LLCs are suitable
for many business and investment endeavors, including but not limited
to the following:
Corporate joint ventures (where the corporate co-owners desire both
pass-through taxation and limited liability);
Real estate investment and development activities (because the partnership
taxation rules allow investors to obtain basis from entity-level debt,
and special tax allocations can be made to investors);
Oil and gas exploration and development (where the partnership rules
can be used to make special allocations of intangible drilling cost
deductions to investors);
Venture capital investments (where the partnership rules allow pass-through
taxation and creation of "customized" ownership interests
with varying rights to cash flow, liquidating distributions, and tax
items);
Business start-ups expected to have tax losses in the initial years
(which can be passed through to investors);
Professional practices - if allowed under state law and applicable
professional standards (where pass-through taxation can be combined
with specially tailored ownership interests that reflect each member's
contributions to the practice); and
Estate planning vehicles (where the older generation can gift LLC
ownership interests to younger family members while retaining control
by functioning as the managers, and where all taxable income is passed
through to the members).
Accordingly to
a survey in the December 1995 issue of Journal of Accountancy, the top
10 types of businesses operated as LLCs were:
Engineering and management support services;
Real estate services;
Construction and general contracting;
Investment companies;
Retailers;
Health Services;
Agriculture;
Oil and gas extraction;
Restaurants; and
Leasing companies.
Some states
do not permit the use of LLCs in certain lines of business, such as banking,
insurance and farming.
Most advisors agree
that the LLC is the best entity alternative if pass-through taxation
is desired (such as with a service business that has no need to retain
significant amounts of earnings within the business entity). However,
empirical evidence shows that LLCs are seldom formed to operate capital-intensive
and high-growth businesses such as manufacturing and high-tech ventures.
Such businesses typically need to retain all earnings to finance capital
expenditures and growing receivables and inventory levels. These businesses
are most often operated as C corporations in order to maximize cash
flow by minimizing current outlays for federal income taxes.
Because LLCs allow
all members to participate in management without the risk of losing
limited liability protection (unlike a partnership), they are ideally
suited for closely held entrepreneurial businesses.
In summary LLCs
may be the best choice for business and investment ventures if:
There will be more than one owner (but not so many owners that the
ownership interest would be considered publicly traded);
Limited liability protection for the co-owners is an important
consideration;
Pass through taxation is desired;
The advantages of partnership taxation are significant compared
to the alternative of S corporation taxation, or the entity cannot
qualify for S corporation status;
The business activity can be operated as an LLC under the state
law and applicable professional standards; and
The co-owners can tolerate certain legal and tax uncertainties of
LLC status;
Although LLC
statutes place no limits on the number of members, there is a tax problem
if ownership interests are so widely held that they are "publicly
traded" within the meaning of IRC s. 7704. If an LLC's ownership
interests are publicly traded, the LLC will be treated as a C corporation
for federal income tax purposes. LLC's are generally only appropriate
for privately held businesses.
LLPs are probably
the best entity choice for professional service ventures if:
Pass through taxation is desired;
LLC status is unavailable or the state LLP statute offers LLC like
liability protection;
LLP status is permitted under state statutes and applicable professional
standards;
Qualifying as an S corporation would be inconvenient, difficult,
or impossible or the entity could qualify as an S corporation but
the benefits of the partnership taxation rules are significant compared
to those of the S corporation taxation rules; and
The co-owners can live with their exposure to the entity's contract
liabilities.
General Partnerships
may be suitable for business and investment activities including, but
not limited to, the following:
Corporate joint ventures (where the corporate co-owners desire both
pass through taxation and limited liability);
Real estate investment and development activities (because the partnership
taxation rules allow partners to obtain basis from entity level debt
and special tax allocations can be made to investors);
Oil and gas exploration and development (where the partnership
rules can be used to make special allocations of intangible drilling
cost deductions to partners);
Venture capital investments (where the partnership rules allow pass
through taxation and the creation of customized ownership interests
with varying rights to cash flow, liquidating distributions and tax
items);
Business start-ups expected to have tax losses in the initial years
(which can be passed through to investors); and
Professional practices (where pass through taxation can be combined
with specially tailored ownership interests that reflect each member's
contributions to the practice).
