Limited Liability Companies
A limited liability company (LLC) is a partnership or a sole proprietorship that limits the liability of the business to the business, not to the partners or proprietor. Unlike working in a general partnership, the partners of an LLC can operate the business without exposing themselves to personal liability for the debt or torts of other partners or for the business. Only the business assets are subject to creditors' claims, not the personal assets belonging to members, even if the LLC only has a single member. However, the IRS and state tax authorities can collect LLC payroll taxes directly from members. Of course, even key employees of C corporations can be held personally able for payroll taxes.
Like a sole proprietorship or a partnership, gains and losses pass through to the owners of the business. Owners are called members and must report and pay taxes on the LLC income on their individual tax returns and they must pay estimated taxes quarterly. LLCs do not pay federal income taxes, although they may pay state taxes. Active members, but not passive investors, also pay self-employment taxes.
A limited liability company combines the corporate benefit of limited liability for the owners and the benefits of partnership taxation, with a single level of tax at the owner level and possible special allocations of income, losses, and cash flows. However, LLCs can elect to be taxed as a C corporation. Most states require annual tax reporting by LLCs.
To report their taxes, single-member LLCs file Schedule C, Profit or Loss from Business, single-member farming LLCs file Schedule F, Profit or Loss from Farming, and multimember LLCs file Form 1065, U.S. Return Of Partnership Income. Because single-member LLCs file like sole proprietors, the LLC is considered a disregarded entity by tax authorities.
The advantages of the LLC over a corporate entity includes the following:
- an LLC is cheaper to operate;
- an LLC can allocate income and expenses to the members that differs from their ownership interest, while corporations must allocate income and expenses according to the shareholders' percentage of ownership;
- an LLC can have an unlimited number of owners, including foreign owners, while an S corporation is limited to 100 shareholders, none of whom can be nonresident aliens.
LLCs are much like limited partnerships except they do not require a general partner that assumes full personal liability for all business debts. Furthermore, unlike LLC members, limited partners can lose their limited liability if they participate actively in the business.
Since LLCs are pass-through entities, there is no double taxation of profits as there is with a C corporation. Furthermore, a liquidation of the C corporation may result in corporate and shareholder taxes, while a liquidation of an LLC usually only has tax consequences to the members. However, any profit left in an LLC at the end of the tax year is taxable income to the members, whether they withdraw the money or not. Hence, they do not benefit from the lower corporate tax rate on C corporations.
Many states also allow the formation of limited liability partnerships (LLPs), which is an LLC for specified professionals — usually state licensed occupations, such as doctors, accountants, lawyers, or architects. The LLP designation, or RLLP for Registered Limited Liability Partnership, must be part of the business's name in all legal transactions and in public advertising. Unlike a general partnership, the partners of an LLP do not have liability for malpractice by the other partners; they only have liability for their own actions. Generally, LLPs are available in those states that do not allow some professionals to be part of an LLC. Additionally, some businesses cannot be LLCs, such as banks, insurance companies, and nonprofit organizations.
Under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, allows pass-through entities, such as partnerships, limited liability companies, and S corporations, and sole proprietorship's and independent contractors to deduct 20% of their business income. However, this deduction starts to phase out for couples earning at least $315,000 or $157,500 for singles.
This new business deduction, referred to as the §199A deduction or the deduction for qualified business income, equals the lesser of:
- 20% of qualified business income + 20% of qualified real estate investment trust dividends and qualified publicly traded partnership income, or
- 20% of taxable income – net capital gains
Unlike the changes for regular taxpayers, most of which expire in 2025, most of the tax changes for businesses have been made permanent.
Forming an LLC
LLCs are regulated under state law and while the laws vary among the different states, there are some common elements. To form an LLC, members must contribute money, property, labor, or skill, to carry on a trade or business. Members can include individuals, other LLCs, corporations, and foreign entities. The members must provide written articles of organization (aka certificate of formation, certificate of organization) that is filed with the Secretary of State. Filing fees generally range from $50 or more, and some states require the payment of an annual franchise tax.
Unless the LLC has only a single member without employees, in which case, he can use his own Social Security number, it must obtain a federal identification number (FEIN), especially if the LLC will have employees. There may be other requirements such as the publication of the business name in a local newspaper, a local business or occupational license, or a sales tax permit.
An operating agreement governs LLC members and their operation of the LLC, including voting rights, who has check-signing authority, profit-sharing, rules for ownership transfers, responsibilities of the individual members, and other essentials. An LLC has no documenting requirements like corporations, such as keeping minutes, passing resolutions, or recording annual meetings, although it may be wise to document important decisions.
The operating agreement for a multimember LLC must specify the percentage of income or loss allocated to each member. LLCs also allow special allocations of separately stated items, as do partnerships, but they must satisfy specific tax code requirements and must be specified in the LLC operating agreement. The purpose of special allocations cannot only be tax avoidance.
Although converting another business entity to a limited liability company is not difficult, it may have tax consequences, especially if the previous business entity was a corporation. In such a case, a C corporation would have to be liquidated, where, under tax law, the assets of the corporation will be treated as being sold to the shareholders, resulting in income or losses for both the corporation and the shareholders.
Many businesses use multiple LLCs, especially for owning real estate. This further limits liability to each individual LLC. However, greater administrative expenses and taxes may have to be paid, since most states tax LLC entities. However, some states — Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, Utah, and to a limited extent, Wisconsin — allow a type of entity known as a series LLC (aka cell LLC) that can be used to manage other LLCs, while each of the individual LLCs still maintain separate liability.
- An LLC can request an extension for filing its tax return, but the extended period is for only 5 months instead of the 6 months accorded to individuals.