Choosing the Form of Your Business Entity: WHY DO 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 would be treated as a partnership or a corporation (including an S corporation) for tax purposes. Today some TWO THIRDS OF ALL STATE ENTITY FORMATIONS ARE LLCS, as opposed to corporations 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. However, operating as a sole proprietorship or general partnership means there is no entity “shield” surrounding one’s business liabilities from their broader personal assets. Sole proprietors and general partners have unlimited personal responsibility for liabilities arising from their businesses, which usually makes “no entity” 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, technically, the legal person ultimately responsible for the liabilities arising from the running of its business. Officers, directors and employees (including licensed professionals like lawyers, doctors, CPA’s and architects) can still be sued personally, but usually only 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 LIABILITY PROTECTION.
Before one considers the types of limited liability entities business owners can choose from, a loud confusion alert is warranted: an entity can be formed as one type of entity under the state law where it is organized, but can be treated as a completely different kind of entity for federal tax purposes. Tax considerations are usually compelling in choice of entity decisions, so the ultimate choice is usually: what kind of entity should the business be for tax purposes.
STATE LAWS OFFER A MYRIAD OF CHOICES FOR TYPES OF ENTITIES that can be formed as the separate corporate legal persons the state will recognize. Maryland, for example, allows for the formation and recognition by the state of corporations, LLCs, limited partnerships, statutory trusts, nonstock corporations, professional service corporations, benefit corporations, and cooperatives, among others. Specific aspects of the particular business may drive the choice as between these different state-law formation choices. A group wanting to become a tax-exempt charity will choose to be a nonstock corporation so that no financial benefits inure to private stockholders. A group of physicians will choose to organize as a professional service corporation, so that their professional services can lawfully be managed by their entity.
Once the business owner moves beyond what the entity will be for state law purposes, the choices FOR TAX CLASSIFICATION OF THE ENTITY comes into keen focus. THERE ARE ESSENTIALLY ONLY FOUR CHOICES FOR TAX 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, 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 listed above.
DISREGARDED ENTITIES. An LLC with a single owner is its own separate legal person for state law purposes, but it is a totally disregarded entity for federal tax purposes. The LLC is ignored for tax purposes, and the owner of the LLC is considered to personally own all of the assets and be liable for the all of the liabilities of the company for tax purposes. The single owner will report all taxable income and expenses on his own tax return, just as one might do if he was a sole proprietor. The tax attributes of the LLC “pass-through” to the sole owner.
PARTNERSHIPS. LLC’s with more than one owner will not be disregarded entities, but they will usually be treated as pass-through entities. The default tax choice for treatment of LLC’s with multiple owners is that they will be treated as a partnership for tax purposes. As a partnership, the entity will need to file its own partnership-level tax return, but partnerships do not pay income taxes at the partnership entity level. Instead, the profits and losses pass-through to the partners (nee, LLC “Members”) annually, and the LLC Members include their respective shares of income and loss on their own personal income tax returns.
S AND C CORPORATIONS. The tax shape-shifting possibilities of an LLC do not end here. An LLC may also elect to be treated as a corporation for tax purposes. An LLC that elects to be treated as a corporation can then further elect to be treated as an S corporation (which is also a pass-through entity, but with a tax regime somewhat different from the tax regime applicable to partnerships), but to do so the LLC must comply with the peculiar subchapter S requirements as to number and characteristics of “shareholders” and S corporation “single class of stock” requirements discussed below.
Finally, an LLC that has elected to be treated as a corporation, but does not elect (or fails to qualify) as an S corporation, 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 well known as the “double taxation” of C corporations.
Why would owners of an LLC choose to be treated as a 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, whereas the S corporation form allows self-employment income to be limited to particular Member-employees. S and C corporations qualify for certain statutory tax benefits, such as those associated with issuing incentive stock options.
These somewhat minor advantages for S corporations usually do not merit the “S” choice and the limitations on management and ownership that come with an S election by an LLC. Requirements for S corporations include that, in general, 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. To be treated as an S corporation, an LLC must timely file an S election. Most burdensome is the “single class of stock” requirement for S corporations. S corporations, and LLC’s treated as S corporations, cannot have preferred stock shares or any other forms of differences between equity owners’ rights, other than to allow for some shares to be voting and others to be non-voting.
The single share of stock requirements 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 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 separate levels of taxation.
For these reasons, OWNERS OF MOST MULTIPLE-MEMBER LLC’S CHOOSE TO STICK WITH THE DEFAULT CHOICE OF HAVING THE LLC TREATED AS A PARTNERSHIP FOR TAX PURPOSES. The entity will remain a pass-through entity, meaning that there is only a single level of taxation at the shareholder level. 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 that are treated as partnerships precisely because the company purchase 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.
At the state law level, the entity remains an LLC for management and governance purposes, 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 CAN COMPENSATED FOR THEIR DIFFERENT LEVELS AND TIMES OF INVESTMENT IN THE COMPANY AS IT 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. There are other circumstances and rationales, obviously, why a business ownership group would decide form a state law corporation, and keep it as, say, a C corporation for tax purposes. The tremendous flexibility that LLC’s offer for tax planning, income distribution waterfalls for equity members, and company management explains why LLC’s, treated as partnerships, are now the most common entity choice.