Limited Liability Company

The one form of business entity that has gained a lot of popularity in usage over the last couple of decades is the Limited Liability Company (“LLC”). The LLC is a state-chartered entity that provides for a shield of liability against debts that are asserted against the business or real estate contained within the LLC much like a corporation. The LLC (if it is a single member LLC) can be taxed as a disregarded entity and reported on the individual taxpayer’s 1040 Return. If it elects to be taxed as a partnership, when there are two or more members, then the LLC needs to file a separate partnership tax return. If it is taxed as a Corporation, then you would need to file a corporate tax return.

Most of our discussions here are going to concentrate on the LLC. We have talked about the flexibility of the LLC. Depending on the number of LLC members and the tax election made by the LLC, the entity will be taxed as either a corporation, partnership, or as part of the LLC member’s tax return (as a disregarded entity). The LLC is a very good asset protection vehicle which protects against both outside and inside creditors. It is relatively easy and inexpensive to form and operate. You do not need the corporate formalities that are associated with a Corporation. At the same time, there can be complications and these complications must be addressed in the Operating Agreement which is the agreement governing the LLC. Additionally, in California, there is Gross Receipts Tax which is imposed by the Franchise Tax Board on all LLCs and based on the LLC’s annual gross revenue. This tax maxes out in 2019 at $11,790.

A single member LLC is generally taxed as a disregarded entity like a Sole Proprietorship. Multi-member LLCs are generally taxed as a Partnership. A single member LLC taxed as disregarded entity means that no separate federal income tax return is required and the business of the LLC is treated as either a real estate investment of the single owner or as the business of a proprietor.

The principal advantage of the single member LLC is that it is disregarded as a federal tax entity and does not have to file a separate federal income tax return. The income expenses of the single member LLC are reported on the owner’s Form 1040 on Schedule C if it is a business or with respect to real estate on Schedule E. Many structures of a single member LLC, of course, provide for continued authority vested entirely in the single member who is normally the manager of the LLC.

A vested management structure is where the management is vested in a single manager (like a General Partner in a Limited Partnership). Direct management, on the other hand, is commonly utilized with a member-managed LLC where there are multiple members. One of the problems with a multi-member LLC is that the members are subject to self-employment taxes on allocated profits. With an LLC, a member transferee that it is not admitted as a member succeeds only to the transferor’s economic rights and not the right to participate in the management or in some cases to demand information.

There are two types of creditors; namely, “inside” or “outside.” An inside creditor is a creditor whose claims are directed against the business operation or real estate operated and owned inside a business entity (e.g., a lawsuit against the LLC). An outside creditor is a creditor whose claims are outside of the scope of the business entity and are generally asserted against the owner of the business individually. An outside creditor will typically attempt to reach the individual assets of the business owner, including the owner’s LLC member interests, to satisfy a judgment. Provided that the LLC can withstand an attack to its veil of liability protection, an inside creditor is generally limited to remedies against the assets within the LLC itself. As a result, single-member LLCs (like a Corporation) typically do not have any protection from outside creditors. In contrast, multi-member LLCs generally have the best protection from outside creditors because of the Charging Order (see below).

Investment assets are normally better owned by an LLC because of the fact that there is a step up in basis upon the death of one of the members for tax purposes and any liens or debts on the operating assets (like a mortgage on real estate) are added to the basis of the individual owner which allows for more deductions.

New Tax Law

Section 199A was enacted as part of the Tax Cuts and Jobs Act and is in effect for tax years beginning after December 31, 2017 and before January 1, 2026. Section 199A provides a deduction of up to 20% of income from a qualified trade or business operated as a Sole Proprietorship, Partnership, S-Corporation, Trust or Estate. Specifically, Section 199A was enacted to provide tax relief for small pass-through businesses that do not operate as C-Corporations (since the C-Corporation tax rates were significantly reduced under the Tax Cuts and Jobs Act). Unlike the decrease in the C-Corporation tax rates, the 199A deduction is subject to certain limitations, including limitations based on the type of business and the taxable income of the taxpayer, among others. Despite the limitations of the Section 199A deduction, many tax advisers and legal professionals understand that the new 199A deduction has the potential to offer a valuable benefit to the owners of LLCs.

