The Evolution of the LLC
The limited liability company (LLC) is a relatively new type of business entity. It first appeared in the United States in the 1970s in Wyoming but was slow to gain acceptance because of uncertain tax treatment under the Internal Revenue Code. Specifically, in order to be able to adopt the favorable pass-through tax treatment of a partnership, the early LLC, among other restrictions, had to have at least two members and could not have the perpetual existence of a corporation.
When so-called “check the box” regulations were adopted by the IRS in January 1997 allowing an LLC to simply check a box to determine how it would be taxed, the LLC gained widespread acceptance in the 1990s. It is a popular choice for real estate holdings and also for small businesses. Every state now allows an LLC to be formed and operated by a single owner, called a member.
Why the LLC is a Popular Choice
There are several reasons for the popularity of the LLC. It is simple to form and maintain, particularly for a single member. It offers pass-through tax treatment to avoid double taxation, unless the members choose an alternative tax classification. LLC members enjoy the same personal liability protection for their personal assets as shareholders in a corporation, but are not required to maintain the same formalities such as annual meetings and written corporate minutes. The LLC also offers members greater flexibility than a corporation in structuring the management of the LLC business. This is discussed in more detail below.
The advantages of the LLC entity type are sometimes misunderstood or exaggerated, and the disadvantages or drawbacks of operating as an LLC are often overlooked or ignored. This article will provide you with information on both the advantages and limitations of owning real estate or operating your business as an LLC.
Initial Ownership Considerations Affecting LLC Advantages and Disadvantages
The number of owners in the LLC and their relationship has a direct bearing on certain factors creating both advantages and disadvantages for the LLC. Specifically, a single member LLC is simple to form, simple to manage, and simple to maintain. From a management standpoint, it is essentially the same as a sole proprietorship but provides an owner with the limited liability protection not available to a sole proprietor business. Unless a different tax classification is chosen, a single member LLC will also have the same pass-through tax treatment as a sole proprietorship.
When a spouse is added as a second member of the LLC, the simplicity inherent in a single member LLC doesn’t really change. For tax purposes, the parties will still be treated as a pass-through tax entity unless they choose a different classification. Spouses have the choice of being treated either as a partnership or as a “disregarded tax entity,” both of which result in pass-through taxation. Spouses also normally would avoid the additional expense involved in preparing a written operating agreement as the governing instrument for the LLC.
When an LLC has multiple members who are not spouses, the management considerations, profit and loss considerations, transfer restrictions and other factors make it prudent for a written operating agreement to be prepared, adding significantly to the formation cost of the LLC.The operating agreement is discussed in more detail below.
The Advantage of Personal Liability Protection
The personal liability protection for the members in an LLC is essentially the same as for the shareholders in a corporation. Except in rare circumstances, members will not be personally liable for the debts and obligations of the LLC business. There is sometimes a misconception that an LLC offers better personal liability protection than a corporation because LLC stands for limited liability company. That’s essentially inaccurate.
There is one scenario, however, that is worthy of mention where the limited liability protection differs between a corporation and LLC. If a creditor obtains a personal judgment against a member in an LLC, the creditor is able to obtain what’s known as a “charging order” against the member’s economic interest in the LLC (but not the full ownership interest). Any distributions of cash that would normally be made to the member must be made to the creditor until the judgment is satisfied. The creditor is not entitled to participate in the management of the LLC business or to enjoy voting rights afforded only to full members of the LLC.
Moreover, a well-prepared operating agreement will also cover this contingency by requiring the vote of a majority-in-interest of the other members (or even a unanimous vote) before a person can be admitted as a full member and have these rights.
A creditor who obtains a judgment against a shareholder in a corporation may be able to enforce the judgment and acquire title to the stock owned by the shareholder, but since shareholders don’t have the right to participate in the management of the corporation’s business in any event, a creditor who gains the rights of the shareholder will generally be limited unless the ownership interest that is acquired is sufficient to control the corporation, cause it to be dissolved (terminated), or otherwise adversely affect the corporation.
One Major LLC Advantage is Management Flexibility
The flexibility in the management structure is one of the main advantages an LLC offers over the corporate form. Every corporation must have the same structure: shareholders, directors, and officers. Even though every state allows one person to form and manage a corporation, that person must still be designated as a shareholder, a director, and be appointed as the president, treasurer, and secretary of the corporation.
This hierarchical structure required for every corporation is set forth in extensive and detailed statutes in every state. Many of the rights afforded to the various positions in the corporate structure (shareholders, directors and officers) cannot be varied by the corporation’s governing documents. Where variances are permitted, the flexibility allowed in altering the management structure is still far more restrictive that an LLC.
The LLC Management Structure and Operating Agreements
An LLC has several management options available. It may be managed solely by the members, designated as a member-managed LLC. The members also have the option of appointing one or more officers, though this is not a requirement. A third option is for the members to appoint one or more managers, designating the LLC as manager-managed. A manager-managed LLC becomes more akin to a corporation where the managers operate the LLC business on a daily basis while the members may take on a more passive role like directors in a corporation.
