A limited liability company (LLC) is a hybrid of a partnership and a corporation. An LLC can be treated like a corporation for liability purposes and can be taxed as a partnership (or even a sole proprietorship). When taxed as a partnership, income, losses, and other tax attributes pass through to the owners either pro rata or as allocated in the operating agreement (also referred to as a limited liability company agreement or a member control agreement). Such an allocation of tax attributes is referred to as each member’s distributive share. Creation of the LLC was an attempt to provide investors with the primary advantages of some of the other business entities but without their major drawbacks. Unlike a limited partnership, for example, an LLC typically permits all of its members to participate in management of the business without compromising their liability protection. Because LLCs are a relatively recent innovation, however, there is a lack of uniformity among the states as to how they are to be treated. The following discussion assumes that the LLC is taxed as a partnership for both federal and state purposes.
When It Can Be Used
The limited liability company (LLC) form of entity is a good choice for almost any type of business venture with a small number of active investors. It is well suited for real estate investments, passive investments, or joint ventures between existing business (under certain conditions). It is suitable for certain medical service organizations and for family businesses that want to keep control within the family. While LLCs are appropriate in many situations, some states do not allow the practice of a profession (such as law) through an LLC.
Strengths
May be Relatively Simple and Inexpensive to Create and Operate
A limited liability company (LLC) may be relatively inexpensive and simple to create and maintain. An LLC is a creature of state statutory law and generally requires more effort than a partnership. You must file articles or a certificate of organization (a document that outlines the company’s purpose and structure, and provides contact information) with your state and create an operating agreement in which you prescribe, among other things, how the LLC is to operate and the relationship between members.
No Limit on the Number and Type of Owners
An LLC is unlimited in the number and type of members it may have. Most states allow single-member LLCs. In addition, an LLC can have other business entities (such as partnerships, corporations, trusts, and estates) as members. Compare this to an S corporation, which is limited to 100 shareholders meeting certain eligibility criteria.
Profits Taxed Only Once
An LLC that is taxed as a partnership will not be assessed an entity-level tax. Instead, the members will pay income tax on the profits of the LLC. Single-member LLCs may be permitted under state law to be taxed as sole proprietorships. Therefore, an LLC is not subject to the double taxation often associated with a C corporation (unless it elects to be taxed as a C corporation).
Note: For tax years beginning prior to January 1, 2003, dividends were taxed as ordinary income. In an attempt to mitigate some of the burden of double taxation, various pieces of legislation provide that dividends received by an individual shareholder from domestic corporations and qualified foreign corporations are taxed at the rates that apply to capital gains. Most recently, in general, the American Taxpayer Relief Act of 2012 permanently extended the preferential income tax treatment of qualified dividends and capital gains, and established new rates for higher-income taxpayers. Capital gains and qualified dividends are now generally taxed at 0% for taxpayers in the 10% and 15% tax brackets; at 15% for taxpayers in the 25% to 35% tax brackets; and at 20% for taxpayers in the 39.6% tax bracket. Also, as a result of the Affordable Care Act of 2010, an additional 3.8% Medicare tax applies to some or all of the investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.
Members can Deduct Losses and have them “Specially Allocated”
Members can deduct the losses of an LLC on their personal tax returns. Most significantly, within certain limitations, a member can have deductions “specially allocated” to him or her. This means that a larger number of deductions can be allocated (within certain limitations) to the member who pays the most taxes—say, for example, because he or she is in the top individual tax bracket. This feature gives an LLC an advantage over an S corporation, as shown in the following example:
Example: Ken is a 25 percent member-manager of an LLC. The operating agreement allocates 50 percent of all losses to him. The LLC has had $50,000 in losses this year alone. Ken can deduct 50 percent of this $50,000 ($25,000) on his personal tax return. If, instead, Ken were an S corporation shareholder, his deduction would be limited to his percentage of ownership in the corporation (25 percent).
Your method of allocating losses should be recorded in your operating agreement and must also have a substantial economic effect for it to be valid. An LLC is a good idea if you anticipate large losses in the first several years of operation, because it allows members to reap immediate tax savings by deducting losses on their personal tax returns.