The LLC Operating Agreement

The Operating Agreement of the LLC is the basic document that governs the rights and duties of the members and governing operations of the LLC. In California, as in many states, the Operating Agreement need not be in writing, but it obviously should be. The Operating Agreement must contain basic information, including the entity name and organizational data for the LLC. The address of the principal place of business and records location should also be included. In certain circumstances, it may also be appropriate to set forth the business activity of the LLC.

The LLC Operating Agreement should also contain other provisions including: the voting rights of the members; the right to call a meeting of the members; the procedure to admit new members; the process for initial, mandatory, and additional capital contributions; the rights of members upon dissolution of the LLC; the rights of the members and the LLC to buy another member’s interest upon the retirement, divorce, death, or departure of a member; the appraisal procedure for valuing LLC member interests; and the transferability of a member interest. Some of these transferability provisions have potential asset protection ramifications because if a creditor becomes a member as a result of legal proceedings against the debtor member, the other members may disagree with the recommendations by that member and they do not want that member to have any authority over the business.

Depending on the nature of the business of the LLC and its capital needs, the Operating Agreement may also contain sophisticated provisions related to the capital accounts of the members of the LLC. Further, the Operating Agreement will outline the scope of duties of the manager, along with other applicable provisions such as compensation, indemnity, and the scope of authority for the manager for major decisions such as capital calls, dissolution, and sale of all or substantially all of the LLC assets, among other things. It also usually contains provisions regarding the substitution or changing of the manager.

In setting up an LLC, particular attention has to be paid to allocation of profits and losses. It is typically pro-rata by ownership percentages, but it may be by adjustments for contributions and withdrawals. A buy-sell agreement with respect to the buy-out of an individual who leaves, for one reason or another, often is set forth in format of a cross purchase agreement for the other shareholders buying the departing member out or it can be a redemption type of an agreement for the entity itself buying the departing member out. It is often times covered by insurance. Another problem is disability. Disability insurance is very expensive. Bankruptcy, divorce, withdrawal all have problems and we mentioned that valuation has to be taken into account in the event of a buy-out. In California, the community property law usually requires that the member’s spouse consent to and approve the Agreement.

Types of LLCs

A multi member LLC is typically taxed as a partnership. However, the LLC can elect to be taxed as an S-Corporation providing the members qualify as S-Corporation owners. The standard Operating Agreement is written for an LLC taxed as a partnership. It has to be amended to comply with the S-Corporation rules of one class of stock, income/loss allocations, etc.

The remedy for a judgment creditor of an LLC member is a Charging Order. This should be applied without regard to the tax status of the LLC. However, it may not apply to a single member LLC.

The principal disadvantage of having the LLC taxed as a disregarded entity or a partnership compared to an S-Corporation is that all business income is subject to self-employment tax. Sale of a member interest may generate ordinary income or loss, depending on the assets of the LLC, under IRC §751. The balance is capital gains, although some may be at 25% or 28% of federal rates. A pre-existing election under IRC §754 may cause a reduction in the basis of partnership assets.

The principal tax advantage of an S-Corporation over an LLC taxed as a disregarded entity or a partnership is that the sale of S-Corporation stock is usually all capital gains. Also, provided reasonable salaries are paid, distribution of business profits are not subject to payroll taxes.

The principal disadvantages of having the LLC taxed as an S-Corporation is the lack of flexibility in allocating income or distributions. Distributions and allocations of income have to be based on the percentage interest of ownership. Moreover, the basis in S-Corporations stock for purposes of deducting losses is increased only by direct loans from the shareholder to the S-Corporation. This means that if the S-Corporation has a debt, it does not necessarily increase the tax basis of the owner. Moreover, reasonable compensation for services, subject to payroll taxes, must be paid regardless of the source or character of the income. Distributions of property to shareholders normally generate gain to the S-Corporation.

The answer to the question of what form of business entity is the best for tax purposes depends on the specific taxpayer. Because this determination is initially made before the taxpayer has begun the business, it is important to review not only the business plan, but also the reasonableness of the assumptions on which the business plan is based. Further, the ongoing viability of the initial tax election must be revisited by the LLC owner and his advisers from time to time to make sure it still achieves certain goals and objectives.

For more information on Limited Liability Companies In California, an initial consultation is your next best step. Get the information and legal answers you are seeking by calling (714) 384-6300 today.

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