In addition to these choices for management structure, the management flexibility is further manifested in the ability to create a comprehensive, customized operating agreement. An operating agreement is essentially a partnership agreement among LLC members and any managers. If properly prepared, it will be specifically customized to reflect the exact relationship that the members desire. It will describe their respective duties and responsibilities, their rights and powers, permissions or restrictions on transferring membership interests, the method for valuing an ownership interest that may be transferred, and many more factors.
In a manager-managed LLC, in addition to the above factors that pertain only to the members, a well-prepared operating agreement will specifically describe the duties and responsibilities and powers and limitations of a manager, compensation, time-commitment, procedures for removal, the types of decisions that require member approval, and matters that are left solely to the decision of the members.
The Two-Edged Sword of Management Flexibility and Operating Agreements
The LLC is rightfully touted for the management flexibility it offers. However, this flexibility is most evident when the LLC has multiple members, and even more so when the members add one or more managers to the LLC structure. What is often overlooked in this discussion is that a written operating agreement is not a “one-size-fits-all” document where one simply purchases or is provided a preprinted form and fills in the blanks, or tries to edit a sample document provided by an incorporation service company in its forms CD.
An operating agreement combines the provisions typically included in a partnership agreement as well as many provisions usually included in a corporation shareholder buy-sell agreement. These include provisions relating to the ownership of the business, the voting rights of the members, allocations of profits and losses, distributions from the business, any preferential rights or authority given to one or more members, requirements and procedures for admitting a new member or expelling a current member, and many more important provisions. In short, an operating agreement should be prepared by an experienced attorney to be done properly.
When you read that an LLC is “simpler to form” than a corporation, you should understand that this will not be the case if you are forming a multiple-member LLC with a customized written operating agreement. Further, as with any agreement, as circumstances change and provisions in the original agreement become outdated, it will be necessary to amend the agreement from time to time at additional expense.
The necessity of having a customized written operating agreement has another drawback. Because of its inherent complexity, it may operate as a deterrent to attracting investors when the business is structured as an LLC. Investors understand stock ownership in a corporation and the hierarchical structure with a corporation’s shareholders, directors and officers. Investors also understand that corporate statutes provide an extensive degree of regulation for a corporation.
On the other hand, state LLC statutes are much less extensive and offer far less regulatory protection because they leave most of the responsibility for determining the management and operation of the LLC to the operating agreement. Rather than having a “bundle of rights” based on stock ownership in a corporation, a prospective investor must often retain an attorney to review an operating agreement and explain the rights the investor will have as a member of the LLC.
LLC Tax Classifications and Advantages Over an S Corporation
As touched upon above, the default or assigned tax classification for both a single member and multiple member LLC is “pass-through” taxation. For a single member LLC, this pass-through taxation will be either as a sole proprietor or a disregarded tax entity. For a multiple member LLC, it will be partnership tax treatment.
Both single and multiple member LLCs also have the option to be taxed either as a C corporation or as an S corporation. Let’s explore why an LLC would choose either of these corporation tax classifications.
A C corporation offers one major tax advantage over LLC and S corporation pass-through taxation: it may provide certain fringe benefits to employees that are excluded from the taxable income of the employee but are still deductible as expenses of the corporation. The following are some of the fringe benefits recognized by the IRS:
- Accident and health benefits;
- Adoption assistance;
- Dependent care assistance;
- Group-term life insurance coverage; and
- Health savings account contributions
LLC members are treated like partners in a partnership for tax purposes and the value of any fringe benefits they receive must be reported as part of their taxable income. If the LLC members are actively involved in the management of the LLC business and these types of fringe benefits would be attractive to the members, they might consider the tax advantages they would receive by choosing C corporation tax classification for the LLC while also balancing the potential for double taxation that is inherent in the C corporation classification.
While the S corporation tax classification would avoid the double taxation issue, it would not allow the LLC members to enjoy the fringe benefits tax advantage because employees in an S corporation who own 2% or more of the corporation stock must still report the value of the fringe benefits they receive as taxable income and pay tax on this value.
Choosing the S corporation tax classification would, however, allow members who are actively involved in managing the LLC business to achieve some savings of self-employment (SE) taxes, primarily Medicare and Social Security taxes that have a combined rate of 15.3%. Just like in a traditional corporation, the LLC members would be treated as employees of the LLC and be paid a reasonable salary based upon the services they provide. Any additional amount each member receives in a year in excess of his or her salary would be treated as a profit distribution rather than compensation and not be subject to SE taxes.
LLC Advantages Regarding Ownership Requirements and Profit and Loss Allocations
A multiple member LLC taxed as a partnership and an S corporation are both pass-through tax classifications. There are differences, however, and these favor the LLC. First, certain requirements must be met to be entitled to S corporation tax treatment. The most significant requirement is that the shareholders must be individuals who are U.S. citizens or resident aliens. Certain types of trusts and estates may also be an S corporation shareholder, but shareholders may not be other corporations, LLCs, nonresident aliens, or other entities.
Profit and loss distributions to S corporation shareholders must be based on their ownership percentages in the corporation. A shareholder who owns 10% of the corporation’s stock must report a distribution of 10% of the corporation’s year-end taxable profit or 10% of the corporation’s year-end loss on the shareholder’s personal tax return.