Caution: Certain limitations on the deduction of losses, including the passive loss rules and the at-risk rules, may apply. Disallowed losses can generally be carried over to later years.
LLC can have Centralized Management
Generally, all members of an LLC participate in management. The members may, if they wish, elect a small committee of managers, in which case only the managers have the power to “bind” the LLC and its members (i.e., to make them responsible for the managers’ acts).
A Member’s “Basis” is Increased by His or Her Share of LLC Liabilities
A member can increase his or her basis in an LLC by the member’s allocation of the recourse liabilities of the LLC. A recourse liability is one where the member bears an economic risk of loss, such as an obligation to repay the LLC’s creditors upon a liquidation. In addition, to the extent that no member bears an economic risk of loss for a liability (called a nonrecourse liability), the liability is generally allocated to all members in the same proportion as they share profits. This feature also gives the LLC an advantage over an S corporation, as shown in the following examples:
Example: Ken, a member in an LLC that is taxed as a partnership, paid $1,000 for his 50 percent interest in the LLC. Thus, Ken’s basis in the LLC is $1,000. Subsequently, the LLC borrows $20,000 from a third party. Ken, who assumes liabilities of the LLC in proportion to his ownership interest, now has a basis of $11,000 ($1,000 + 50 percent of the $20,000 loan).
Caution: While basis may increase with increased liabilities, allowing more losses to be deducted, basis will be subsequently reduced as liabilities are paid down or when the business is sold and the liabilities are paid off.
Example: Assume the same facts as in the preceding example, except that Ken is instead a 50 percent shareholder in an S corporation. Because S corporation shareholders cannot increase their basis by loans from third parties, Ken’s basis will remain at $1,000 despite the $20,000 loan to the S corporation.
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Old Basis
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Liabilities Added to Basis
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New Basis
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LLC Member
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$1,000 +
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($20,000/2)
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= $11,000 (Basis reduces as liability is paid down)
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S Corporation Shareholder
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$1,000 +
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$0
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= $1,000
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Members can “Assign” Their Interests
Absent a contrary provision in the operating agreement, members can assign their LLC interests to another person or entity without restriction. An assignment, in contrast to outright sale, is only the transfer of economic rights (i.e., the transferee generally gains only the right to receive profits or deduct losses). You can restrict a member’s right to assign or sell his or her interest by including a restrictive provision in the operating agreement.
LLC is Flexible in Sharing Profits and Control
With certain limitations, an LLC can create ownership interests that would provide preferential treatment when profits are distributed to the members or that would disallow participation in management by certain members. An LLC can thereby regulate the sharing of profits and control (unlike an S corporation, which is relatively inflexible in this regard).
Members can Generally Contribute Appreciated Property Tax Free
You can generally contribute property to the LLC in exchange for your LLC interest. Such a contribution is tax free, even if the property has appreciated in value since you purchased it. An example of such a transfer is when a member exchanges real property (e.g., an office building to be used by the LLC) for an ownership interest in the LLC. However, there may be later consequences for a member who contributes appreciated property, including possible recognition of gain.
Liquidation of an LLC is Generally Tax Free to Members
Generally, when an LLC is liquidated (i.e., when all of its assets are distributed to the LLC’s members), the LLC and its members are not taxed. However, the LLC members may recognize gain or loss to the extent money is distributed to the members in liquidation of the LLC. An S corporation, by comparison, will be treated as if it sold the assets to the shareholders at fair market value (FMV). Thus, the taxes on this deemed sale by the corporation flow to the shareholders.
Tradeoffs
Members can Typically Bind the LLC
Because all members of an LLC generally manage the business, all can bind the LLC (to “bind” means to enter into contracts on behalf of the LLC). However, this is usually addressed in the operating agreement. If the LLC agreement provides for the members to elect a committee of managers, those member-managers will typically be the only members capable of binding the LLC. In that regard, the LLC is analogous to a limited partnership in which, generally, only the general partners (as opposed to limited partners) can manage and bind the business.
