then be classified as a completely different type of entity for federal income tax purposes.

Specific aspects of the particular business may drive the choice between different state-law formation choices. A group seeking to provide a public benefit and to become a tax-exempt charity will choose to be a nonstock corporation so that no financial benefits or other private benefit inures to private stockholders. A group of physicians will choose to organize as a professional service corporation, so that their medical services can lawfully be managed by their entity.

Once the business owner moves beyond what the entity will be for state law and liability purposes, the choices for tax classification of the entity come into keen focus. There are four choices for tax classification purposes: a disregarded entity, a partnership, a C corporation, or an S corporation.

Note that an LLC is not itself a choice for an entity for tax purposes. There is no separate regime of federal taxation for LLC’s. Instead, as discussed below, depending on the circumstances of the ownership and management of the company, and taxpayer elections, an LLC can be treated as any one of the four tax-classification choices.

Disregarded Tax Entities

While an LLC with a single owner has its own separate liability shield for state law purposes, its default classification is a disregarded entity for federal tax purposes. The tax attributes of the LLC “pass-through” to the sole owner who is considered to personally own all of the assets and be liable for all of the tax debts. The single owner will report all taxable income and expenses on his own tax return, just as one would do if he was a sole proprietor.

Partnerships

The default tax classification for multiple member LLC’s is that they will be classified as a partnership.

As a partnership, the entity will need to file at the partnership level but it does not pay income taxes. Instead, the profits and losses pass-through to the partners (nee, LLC “Members”) each year, and the LLC Members include their respective shares of income and loss on their personal income tax returns.

S and C corporations

The tax shape-shifting possibilities of an LLC do not end here. An LLC with a single member or multiple members may also elect to be classified as a corporation for tax purposes.

An LLC that elects to be classified as a corporation can remain as a C corporation or further elect to be classified as an S corporation (which is also a pass-through entity, but with a tax regime somewhat different from that applicable to partnerships). To obtain benefits of pass-through treatment, the LLC must comply with all of the particular subchapter S requirements, including those limiting the eligibility and number of the shareholders/members and the S corporation “single class of stock” requirements discussed below.

An LLC that has elected to be classified as a corporation, but does not elect, fails to quality or inadvertently has its S corporation terminated, will be classified as a C corporation. LLC’s treated as C corporations must pay tax at the entity level, and then the LLC Members must pay another layer of tax when and as they receive distributions from the LLC “corporation.” This is the well known “double taxation” of C corporations.

Why would owners of an LLC choose to be treated as an S corporation rather than as a partnership for tax purposes? In a partnership, all trade or business income will be treated as self-employment income to the LLC members, while classification as S corporation, allows self-employment income to be limited to particular Member-employees.

Tax benefits and constraints of corporate status

State law corporations that are taxed as S or C corporations qualify for certain statutory tax benefits, including those associated with issuing incentive stock options, other qualified retirement plans, and (for certain C corporations) a long-term capital gain exclusion.

These (sometimes minor) tax advantages for utilizing corporations, usually do not merit the limitations on management and ownership flexibility that come with forming an LLC under state law and then utilizing a timely ‘S’ election to receive those same benefits.

Requirements for S corporations include that all LLC Members (who are all deemed shareholders for purposes of these requirements) must be US citizens or permanent residents, and that there may be no more than 100 total shareholders.

More burdensome is the “single class of stock” requirement for S corporations. While S corporations, and LLC’s classified as S corporations, can have non-voting common stock, they cannot have of any class of preferred stock (i.e., stock with different rights on distributions or in liquidation. The single “class” of stock requirement inhibits capital raising for the business, since new investors into the company cannot be offered income or liquidation preferences and protections.

Even inadvertent violations of the shareholder eligibility requirements or the single class of stock requirement can cause the entity to suddenly lose S corporation status and then automatically become a C corporation for tax purposes, subjecting the company and its shareholders to unintended double levels of taxation.

Why most LLC’s default to partnership tax treatment

Owners of most multiple-member LLC’s choose to stick with the default classification of having the LLC treated as a partnership for tax purposes. This means there is only a single level of taxation on the business operations at the member level.

Regardless of its tax classification, state LLC laws offer enormous flexibility for the ways in which an LLC can be managed, and how its equity owners and key employees can be compensated for their different levels (and times) of investment as the company grows. LLC’s are governed according to operating agreements that can be tailored for the needs of each individual LLC and its diverse ownership and management group. Unlike state law corporate statutes, there are no legal requirement to adopt bylaws, have a board, or appoint officers.

If the company is successful, and owners choose to sell either all of the LLC membership interests, or all of the assets, there will only be a single level of tax—on the owners—at the time of sale.  Private equity and other company buyers typically prefer to buy equity or assets from LLC’s classified as partnerships because the transaction is treated as an asset purchase for tax purposes, giving the acquirer an immediate step-up in basis on all company assets (including goodwill) when they pay a premium price to buy the entire company.

The tremendous flexibility that LLC’s offer for tax planning, income distribution for equity members and company management explains why LLC’s, classified as partnerships, are now the most common entity choice.