In an LLC, there are no such restrictions on who may be a member. Nonresident aliens, other corporations and LLCs, trusts and other entities may all be members. There is also no requirement that profits and losses be distributed to the members based upon their ownership percentages. A member with a 20% ownership interest could receive 50% of the year-end profits. A member with a 10% ownership interest could receive 75% of the year-end losses. A written operating agreement would have to provide for these disproportionate allocations because otherwise a member’s share of profits and losses would be based on his or her ownership percentage.
How would these disproportionate allocations be used? Here’s an example. Let’s suppose Alan and Bob wanted to start a web design and web hosting business. They have the experience and the know-how but lack the money to purchase the necessary equipment and other assets. They need outside investors. To keep this simple, let’s assume they find one investor who is willing to provide the necessary cash.
Alan and Bob will each have a 25% ownership interest in the business and the investor will have the other 50%. Alan and Bob will each draw a small salary until the business becomes profitable. The investor wants to have preferred distributions to reduce the amount of his investment before Alan and Bob are entitled to receive profits based upon their ownership percentages.
The parties prepare a written operating agreement that provides for the investor to receive 80% of the profits from the business until half of his investment has been returned to him. Alan and Bob will each receive 10% of the profits during this period. The agreement also provides that the investor will receive an allocation of 80% of any net operating loss of the LLC business while Alan and Bob will each receive 10% of any reportable loss. This allows the investor to be able to use this loss to offset taxable income from other sources since Alan and Bob can’t use the losses personally.
These types of disproportionate allocations cannot be implemented among shareholders in an S corporation because they are required to allocate profits and losses based on their ownership interests in the corporation.
LLC Advantage in Real Estate Investments
Tax regulations benefit the LLC choice when it comes to real estate investments, particularly the treatment of losses.
The profits distributed from an LLC and an S corporation are treated the same: all profits flow through to the owners and are taxed at the personal income rate. With both tax classifications, any losses also flow through to the owners. In addition to the ability to have losses allocated in different percentages that ownership interests discussed above, the LLC has an advantage in how the losses are calculated.
In an LLC, members are allowed to add the amount of certain recourse debt mortgage to their basis for the purpose of computing a loss. For the S corporation, this is not the case. Only debt personally loaned and properly documented may increase shareholder basis in S corporation stock.
Let’s say you purchase a rental home for $150,000. You invest $15,000 as a down payment and finance $135,000 with a mortgage on the property. Your tax basis is $15,000. Vacancies and rental values leave your property with a $25,000 loss at the end of year one. If you had created an S corporation, the IRS will only allow you to take a $15,000 loss on your personal income tax (because your tax basis is $15,000); the remaining $10,000 loss will be deferred. But with an LLC, you’re allowed to deduct the entire $25,000 in the first year.
This advantage of the LLC in owning real estate should be balanced with some offsetting disadvantages. There are title, financing, bankruptcy and other issues that remain unsettled in this area because the LLC is a relatively new entity and these issues have not had sufficient time to be tested and resolved by the courts. This uncertainty commonly results in additional complications for an LLC when dealing with lenders, title companies and others who provide services in connection with real estate transactions. To learn more about these unsettled issues, please go to our Articles section and select “Forming an LLC for Rental Property: Traps for the Unwary.”
Taming Another LLC Exaggeration
You will likely search in vein to find any article that discusses the advantages of the LLC that doesn’t include among this list the lack of “formal meetings and burdensome paperwork” required for a corporation. This conjures up the image of the small business owner and his co-shareholder wife, close friend or relative spending countless hours in formal corporate meetings and preparing reams of detailed written minutes to document every action taken by the corporation rather than devoting this time to running the business.
Nothing could be further from the truth! There is no requirement in any state corporation laws that shareholders or directors of a corporation ever hold a meeting. Corporation statutes in every state allow actions to be taken by shareholders and directors by simply signing a written resolution agreeing or consenting to a decision on behalf of the corporation without ever holding a meeting. These are known as “written consent resolutions” or “written consent minutes.” As long as the written consent is signed unanimously or by the required majority of shareholders or directors, the written consent is valid and effective.
Moreover, in a small business corporation, the types of activities or events that need to be documented in written minutes is usually quite limited because only certain important activities or events need be documented in minutes. These include such things as signing important documents (leases or purchases of property, equipment, vehicles, etc.), borrowing money, adopting employee benefits such as a medical plan or retirement plan, and the annual election of directors by the shareholders. A typical small business corporation may have 2-5 such events in any year and the minutes could be done in a couple of hours at most. In short, corporate minutes are not a burdensome task at all, and the avoidance of formal meetings and corporate minutes should not be a heavily weighed factor in selecting the LLC form.
There are distinct advantages to forming an LLC in certain situations but it should not be perceived as the best choice in every situation. For a sole proprietor who will remain a sole owner, it offers a simple solution to establish a limited liability entity and maintain the advantage of pass-through tax treatment.
For multiple owners, the choice requires more analysis of the objectives of the members, their relationship, and whether the advantage of a flexible management structure and the accompanying cost of having a customized operating agreement prepared offers the best solution.