General Partnerships
are probably the best entity choice when:
There are at least two co-owners, all of whom have a high degree
of trust in each other;
Pass through taxation is desired;
LLC and LLOP status are unavailable;
Liability concerns can be managed with insurance;
Qualifying as an S corporation would be inconvenient, difficult,
or impossible, or the entity could qualify as an S corporation, but
the benefits of the partnership taxation rules are significant compared
to those of the S corporation taxation rules; and
The co-owners can live with the fact that the general partnership
will not have an unlimited legal life or free transferability of ownership
interests.
In most cases
the desire to limit owners' liability is so significant that only a limited
partnership, as opposed to a general partnership, will make sense. In
the case of professional practices, operating as an LLC, LLP or C Corporation
should be explored. Most advisors agree that general partnerships and
sole proprietorships are by far the least attractive entity option.
Business and investment
activities where Limited Partnerships make sense include, but are not
limited to, the following:
Real estate investment and development activities (where the partnership
taxation rules allow investors to receive preferred returns, special
allocations of tax losses, and additional basis from partnership level
debt);
Oil and gas exploration and development (where the partnership taxation
rules allow preferred returns and special allocations of deductions
from intangible drilling costs);
Venture capital investments (where the partnership rules allow
pass through taxation and the creation of ownership interests with
varying rights to cash flow, liquidating distributions, and tax items);
Business start ups expected to have tax losses in the initial years
(which can be passed through to the partners);
Estate planning vehicles (where the older generation can gift limited
partnership interest to younger family members while retaining control
by functioning as the general partnership, and where all taxable income
is passed through to the partners);
Limited partnerships
can be attractive if;
There are at least two co-owners (but not so many co-owners that
the ownership interests would be considered publicly traded under
IRC s. 7704);
Pass through taxation is desired;
LLC status is unavailable;
Qualifying as an S corporation would be inconvenient, difficult
or impossible;
The entity could qualify as an S corporation, but the benefits
of the partnership taxation rules are significant compared to those
of the S corporation taxation rules;
The cop-owners who will be limited partners can live with the fact
that they cannot become too actively involved in management of the
venture without losing their limited liability protection; and
The co-owners can live with the fact that the limited partnership
will not have an unlimited legal life or free transferability of all
ownership interests.
Most advisors
agree that LLC's when available are superior to limited partnerships.
However, when pass through taxation is desired, limited partnerships are
often the second best choice.
In general, C corporations
may be preferred to LLCs, LLPs, General and Limited Partnerships, and
Sole Proprietorships if:
Limiting owner liability is a critical concern;
There will be only one owner (making partnership taxation unavailable
by definition) and the S corporation restrictions make operating an
S corporation difficult or impossible); or
The activity cannot be operated as a limited partnership, because
the owners who would be limited partners cannot live with the fact
that they must avoid management involvement to maintain their limited
liability protection; and
The activity cannot be operated as an LLC or LLP under state law
and/or applicable professional standards; or
The business cannot be operated as an LLC, because the owners cannot
live with the legal uncertainties associated with LLC status; or
The benefits of pass through taxation are not required (because
the graduated corporate rates counteract the ill effects of double
taxation or because the venture's income can be drained with deductible
payments to or for the benefit of the owners); or
Being able to borrow against their qualified retirement plan accounts
is a critical issue for the owners.
C Corporations
are often underrated because of the issue of double taxation. However,
the differences between corporate tax rates and individual tax rates mean
that pass through taxation often results in higher current outlays for
federal income taxes. Recent empirical evidence shows that C Corporations
are still being formed to operate capital intensive and growth businesses,
such as manufacturing and high tech ventures, because such businesses
typically need to retain all earnings to finance capital expenditures
and growing receivable and inventory levels. Operating as a C Corporation
maximizes cash flow by minimizing current outlays for federal income taxes.