Life of LLC may be Limited
The life of an LLC is typically limited. States may, for example, limit the life of an LLC to less than 30 years. In addition, the LLC lacks continuity of life. The withdrawal, death, bankruptcy, retirement, insanity, expulsion, or resignation of a member dissolves (ends) the LLC for “nontax purposes.” In other words, the LLC no longer exists under state law, though it may still be taxed by the IRS as a partnership. However, most operating agreements address this issue and provide for the continued existence of the LLC. Some states are currently revising limitations on the life of an LLC. An LLC will, however, dissolve for “tax purposes” when one of two things occurs. The first is a cessation of business. This means that no portion of the business is conducted by any of the members. The second scenario is when there are exchanges or sales (within any 12-month period) that total 50 percent or more of the total interest in the LLC’s profits or capital. If the LLC continues to operate after either of these events, it will be treated as if it were newly created. Members may avoid dissolution if they place a provision in the operating agreement that permits the remaining members to continue the business after a member withdraws. No provision in the operating agreement can prevent an LLC from terminating for “tax purposes.” However, if the LLC is an “electing large partnership” for tax purposes, the sale of 50 percent or more of the total interest in the LLC will not cause the partnership to dissolve for tax purposes.
LLC may be Treated Differently State to State
States differ from one another as to how they treat LLCs that operate within their jurisdictions. Thus, your LLC may be treated somewhat differently in each state in which it conducts business. This could mean higher administrative costs.
Members Typically Cannot Sell their LLC Interest
Generally, a member cannot sell (as opposed to assign) his or her LLC interest unless every member consents to the transfer or the operating agreement provides for such sale. Otherwise, the sale of a member’s interest may dissolve the LLC for nontax purposes. Members may avoid dissolution if they place a provision in the operating agreement that permits the remaining members to continue the business after a member withdraws.
Members Typically have the Right to Withdraw from the LLC
Unless members are restricted from doing so through a provision in the operating agreement, a member generally has the right to withdraw from the LLC. Such an act may cause the LLC to dissolve for nontax purposes. One solution is to place a provision in the operating agreement that both disallows members to withdraw and permits remaining members to continue the business whenever a member ceases to be associated with the LLC. Though a member may nonetheless withdraw, the member might now be sued for violating the operating agreement. If this seems harsh, think about this: A member with no such incentive to remain could unilaterally dissolve the whole LLC against the wishes of all other members merely by withdrawing!
Fringe Benefits are Taxable to Member-Employee
An LLC can generally provide tax-free benefits (such as life, disability, and health insurance) to nonmember employees. However, LLC members are taxed on the cost of fringe benefits received, although the member may be able to deduct a percentage of the cost of health insurance. Contrast this with a C corporation, whose shareholder-employees typically receive fringe benefits tax free.
How To Do It*
Consult an Attorney
You should consult an attorney experienced in business planning. Your attorney should be familiar with your state’s laws prescribing the requirements you will need to fulfill.
File Articles or a Certificate of Organization and Create a Written Operating Agreement
You must deliver a document called the articles (or certificate) of organization to the secretary of state. State law dictates what this document should contain. (Your attorney can help you.) You should also create a written operating agreement. In it, you should dictate, among other things, how the limited liability company is to operate and in what manner profits and losses are to be shared by the members.
*Checklist is not exhaustive.
Tax Considerations
The following discussion assumes that the limited liability company (LLC) is being taxed as a partnership (as most are), not as a corporation or as a sole proprietorship.
Members can Deduct Losses and Generally have Them Specially Allocated
Members can deduct the losses of the LLC on their personal tax returns. Most significantly, a member can generally have deductions “specially allocated” to him or her. This means that a larger number of deductions could be given to the member who pays the most taxes (say, for example, because he or she is in the top individual tax bracket). The result is potentially lower taxes for that member. This feature gives the LLC an advantage over the S corporation, as shown in the following example:
Example: Ken is a 25 percent member-manager of an LLC. The operating agreement allocates 50 percent of all losses to him. The LLC has had $50,000 in losses this year alone. Ken can deduct 50 percent of this $50,000 ($25,000) on his personal tax return. If, instead, Ken were an S corporation shareholder, his deduction would be limited to his percentage of ownership in the corporation (25 percent).
