Timothy E. Brown, CPA
The Pros and Cons of a Limited Liability Company (LLC)
In my daily work, I get asked quite often the pros and cons of an LLC. I am going to share a few of those items today. I am not an attorney, and I am not providing legal advice, just some elementary principles of this legal type. Please check with your legal professional for the right decision for you and your situation.
Generally, an LLC is treated as a partnership for federal income tax purposes, unless it elects to be treated as a corporation. (An LLC can elect to be taxed as a C or S corporation. This is done by filing IRS Form 8832 Entity Classification Election).
If a newly formed entity is not a corporation and does not make an election, it will generally be taxed as either a partnership, if it has more than one owner; or with a single owner, it will be treated as an entity not separate from its owner (such as a sole proprietorship).
Filing requirements. An LLC must file a return, regardless of the amount of income or loss. Must have two owners to file as a partnership, an S corporation can have a single shareholder and file. Although all states allow single-member LLCs (SMLLCs), the business is not allowed to file as a partnership for federal tax purposes. If an SMLLC does not elect to be treated as a corporation, the LLC is a disregarded entity, and the LLC’s activities should be reflected on its owner’s federal tax return. If the owner is an individual, the activities of the LLC will generally be reflected on Schedule C (Profit or Loss from Business), Schedule E (Supplemental Income and Loss), or Schedule F (Profit or Loss from Farming). If an SMLLC is owned by a corporation or partnership, the LLC should be reflected on its owner’s federal tax return as a division of the corporation or partnership.
Basis of LLCs
Limited liability companies are created and regulated under the laws of each state. An LLC has the limited liability characteristics of a corporation but is generally treated as a partnership for federal income tax purposes.
Unlike general partners, whose personal assets are at risk for claims against the partnership, LLC members are generally only at risk for their investment in the LLC. An LLC is nevertheless allowed pass-through taxation, avoiding double tax on income that is present in C corporations.
As partnerships the LLC can:
Specially allocate income, gain, loss, deductions, and credits.
Make an election under IRC Sec. 754 to adjust the basis of LLC assets upon sale or exchange, a member’s death, or certain property distributions.
Use debt to increase a member’s basis.
Advantages of LLCs
Same pass-through features of an S corporation or partnership, which avoids double taxation of profits.
Flexibility of a partnership without the restrictions of an S corporation. For example, an LLC is not limited to one class of stock; the number of members is not limited, any entity can be a member, and it can have flexibility in its profit/loss allocation. An LLC can allocate start-up losses to investors in order to attract capital, whereas an S corporation cannot.
Liability protection for all LLC members, whereas the general partner in a limited partnership has unlimited liability. Also, if a limited partner in a limited partnership participates in management, the limited partner is exposed to personal liability. An LLC member who participates in management is generally not exposed.
Tax-free liquidation of an LLC treated as a partnership. Liquidation of an S corporation interest is a taxable event and is treated as if the corporation sold the liquidated assets at fair market value to the shareholder.
LLCs and their members are not subject to special taxes that apply to C and S corporations. These taxes include the built-in gains tax and excess net passive income tax applicable to S corporations, and the personal holding company tax and accumulated earnings tax applicable to C corporations.
Ability to have a foreign individual as a member. However, this may subject the member to a federal tax return filing requirement and income tax withholding.
Disadvantages of LLCs
Owners cannot be paid as employees but must be compensated for services via guaranteed payments that are subject to SE tax.
Distributive shares of income that are the result of services rendered are subject to self-employment tax. LLC members involved in business operations are not passive investors.
Owners cannot participate in Section 125 (cafeteria) plans since they are not employees.
Owners can participate in group-term life insurance, disability insurance, and meal and lodging arrangements, but they cannot do so on a tax-advantaged basis.
Limited life for LLCs in certain states.
LLC may lose its ability to use the cash method of accounting if more than 35% of losses can be allocated to nonparticipatory members.
LLCs cannot take advantage of incentive stock options, engage in tax-free reorganizations, or issue Section 1244 stock.
LLCs that operate in more than one state may not receive consistent treatment due to the lack of uniformity in state LLC laws.
Some states do not tax partnerships, but they do tax LLCs.
Conversion of an existing business to LLC status could result in tax recognition on appreciated assets.
If you would like to develop a strategy for how to approach your new or existing business or you have questions regarding the best ways to position your business, book your discovery session today.