Limited Liability Companies

Transcription

1 C H A P T E R Limited Liability Companies 11 Taxes Federal Tax Reporting State Taxes Unequal Allocations of Profit and Loss Comparing LLCs With Other Entities Operating Your Limited Liability Company (LLC) Forming an LLC Converting a Business to an LLC LLC Members Rights Transferring Ownership Sale or Death Terminating a Limited Liability Company...182

2 178 Tax Savvy for Small Business I stay within the law only because the law is maneuverable, it can be manipulated. William M. Kunstler An increasingly popular way to organize a small business is the limited liability company (LLC for short). An LLC offers nontax advantages over a sole proprietorship, partnership, or a corporation. Unlike a sole proprietorship or general partnership, an LLC protects its owners personal assets from business creditors. LLC owners liability for business debts is limited to their ownership interest in the business hence the name limited liability. Plus, all LLC members can take an active role in the operation of the business without exposing themselves to personal liability unlike partners. According to one nationally known small business expert, Gene Fairbrother, the LLC is far superior to either the sole proprietorship or partnership because of the limited liability feature alone. In the long run, Mr. Fairbrother says, the LLC could be the least expensive insurance that you ever buy. Taxes The LLC is a pass-through tax entity, like a partnership or S corporation. Owners (called members) report and pay taxes on LLC income on their individual tax returns and are responsible for filing and paying quarterly estimated taxes like sole proprietors and partners. LLC losses also pass through to the members and can be claimed on their tax returns for tax benefits. LLC members claiming losses must have materially participated in the business; they cannot just be passive investors. Federal Tax Reporting LLCs, like partnerships and S corporations, do not pay federal income taxes, so LLC income is taxed at a single level to the members. Even though no taxes are due, LLCs and members have tax reporting duties: Members pay estimated quarterly taxes, file Form SE (Social Security & Medicare), and pay taxes like sole proprietors. (See Chapter 7.) The LLC is responsible for payroll taxes only for its nonmember employees. (See Chapter 6.) Single member LLCs (and husbands and wives in community property states) can report LLC income or loss on Schedule C, the same as a sole proprietor. Multimember LLCs typically file Form 1065, U.S. Partnership Return of Income, and issue each member a Schedule K-1 showing that partner s share of LLC profit or loss. The person reports that amount on his or her Form 1040, individual income tax return. (See Chapter 10.) LLCs may choose to file corporate tax returns, although few do. There are special rules for foreign LLCs that are not covered in this chapter. State Taxes States often tax LLCs, even though the IRS doesn t. For example, in California, LLC taxes and fees range from $800 to as much as $12,000. Most states require annual tax reporting by LLCs on their own state forms. Unequal Allocations of Profit and Loss LLC profits and losses pass through the LLC and are allocated and taxed annually to the LLC

3 chapter 11 Limited Liability Companies 179 members. Or, put another way, the LLC owners, not the LLC itself, are responsible for paying income taxes on business profits. The percentage of income or loss allocated to each LLC member is stated in the LLC s operating agreement. In a one-member LLC, of course, all income and loss will pass through to the sole owner. However, an LLC may allocate profits (or losses) disproportionately to its members. These are called special allocations. An LLC can allocate profits unequally only if it meets some technical tax code rules. This means special language in your LLC operating agreement. This is tax pro stuff not for do-it-yourselfers. Comparing LLCs With Other Entities LLCs are attractive because they combine the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. So, if the business is sued or incurs obligations it can t meet, a creditor can only go after business assets not property belonging to the members. Hence, the term limited liability. One exception: The IRS (and probably your state tax authority, too) can collect delinquent LLC payroll taxes directly from members. This limited liability feature is the reason most folks choose an LLC. Here s a summary of how LLCs stack up against other entities: Sole proprietorship. An LLC can be a oneman band, but owners aren t personally responsible for nontax LLC debts, as are solos. General partnership. A multimember LLC usually elects to be taxed like a partner ship. But LLC owners aren t personally liable for nontax business debts as are general partners. Limited partnership. Limited partners, like LLC members, are shielded from personal liability for business debts. However, LPs can lose this protection if they participate in the management of the business. Limited liability company members have no such restrictions on participation. Plus, each limited partnership must have at least one general partner with full personal liability for business debts. S corporation. LLCs and S corporations are both tax pass-through entities, so profits and losses flow through the business to its owners. LLCs are less formal and cheaper to operate than corporations. LLCs can allocate income and expenses to their members disproportionately; S corporations must allocate income and expenses according to the shareholders percentages of ownership. There s no limit on the number or types of owners (members) an LLC can have. By contrast, an S corporation may have no more than 100 shareholders. And S corporation shareholders can t be nonresident aliens which rules out any foreign shareholders. Because LLCs aren t under the ownership restrictions of S corporations, it may be easier for them to bring in more members to raise capital. C corporation. As separate entities, C corporations offer shareholders protection from business creditors. However, C corporations unlike LLCs are taxpaying entities, which could mean double taxation of profits. Also, the liquidation of a C corporation may trigger corporate and shareholder taxes. An LLC liquidation will usually only have tax consequences to the members. In addition, an LLC can be run less formally than a corporation. A C corporation can keep some of its earnings in inventory or in cash for future growth at a tax rate as low as 15%. LLC members, on the other hand, can t leave profits in the business without first paying Part 2 The Structure of Your Business