And for very successful businesses, the C Corporation format lays the
best groundwork for going public.
QSBC shareholders
(other than C Corporations) potentially qualify to exclude from taxation
50% of their gains upon the sale of shares. However, the shares must
be held for more than five years, and a number of other restrictions
apply.
In general C Corporation
that meet the definition of a QSBC may be preferred over LLC's Partnerships,
and Sole Proprietorships, if:
Limiting owner liability is a critical concern; and
There will be only one owner (making partnership taxation unavailable
by definition) and the S Corporation restrictions make operating as
an S corporation difficult or impossible; or
The activity cannot be operated as a limited partnership, because
the owners who would be limited partners cannot live with the fact
that they must avoid management involvement to maintain the limited
liability protection; and
The activity cannot be operated as an LLC under state law; or
The business cannot be operated as an LLC, because the owners cannot
live with the legal uncertainties associated with LLC status; or
The benefits of pass through taxation are not required (because
the graduated corporate rates and QSBC tax benefits counteract the
ill effects of double taxation, or because the venture's income can
be drained off with deductible payments to or for the benefit of the
owners); or
Being able to borrow against their qualified retirement plan accounts
is a critical issue for the owners.
The same comments
as apply to C Corporations apply regarding a QSBC, except that the QSBC's
are more attractive than regular C corporations because of the 50% gain
exclusion tax break.
In general S corporations
may be preferred over C Corporations, LLCs, LLPs, partnerships and sole
proprietorships if:
Limiting owner liability is a crucial concern;
Pass through taxation is desired;
The S corporation eligibility rules can be met without undue hardship;
The restrictions on eligible S shareholders do not cause undue hardship
with regard to the owners' future plans to transfer ownership interests
to others for estate planning, family tax planning, or business succession
planning purposes;
There will be only one owner (making partnership taxation unavailable
by definition);
The activity cannot be operated as an LLC under state law and/or
applicable professional standards;
The business cannot be operated as an LLC, because the owners cannot
live with the legal uncertainties associated with LLC status;
· The activity cannot be operated as limited partnership
because the owners who would be limited partners cannot live with
the fact that they must avoid management involvement to maintain their
limited liability protection;
The business either cannot be operated as an LLP, or the liability
protections offered by LLPs are considered inadequate; and
The benefits of partnership taxation compared to those of S corporation
taxation are not considered significant enough to warrant setting
up a partnership, LLC or LLP.
Most advisors
agree that LLCs and limited partnerships are superior to S corporation.
However, when there is a single owner and double taxation must be avoided,
the S Corporation is the only alternative to sole proprietorship status
unless single member LLCs are permitted under state law, and applicable
professional standards.
The sole proprietorship
may be the preferred form of doing business if:
Single member LLCs are not permitted by state law and/or applicable
professional standards;
Adequate liability insurance is available at an accept able cost;
The major liability exposures are from the owner's practice of
a profession (a problem that generally is not cured simply by operating
as a liability limiting entity;
The business is in the early stages, and minimizing administrative
expenses and paperwork is a major objective;
There are no employees;
At this time the owner does not wish to deal with the issue of
how ownership interests will be transferred in the future (for estate
planning, succession planning or other reasons);
At this time, the owner does not wish to deal with the issue of
how additional equity capital might be raised in the future; and
The business is small enough that operating as a sole proprietorship
is still a rational choice in light of all the above considerations.
The primary
attraction of sole proprietorships is their administrative simplicity.
As soon as a business begins to generate significant income and wealth
for the owner, however, the use of a liability limiting entity is highly
advisable. Generally, the S Corporation or single member LLC (if permitted
by state law and applicable professional standards) will prove the best
choice for single owner business, because double taxation is avoided.
However, when it is critical to retain the maximum amount of capital to
finance growth, the C Corporation's lower graduated tax rates can make
it the better choice particularly if the corporation can meet the definition
of a QSBC.