Your method of allocating losses should be recorded in your operating agreement. The method of allocation chosen must have a substantial economic effect for it to be valid. An LLC is a good idea if you anticipate large losses in the first several years of operation, because it allows members to reap immediate tax savings by deducting losses on their personal tax returns.
Caution: Certain limitations on the deduction of losses, including the passive loss rules and the at-risk rules, may apply. Disallowed losses can generally be carried over to later years.
Losses Limited to Member’s Basis
A member’s distributive share of losses is limited to the member’s basis in the LLC—generally, what the member paid for his or her LLC interest plus (among other things) his or her pro rata share of the LLC’s liabilities. Losses that exceed a member’s basis may be carried over and deducted in a subsequent year to the extent that the partner then has a basis greater than zero.
Example: Assume the same facts as in the previous example: Ken is a 25 percent member, and the operating agreement allocates 50 percent of all losses to him. The LLC has had $50,000 in losses this year alone. Ken can deduct 50 percent of this $50,000 ($25,000). However, because his “basis” (what Ken contributed to the LLC for his 25 percent interest) is only $20,000, Ken can deduct that amount only and will have to carry the remaining $5,000 loss to subsequent years and deduct it when he has basis available to offset the loss.
Caution: Certain limitations on the deduction of losses, including the passive loss rules and the at-risk rules, may apply. Disallowed losses can generally be carried over to later years.
A Member’s Basis is Increased by Share of LLC Liabilities
A member can increase his or her basis in the LLC (the number against which the member can deduct losses) by the member’s allocation of the recourse liabilities of the LLC. A recourse liability is one where the member bears an economic risk of loss, such as an obligation to repay the LLC’s creditors upon a liquidation. In addition, to the extent that no member bears an economic risk of loss for a liability (called a nonrecourse liability), the liability is generally allocated to all members in the same proportion as they share profits. This feature gives the LLC an advantage over the S corporation, as shown in the following examples:
Example: Ken, a member in an LLC that is taxed as a partnership, paid $1,000 for his 50 percent interest in the LLC. Thus, Ken’s basis in the LLC is $1,000. Subsequently, the LLC borrows $20,000 from a third party. Ken, who assumes liabilities of the LLC in proportion to his ownership interest, now has a basis of $11,000 ($1,000 + $20,000/2).
Caution: While the member’s basis may increase with increased recourse liabilities allowing more losses to be deducted, basis will be subsequently reduced as liabilities are paid down or when the business is sold and the liabilities are paid off.
Example: Assume the same facts as in the previous example, except that Ken is instead a 50 percent shareholder in an S corporation. Because S corporation shareholders cannot increase their basis by loans from third parties, Ken’s basis will remain at $1,000 despite the $20,000 loan to the S corporation.
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Old Basis
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Liabilities Added to Basis
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New Basis
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General Partner
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$1,000 +
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($20,000/2)
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= $11,000 (Basis reduces as liability is paid down)
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S Corporation Shareholder
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$1,000 +
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$0
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= $1,000
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Members Taxed on Their Distributive Share of Income
A member is taxed on his or her distributive share of LLC income regardless of whether it is actually distributed to the member. Note, though, that if a member’s share of income is retained by the LLC, his or her basis is increased dollar for dollar. This ensures that a member is not taxed twice—once when the LLC retains earned income, and again when the member sells his or her LLC interest or later distributes the income. Alternatively, as you may have guessed, when LLC income is distributed to a member, there is a corresponding decrease in his or her basis. An LLC (or any other pass-through entity, for that matter) that anticipates retaining earnings for business purposes should consider distributing enough income so that each member can pay his or her tax liability.
