What is the best form of organization is a common question among small business owners. The answer is always “it depends”. Here are some things you should know about before you set up a Limited Liability Company. Incfile review
An LLC is legally a corporation, but it has many of the attributes of a partnership.
LLCs with more than one member are taxed as partnerships. If the LLC has only one member (owner) by default it is taxed as a sole proprietor, income is reported on Schedule C of the owners 1040. As a single member LLC it can elect to be taxed as a C corporation. Few LLCs elect to be taxed as a regular C corporation, because of double taxation and high administrative costs. It is possible to form an LLC and then elect S corporation status by filing form 2555 if S status is desired.
Nearly all limited liability companies (LLCs), choose to be taxed as partnerships. Single member, LLCs normally choose to be taxed as sole proprietors.
Lawyers experienced in the LLC area will tell you that the single member LLC does not avoid legal liability in most cases. The corporate shell alone does not provide protection. Their reasoning is as follows: A sole proprietor, who is an LLC, is responsible for his or her own actions. The fact that they operate within an LLC does not relieve him of personal responsibility. Both the LLC and the individual would be liable for damages. An owner of a single member LLC could lose everything corporate and personal in a lawsuit. If an LLC has employees, organizing as an LLC would provide some protection for the owner. It also should provide protection for members who do not participate in management.
The real protection in most business situations is normally adequate insurance.
Legal niceties should be observed upon formation. Corporate paperwork should be filed, by laws should be established and a written understanding should be in place detailing out work duties, compensation and other operating issues between the partners. A plan to dissolve the business should be considered at the time of startup.
The contribution of appreciated property to an LLC can generally be done tax free. This may not be true with an S Corporation. Partners can withdraw accounts or sell out their interest in an LLC far more easily than an interest in a corporation. Generally with no tax.
LLCs allow the partners to split up the income by virtually any reasonable economic formula that makes sense to the partners so long as there is an economic reason other than tax avoidance. For instance, an LLC could allocate start up losses, within limits to the partners who raised the capital. It can make special allocations of profits or losses and credits. There is no ceiling for an LLC on the number of partners it may have.
S corporations must divide income or loss based on the percentage ownership of the stock. This is not true with LLCs; they are not limited by the ownership percentages.
There is a major issue with multi partner LLCs on self employment taxes. There is no settled answer on how this should be handled. Proposed IRS regulations say members are not subject to self employment tax on their share of profits unless they preformed 500 hours a year of services or were active in the management of the business. An alternative treatment would be to pay partners a reasonable amount for services rendered that would be subject to self employment tax. The rest of their share of earnings would not be subject to self employment tax. Service LLCs would be subject to SE (self employment) tax on all earnings.
An LLC that is an operating business can not totally avoid self-employment taxes. Trying to avoid all self employment taxes is not a reasonable tax position and will result in problems with the IRS. Earnings from real estate rentals of course are not self employment income and not subject to SE tax.
This issue should be considered carefully. The IRS imposes penalties for taking unsupported positions on tax issues. Self employment tax can become a very big expensive issue if the LLC is profitable.
Liquidating a LLC is generally easier than liquidating a corporation. Normally there is no tax upon the liquidation or dissolving of an LLC, unless cash is distributed in excess of the basis. Not all states treat LLCs equally. There are differences, if the plan is to have partners from different states involved a careful checking of the laws in each state should be done.
As with any business organization operating rules and procedures should be established in the beginning. In the long run the exact form of business may be less important than who is involved. Partnerships (and LLCs) biggest problems stem from the falling out between the partners.