LLCs have become very popular, principally because of pass-through taxation (federal taxation as a partnership instead of as a corporation). Pass-through taxation means that the profits and losses of the business pass through to the personal tax return(s) of the owner(s). The business does not pay tax on profits, the owner(s) do. This is important because once the owner(s) have paid the taxes, the business can then distribute the profits of the business to the owners in a tax free manner.
This avoids the dreaded “double tax” of C corporations, where the business pays tax on profits, and then the owners pay tax when they receive dividends.
Conversely, if the LLC has losses, the losses pass through to the owner(s) of the business to their personal tax returns, allowing them to shelter other income. Losses will generally be limited to the amount of basis (for tax purposes) they have in their membership interests.
There are three circumstances that will almost always favor formation of a LLC instead of a corporation:
- There is one owner of the business, and that is the way it will likely remain. When there is only one owner, called a “single member LLC,” the LLC will be a disregarded entity for federal income tax purposes, meaning that for federal income tax purposes it will be as if the LLC does not exist. The LLC itself does not have to file a federal tax return; the owner will take the profits or losses on his or her personal tax return (normally a Schedule C). [Keep in mind that the LLC does exist for state taxation purposes and will have to file applicable franchise tax returns and pay applicable franchise taxes].
- There are two owners, they are a husband and wife pair that own the LLC interests as community property, and that is the way it will likely remain. In this circumstance, the owners may elect for the business to be a disregarded entity as if there were a single owner. See IRS Revenue Procedure 2002-69.
- You plan to cash flow the business. When the business will produce profits, and the business plans to make profit distributions to the owners, avoiding the “double tax” will make a big difference the amount of after-tax cash the owners will receive out of the business. The LLC can be ideal for “lifestyle” businesses, meaning the owners plan to make a living through the business, for example, by providing the personal services. This can also be useful for other types of business that will cash flow, such as restaurants.
Other considerations militate against forming your business as a LLC. If you plan to add owners to the business from time to time either by raising capital or issuing equity incentives to employees and independent contractors, the LLC is not ideal. Each time you add an owner you have to amend the limited liability company agreement, and the LLC will have allocate to each owner his, her or its profits or losses of the business annually and provide each owner a K-1 annually. A large number of owners of the business can create and administrative nightmare with preparing and maintaining the legal and accounting documentation. It would make little sense for startups wishing to make an equity-based crowdfunding offer. Can you imagine sending K-1s to 500 crowdfunding investors?
This article originally appeared on Venture Docs, an online platform for automating the creation of important legal documents for startup companies, investors, crowdfunding portals and attorneys.
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