4 180 Tax Savvy for Small Business taxes on these profits at their individual tax rates, which might be as high as 35%. Professional Limited Liability Partnerships and LLCs Many states allow certain professionals to form professional LLCs, but a few states call them limited liability partnerships (LLPs). Only certain state-licensed occupations such as doctors, lawyers, and accountants may form these professional LLCs or LLPs. (For example, in California only accountants, lawyers, or architects may form LLPs.) The designation LLP (or RLLP, Registered Limited Liability Partnership) becomes part of a firm s name and must be used in all legal transactions and advertising to the public. Once registered, the partners of the LLP do not have liability for the malpractice of the other partners, but remain liable for their own acts. This limited liability feature not taxes is the primary reason why professionals form LLPs. If you provide professional services, check with your state or your attorney for LLC and LLP restrictions and requirements. Operating Your Limited Liability Company (LLC) As with most business entities, LLCs are formed and regulated under state law. Many states have adopted the Uniform Limited Liability Company Act. However, LLC procedures, paperwork, and expenses vary from state to state. Most, but not all, do not restrict ownership of LLCs, so members may include individuals, corporations, other LLCs, and even foreign entities. What follows is generally true for all states, but yours may be an exception. Forming an LLC To form an LLC, you ll need to prepare written articles of organization (some states call this a certificate of formation or certificate of organization) and send them to your state s filing office, often the secretary of state. The articles may be just a simple one-page form, similar to articles of incorporation. Fees. The filing fee depends on your state and ranges from $50 on up. (Tax-hungry California charges $70 plus a minimum $800 annual tax.) Most states provide a blank articles form on their secretary of state or department of corporations website. Extra steps. Some states require a few extra steps before your LLC can start business. In New York, for instance, you must publish notice of your LLC formation in a newspaper. Also, you may need a local business or occupational license, a sales tax permit, or other local license. Operating agreement. A written agreement (called an operating agreement) may also be required by your state. The operating agreement sets out the internal rules for governing the LLC members: voting rights, check-signing authority, profit sharing, responsibilities, ownership transfers, and other vital matters. This is akin to a partnership agreement or bylaws that govern a corporation. Even if a written LLC operating agreement is not required by your state, it is certainly a good idea. It helps avoid or settle disputes about the management of the LLC business later down the road. Resource See Form Your Own Limited Liability Company, by Anthony Mancuso (Nolo), for help creating an LLC. Also, check Nolo s online legal forms for help creating an LLC online (available for certain states only).

5 chapter 11 Limited Liability Companies 181 Documenting decisions. Most states LLC laws don t require corporate formalities such as keeping minutes, passing resolutions, or holding annual meetings. However, it s wise to document the LLC s major actions, such as entering into an expensive executive employment agreement. See an Expert LLCs can elect to file as a corporation. LLCs (as well as partnerships) can choose either pass-through taxation, like an S corporation, or to be taxed like a C corporation. (It would be unusual for an LLC to want to be taxed like a C corporation, however.) If you re interested, talk to your tax pro and see IRS Form 8832, Entity Classification Election. Where to Get Help Check with your secretary of state s office for LLC fees and filing rules. Most states provide sample LLC articles or fill-in articles forms. See the Resources box at the end of this chapter for recommendations on legal self-help references. Business lawyers can help you form an LLC, and tax pros can do the IRS and state tax reporting. Attorneys fees are about the same as for forming a partnership or corporation ranging from $500 to $2,500. If you are forming a one-person LLC, you can easily do it without a lawyer, but you should seek professional help if there are other members. Again, see the Resources box at the end of this chapter. Tax ID number. After forming a multi-member LLC, you must get a federal identification number (EIN), unless you re a sole owner with no employees. See Employer Identification Numbers in Chapter 6 for details on how to get an EIN. A few types of businesses can t be LLCs, such as banks, insurance companies, and nonprofit organizations. Converting a Business to an LLC There may be tax issues when you change from a solo or partnership to an LLC. You are likely to have tax consequences if you convert an existing corporation to an LLC. The tax code requires that a corporation must be formally liquidated before its assets can be put into an LLC. Liquidating a C corporation with significant assets might mean taxes for the corporation, because this is treated as a sale of the corporation s assets. Then the funds from the sale of assets are deemed to have been distributed to the shareholders, who may be taxed again. (See Chapter 8.) Whatever is left after taxes goes into the LLC. A relatively new C corporation, or one that has not been successful or has minimal assets, may be able to convert to an LLC without a tax cost. If you convert an S corporation to an LLC, you ll fare better, because any taxes on liquidation are placed only on the shareholders. There is no double taxation, as with C corporations. See an Expert Get tax advice before switching. Bottom line: If you are tempted to convert your business to an LLC, see a tax pro first. LLC Members Rights LLC members are not required to be involved in managing the business. They can be passive investors. This is similar to a limited partner or the holder of nonvoting corporate stock. However, there are some legal rights an LLC member must hold (such as the right to vote to dissolve the LLC). Check your state s LLC statute or talk with your legal adviser if you want to restrict the rights of certain LLC members. Part 2 The Structure of Your Business