Members Subject to Self-Employment Tax
A member may render services to the LLC. Payment for such services may be referred to as a guaranteed payment. Such payments are typically subject to self-employment (SE) tax. In addition, the SE tax will typically be imposed upon a member’s distributive share of LLC income. If a committee of managers is elected, however, nonmanaging members will typically be treated like limited partners in a limited partnership. They will not have to pay SE tax on their distributive share. Generally, a member will be treated as a limited partner unless the member (1) has personal liability for LLC liabilities, (2) has the authority to “bind” the LLC, or (3) has significantly participated in LLC business (more than 500 hours during the LLC’s tax year).
Wages to Member-Employees are Generally Considered Business Expenses by the LLC
Wages paid to members who render services to the LLC may be referred to as guaranteed payments. Such payments are considered business expenses of the LLC and are deducted, like all other business expenses, from LLC earnings. The remainder is considered profit (or loss). This profit (or loss), reported by the LLC on Form 1065 and Schedule K-1, is either distributed to the members or retained by the LLC. The members then report their shares of profit (or loss), regardless of whether anything has actually been distributed, on their personal tax returns.
Example: Ken and his sister Liz are 50 percent members in a donut shop, an LLC. Ken is paid $10,000 a year for donut making (guaranteed payment). Liz provides no services. Last year, the shop had $70,000 in income. Assuming no other business expenses, the amount to be distributed to both Ken and Liz or held by the LLC is $60,000 ($70,000 – Ken’s $10,000). Of this amount, Ken and Liz may each receive 50 percent, or $30,000. Ken pays income tax on $40,000 ($30,000 + $10,000 salary), and Liz pays taxes on $30,000.
If, however, a guaranteed payment is conditioned upon LLC profits, the payment is considered a portion of the member’s distributive share and is therefore not treated as a business expense. Such payment would not be combined with other business expenses and would not get subtracted from LLC earnings.
Example: For his services, Ken has instead been promised his 50 percent LLC interest or $30,000, whichever is greater. The donut shop has $50,000 in income. Because 50 percent of $50,000 is $25,000, Ken gets $30,000. The amount that is considered a guaranteed payment is $5,000 ($30,000 – $25,000). Thus, Ken’s $30,000 represents his distributive share of LLC income ($25,000) as well as his salary (guaranteed payment of $5,000). The amount to be distributed to the other members or held by the LLC is $20,000 ($50,000 – Ken’s $30,000).
Fringe Benefits: Deductible by LLC, Taxable to Member-Employee
Fringe benefits are generally deductible by the LLC. An LLC can generally provide certain tax-free benefits (such as life, disability, and health insurance) to nonmember employees. However, like most S corporation shareholders, LLC members are taxed on the cost of fringe benefits received, although the member may be able to deduct a percentage of the cost of health insurance. Contrast this with a C corporation, whose shareholder-employees typically receive fringe benefits tax free.
Members Can Generally Contribute Appreciated Property Tax Free
You can contribute property to the LLC in exchange for your LLC interest. Such a contribution is generally tax free even if the property has appreciated in value since you purchased it. An example of such a transfer is when a member exchanges real property (e.g., an office building to be used by the LLC) for an ownership interest in the LLC. However, there may be later consequences for a member who contributes appreciated property, including possible recognition of gain.
Liquidation of an LLC is Generally Tax Free to Members
Generally, when an LLC is liquidated (i.e., when all of its assets are distributed to LLC members), neither the LLC nor the members are taxed. However, the LLC members may recognize gain or loss to the extent that money is distributed to the members in liquidation of the LLC. An S corporation, by comparison, will be treated as if it sold the assets to the shareholders at fair market value (FMV).
Restrictions on Deductibility for Nonmanaging Members
A member can take deductions to the extent of his or her basis in the LLC. In LLCs that have an elected committee of managers, the nonmanaging members will typically be treated like limited partners. As such, the members will be subject to the passive loss limitation rules. Generally, these rules limit the deductions for losses if the taxpayer does not materially participate in the business.
If you have questions, contact the experts at Henssler Financial:
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- Email: experts@henssler.com
- Phone: 770-429-9166
Disclosures: The following information is reprinted with permission from Forefield, a division of Broadridge Financial Solutions, Inc. This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
