Choice of Business Entity: LLCs – I Don't Know Why, But I Want One!

According to the Indiana Secretary of State in 2006 over 18,515 businesses were formed as LLCs while only 12,463 were formed as traditional "corporations." Why this skyrocketing interest in doing business as an LLC? In part, this may be the "herd" mentality of doing what everyone else seems to do. That begs the question – why is the herd going this way?

The answer lies in a rather rare "white flag" concession by the Internal Revenue Service (IRS) to the business community about ten years ago. Before that, a business owner had somewhat of a "Hobson's Choice" -- you could have either one layer of "flow-through" taxes on business income or limited liability for the actions or debts of the business. It was hard to get both – you could do it, but you had to use a structure that was the equivalent of doing a round-off back handspring in the tuck position with two and a half twists – just to please the IRS. Over time, the IRS simply could not keep up because they lacked the resources to review these contorted structures. So they basically raised the "white flag" and said, "OK, if you want one layer of flow-through taxes and limited liability – just check this box." The rocket was launched. Now business owners can have both via a simple, straight-forward LLC structure as their choice of entity. That is why the overwhelming choice of business entity filed with the Secretary of State in recent years has been the LLC

"Tell me more" you say. OK, here you go, but it might be easier explaining what "HDTV in 1080i" is….

Limited Liability

Limited liability (i.e., the "LL" in LLC, LLP, etc.) for an owner refers to the concept that the owner's personal liability is limited to the amount of investment in the company. In other words, the creditors of the company generally cannot successfully sue its owner for unpaid bills that are owed by the company. And lawsuits for what the company does or doesn't do apply only to company assets. This generally is the case if the company is operated so that it is respected as a separate and distinct business entity, and there is no fraud. An owner of a corporation is referred to as a shareholder and an owner of any form of partnership (e.g., a general partnership, limited partnership or limited liability partnership) is referred to as a partner. An owner of a limited liability company, on the other hand, is referred to as a member. A corporation, an LLC and a limited liability partnership ("LLP") can provide limited liability for its owners; a limited partnership can provide limited liability for its limited (but not its general) partners.

Avoiding Double Taxation

A corporation that has not elected to be treated under Subchapter S (sometimes called a "C corporation" to distinguish it from an "S corporation") is subject to so-called "double taxation" whereby the net income of the company is subject to tax at the corporate level and again when it the corporation distributes its income to its shareholders (e.g., dividends). However, a business that is operated as a so-called "flow-through" entity – which includes partnerships, most LLCs and LLPs and S corporations – the income earned by the company generally will be subject only to a single level of tax imposed on the owner. Consequently, combined federal, state and local income taxes of a flow-through entity may be more than 20 percent less than that of a C corporation.

Simplified Tax Reporting for Single-Member LLCs

Some special tax rules exist for an LLC that has only one member (a "single member" LLC). A single-member LLC is disregarded, or ignored, for most tax purposes even though it is treated as a distinct entity for non-tax purposes. Consequently, the operations of a single-member LLC are included in the tax return of its owner. For example, if the owner is an individual, the LLC's income is reported on Form 1040, Schedule C. Generally, this will simplify the tax reporting obligations of the owner, and is one of the reasons why single-member LLCs enjoy such popularity among small-business owners. On the other hand, a corporation, partnership or multi-member LLC generally will be required to file separate tax returns to reflect its activities.

Deductibility of Losses of Flow-Through Entities

Subject to certain limitations, an owner of a partnership, LLC, LLP or S corporation often is able to deduct net losses incurred by the business on the owner's tax return. This may be especially attractive during a company's "start-up" years when operating losses are projected. A shareholder of a C corporation cannot deduct corporate losses on the shareholder's tax return.

LLCs Are Flexible for Non-Tax Purposes

Generally, it is easier for partnerships and most LLCs to provide different arrangements for voting, allocations of income and losses, and distributions of cash or property to their owners than with either an S or C corporation. A common example is when two owners, one of whom wants to invest "sweat-equity" in a business and the other of whom is willing to provide the initial capital for the company, come together to form an LLC. The LLC could provide that the cash investor would receive a return of her or his original investment and future profits and voting rights would be shared equally. However, if the company is organized as an S corporation, then voting rights, profits and losses, and cash distributions generally must be proportionate to the amount of capital invested by each shareholder. While it may be possible to accomplish a structure similar to the LLC by using a C corporation (for example, by using preferred stock), it often is considerably more cumbersome to do so.

Employment and Self-Employment Taxes

An owner of either an S corporation or a C corporation who actively participates in the business is subject to employment taxes (e.g., FICA) on the amount of his or her salary, but the owner's share of the corporation's profits in excess of his or her salary generally is not subject to these taxes. An owner of a partnership or an LLC who actively participates in the business is subject to self-employment taxes on the entire amount of the owner's share of the company's profits. However, in appropriate circumstances, it may be possible to harmonize the tax treatment of these owners.

Fringe Benefits

An owner-employee of a C corporation may be entitled to certain fringe benefits that effectively are not subject to tax. Although the recent trend has been towards permitting an owner of a flow-through entity to similar treatment with respect to fringe benefits, differences still exist. For example, sole proprietors, partners, members of most LLCs, and S corporation shareholders (who own at least 2 percent of the corporation's stock) are not eligible for the following tax-free benefits: group term life insurance, disability insurance, cafeteria plans, educational expenses, employee paid parking, and meals and lodging furnished for the convenience of the employer.

It should be clear by now that careful consideration of the foregoing factors (among others not listed here such as exit strategy, unwinding the business, etc.) and discussion with an experienced legal and tax advisor is the best way to determine which organizational structure makes the most sense for your business. Even though luck still has a lot to do with whether a business will be successful, selecting the proper organizational structure for running a business should not be entrusted either to luck or following the herd.

Richard Thrapp serves as Deputy Managing Partner at Ice Miller LLP, and previously as Co-Chair of the Firm's Corporate/Mergers and Acquisitions Group. He can be reached directly at: (317) 236-2442 or richard.thrapp@icemiller.com. Michael Buker is a tax advisor in the Firm's Tax Group. Mike's direct telephone number is (317) 236-2172, or he can be reached at michael.buker@icemiller.com.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.