6 182 Tax Savvy for Small Business Transferring Ownership Sale or Death Sale. Unless restricted in the LLC operating agreement, transferring an LLC ownership interest is relatively easy the member simply signs over his or her membership interest. The buyer or transferee gets all the rights (and obligations) of the departing member. The tax consequences to the transferring member are the same as with a partnership the gain or loss is determined by the member s tax basis in his LLC share. (See Selling or Transferring a Partnership Interest in Chapter 10.) Small business LLCs don t want a member forced on them. LLC operating agreements typically contain restrictions on transfers of LLC interests (called buy-sell provisions). An agreement often states that a retiring or departing member of an LLC must first offer his or her shares to the remaining members before selling to anyone else. Usually, a predetermined price for a share or a formula for valuing it is set out in the operating agreement. These buy-sell provisions bind all members and should be agreed upon during the LLC formation process. Death. The IRS becomes interested when a member dies. That s because an LLC interest is an asset in the estate of the dearly departed member. If the estate is big enough, there may be an estate tax return to file. See Chapter 13 for estate tax basics. The good news is that the IRS usually respects the terms of a well-drafted buy-sell agreement (or an LLC operating agreement with buy-sell provisions) for fixing a fair price of a member s share. See Business Buyout Agreements: Plan Now for Retirement, Death, Divorce or Owner Disagreements, by Anthony Mancuso and Bethany Laurence (Nolo), for more information on setting a fair price for LLC membership interests. Caution Tread carefully when estate-valuing an LLC. Valuation of business interests is a number-one concern to an IRS estate tax auditor. Many estate executors end up in IRS battles over just what a small business interest is worth. (See Stand Up to the IRS, by Frederick W. Daily (Nolo), for more information about estate tax audits and business valuations.) Terminating a Limited Liability Company Generally, the rules for terminating or dissolving an LLC are similar to closing up a partnership. Income tax treatment of the members is the same as if they were general partners. (See Ending a Partnership in Chapter 10.) Limited Liability Companies in a Nutshell The limited liability company (LLC) shields the personal assets of its members from business creditors, similar to a corporation. Like S corporations and partnerships, LLCs are not taxpaying entities. An LLC is a simpler, less expensive business entity to set up and maintain than a corporation. State law governs the formation and operation of LLCs. LLCs are usually taxed like general partnerships as pass-through entities meaning that the profits and losses pass through to the individual LLC members. Single-member LLCs are treated like sole proprietors by the IRS and the solo member usually reports LLC income on Schedule C of his or her individual tax return. Multimember LLCs usually file Form 1065, a partnership informational tax return. Any state in which an LLC operates may require annual reporting and impose an annual tax on LLCs.

7 chapter 11 Limited Liability Companies 183 Resources IRS Publication 3402, Taxation of Limited Liability Companies, available at IRS Publication 541, Partnerships, available at A Guide to Limited Liability Companies (Commerce Clearing House) and The Limited Liability Company, by James Bagley (James Publishing). These are technical books written for CPAs and attorneys. Form Your Own Limited Liability Company, by Anthony Mancuso (Nolo). This book provides stepby-step forms and instructions for setting up an LLC without costly legal fees. Your Limited Liability Company: An Operating Manual, by Anthony Mancuso (Nolo). This book provides ongoing help on running your LLC, as well as numerous minutes and resolution forms. Nolo s Online Legal Forms at to create your LLC online. IRS Form 8832, Entity Classification Election. Treasury Regulation Jeffrey A. Quinn, CPA, is a knowledgeable tax professional who assisted in the preparation of this chapter. He can be contacted at www. ashleyquinncpas.com. Part 2 The Structure of Your Business

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