LLC & Partnerships

The LLC is a complex type of business structure which lends itself to significant tax planning opportunities for its owners. The key feature of the LLC (Limited Liability Company) which makes it such an attractive type of business entity is flexibility of its tax structure. It is the most flexible and versatile form of business since it allows its owners to decide which business entity it would like to be taxed as (as an S Corporation, C Corporation, Partnership or Sole Proprietorship).

Although an LLC can elect to be taxed in virtually any way that it chooses, by default, an LLC is taxed as a partnership when there are two or more members and as a sole proprietorship when there is only a single member. Therefore, by default an LLC provides pass through taxation to its members and thus avoids double taxation which exists in the C Corporation.  If the owners of an LLC decide that it would benefit them more by being taxed as a C or S corporation, they have the option to make that election.  It is important to consult with your CPA or Tax Accountant to determine which method of taxation would provide your business with the maximum tax savings.

While a corporation has shareholders that own corporate stock, a Partnership has partners and LLC has members that own interest.  There are two types of interest ownership in the LLC/Partnership: Capital Interest and Profit Interest.  It’s important to understand the difference between the two and how to utilize each type of ownership interest.  Please read the following article about various types of LLC/Partnership interests here: Types of LLC Interest

Another aspect of the LLC which allows for maximum flexibility is its operating agreement which gives its members total control over operation and management.  Through the operating agreement, the members of an LLC can chose specifically how they want to divide responsibilities, allocate profits/losses, transfer ownership interests etc.  Most states give LLC’s the right to govern themselves, and only provide governance where the LLC did not outline a particular point in its operating agreement.

Perhaps the most important feature of the operating agreement is its provision for income allocation.  The members of the LLC can chose to allocate the profits and losses of the business in any way they chose, regardless of how much capital each member contributed to the LLC.  For example, Alan and Bruce were brothers and co-owners of an LLC.  Bruce was in the higher tax bracket – 35%, whereas Alan was in the 25% tax bracket.  They chose to split the income 50/50 and have all losses attributed to Bruce, since he would save the most on taxes by using the company’s losses to offset his other personal income.

If Alan and Bruce were both in the 25% tax bracket, it might still be be advisable to have all losses attributed to one of them if the losses would be enough to push one of the two owners into the 15% tax bracket, and thus create tax savings.  If Alan and Bruce had decided to form their business as an S or C Corporation, this type of flexibility in income/loss allocation would not be possible.  Within a corporation, income and loss is allocated strictly proportionally based on the percentage of ownership.

Aside from flexibility, the LLC also offers other attractive benefits. Like a corporation, an LLC provides its members with limited liability protection.  This means that members are not individually liable for claims arising from lawsuits or debts of the LLC. Each member’s liability is limited to the amount of capital that they invested into the LLC.

Furthermore, an LLC allows debt, like mortgage payable to count towards one’s basis (equity). This is extremely useful for real estate investors who typically use large amounts of debt to finance their investments.  Since losses are limited to the amount of basis, having the entire debt count towards basis allows the investor to make use of a significant tax deduction.  Neither C nor S Corporations allow for debt to count towards basis. It is a feature which is unique to the LLC.

As compared to the S or C Corporation, the LLC is cheaper to maintain since it has no requirements to file quarterly payroll tax returns.  In the case of the single member LLC, there is no requirement to file a separate return at all for the LLC.  It is considered a disregarded entity, and is only reported on the owner’s schedule C of their individual tax return (Form 1040).

Despite all of these attractive benefits of the LLC, there are also drawbacks.  Firstly, the entire net income of the LLC is subject to self-employment tax, which is not the case for the S Corporation.  In an S Corporation, only the salaries are subject to employment taxes (FICA-Social Security and Medicare tax).  Also, it is important to remember that like in S Corporations, each individual member of the LLC is taxed on their proportionate share of net income, regardless of whether the member received any profit distributions.  If a business owner does not plan to take any money out of a business for a while, an LLC may therefore not be the ideal business structure.

Secondly, since the LLC is the newest form of business entity, the case law for the LLC is underdeveloped.  This means that lawsuits involving LLCs will sometimes have unpredictable results due to lack of legal precedent.  Additionally, since LLCs are governed by each individual state, LLCs operating in several states may be subject to differing rules and regulations in each individual state which might make operating the business across several states quite cumbersome.

Finally, the LLC is responsible to file annual reports in certain states like New York and New Jersey and other localities.  In certain states like New York, the LLC has an additional requirement to publicize its formation in a approved local newspaper. Both of these requirements carry with them an additional expense which business owners should keep in mind.  Despite these two requirements, an LLC is still cheaper to maintain than an S Corporation.

Although the information presented in this article should give you an idea as to whether or not the LLC is an effective business structure for your company, it is always advisable to consult with a CPA or Tax Accountant in order to discuss the specifics of your business and to ensure that all tax savings strategies are utilized to provide your business with maximum tax savings.