Non-Tax Benefits of Forming an LLC.
There a number of non-tax benefits that stem from formation of an LLC. Chief among these non-tax benefits are the following:
- LLC members are shielded from personal liability. This is an advantage enjoyed by corporate shareholders and limited partners in a limited partnership. However, unlike in a limited partnership, where one general partner has to be designated to be personally liable for partnership debts and obligations, no such restriction exists in an LLC.
- LLCs may be managed and directed in their day-to-day operations by their members or owners. This provides great governance and control flexibility and eliminates the need for a board of directors. Management may be concentrated or decentralized.
- LLCs are not as formal as corporations. For example, LLCs are allowed to dispense with annual meetings which are often required for corporations.
- LLCs may have an unlimited number of members. For example, S corporations may have no more than seventy-five shareholders. Further, an S corporation may not have any foreign shareholders or investors. Additionally, shareholders in S corporations may only be individuals or certain types of trusts. LLC members may be individuals, trusts, corporations, or partnerships.
- LLCs may issue multiple classes and series of stock and equity. S corporations are limited to the issuance of a single class or series of stock.
- In a number of states one person may form an LLC. This is much like a sole proprietorship, but with limited liability. A partnership requires two or more individuals.
- Employee benefits programs otherwise unavailable to a sole proprietor or partnership may be available to the LLC to attract and retain the services of key employees.
LLC Tax Treatment
State law plays a large role in determining how an LLC will be taxed. In the 1990s, the Internal Revenue Service (IRS) adopted so-called check-the-box regulations that govern the tax treatment of LLCs. If state law does not require classification and treatment like a corporation, an LLC with two or more members may elect to be treated as either a corporation or a partnership. Where corporate status is chosen, the LLC prepares a separate entity tax return and is taxed like a corporation. If partnership status is chosen, the LLC is treated like a pass-through entity and taxes are reported on the individual owners tax returns. In states that allow single member LLCs, the LLC may be treated as a corporation or a pass-through entity and taxed like a sole proprietorship. As a default rule, if the LLC does not elect how it wants to be taxed (as a corporation or partnership) IRS regulations mandate tax treatment as a partnership.
The ability to elect partnership taxation is a great benefit to LLCs. Corporations are subject to double taxation. The corporation pays separate entity taxes. Shareholders pay individual taxes on dividends and distributions. However, when taxed as a partnership, with pass-through treatment, the LLC avoids the double taxation problem corporations present.
Tax Benefits Associated with LLCs
A number of tax benefits are associated with the formation and operation of an LLC. Chief among these tax benefits are the following:
- LLCs may allocate profits and losses on a basis other than ownership percentages.
- According to § 754 of the Internal Revenue Code (IRC) an LLC may make an election to adjust the tax basis of assets after a change in ownership. Further, § 754 allows for the use of debt to increase the basis in determining an owners share of ownership.
- Where restrictions are placed on LLC membership alienability, marketability discounts may be available to offset the basis of member ownership. Marketability discounts are based on the availability, or lack thereof, of a market in which to liquidate the assets and interests of the LLC.
- Key person discounts may be available for estate planning purposes in order to account for the lack of performance of services of a key member of the LLC who has been rendered disabled, incapacitated, or dead.
- Minority discounts may be available for LLCs where the minority-interest holding members, if any exist, lack the ability to manage the LLC.
Family and Estate Planning Guidance: Using LLCs to Benefit the Small Business Owner
Due to their flexibility and non-tax and tax advantages, LLCs can be useful tools in the hands of wise estate planners to assist in answering business continuity and succession planning issues long before they become problematic and potentially catastrophic. In general, LLCs are useful in diminishing family dramas and rivalries if care is taken in their formation and structuring. The LLCs Articles of Organization or Bylaws hold the key in merging family and estate planning into business planning. The Articles of Organization should and must definitively speak to the issues of disability, incapacity, resignation, retirement, death, divorce or other domestic disturbance, debt, and creditors and bankruptcy. In terms of planning guidance, the Articles of Organization should outline and provide procedures and protocol to address the following issues as they arise:
- Resignation or retirement of members or key employees;
- The distribution of LLC assets upon the settlement of a legal separation, divorce or dissolution;
- The effect of a foreclosure of debt and the personal bankruptcy of a member;
- Qualifications to hold LLC offices; and
- The disability, incapacity, retirement, and death of an LLC member.
Finally, with an LLC in place, the small business owner is wise to consider the stand-alone adoption of a Buy-Sell agreement. Legally, a Buy-Sell agreement is a contractual agreement that would speak to the sale of LLC membership interests upon the happening of a specified condition or event. In essence, it would bind the LLC interest holder and the LLC itself to repurchase interests in the LLC upon the occurrence of a triggering event. This triggering event could be the disability, incapacity, resignation, retirement, or death of an LLC member. Offers by outsiders or others to purchase assets or interests in the LLC could very well trigger such an agreement. The Buy-Sell agreement would assure that all LLC interests are accounted for and are being used properly. The Buy-Sell agreement provides a further crutch to ensure that the LLC is not crippled further by the disability, incapacity, resignation, retirement, and death of a member or other specified events.
Disability, incapacity, retirement, and death most certainly make business continuity and succession planning difficult or impossible. Families are often faced with the seminal question: Is it worth keeping this business in the family, or should we just let it go? The next question is often the following: If we decide to keep the business going who is going to manage the business? Establishment of an LLC long before these issues arise gives the small business owner time to groom and train replacements within the family. If this effort fails, the LLC may serve as a useful vehicle to look outside the family to attract and retain key leaders to carry on the business and legacy. Employee benefits and opportunities to own equity in the LLC may go a long way towards attracting the leaders to guide the business beyond the capabilities or earthly limitations (i.e., sickness and death) of the founding member(s).
Some people say that sometimes business and family do not mix. Sometimes this is true. Business and family can mix quite well if thought and planning take place on the business side of the equation. LLCs as outlined above hold special appeal to small business owners concerned about business continuity and succession planning. LLCs offer many non-tax and tax advantages over other forms of business that small business owners and their advisors alike should strongly consider. LLCs are excellent entity choices to address the recurring issues of risk and liability, capital formation and financing, governance and control, and business continuity and succession planning. Finally, the tax benefits and impact of LLC ownership, due to the hybrid nature of an LLC, are tremendous.