Is an LLC Right For You?

Is an LLC the Right Choice for your Business? State laws vary as it pertains to filing requirements and fees. You must refer to the laws applicable to the state or states you are doing business in. This article is intended to provide the tax ramifications at the Federal level but I must include some potential state issues as well. In this case I am using NYS in my example to point out the additional cost associated with forming an LLC. Each state may or may not be similar to NYS so I recommend that you refer to the state or states you are doing business in.

LLC's are one of the most frequently used business entities. Most of the time the business owner forms the entity without consulting an experienced business or tax advisor, often with dire tax consequenses. Even the NYS Department of state Division of Corporations Website mentions this fact "Therefore, it is advised that when deciding which entity to establish, the business situation be analyzed with a mindful eye on the tax implications.

I underlined the last sentence because it is the focus of this discussion. The fact of the matter is that a multitude of LLC's are being formed for the wrong reasons with dire consequences for the businesses and their owners who will bear the burden of this decision for years and possibly decades to come. For some small businesses it will literally be the difference between success or failure.

I will explain what an LLC is and and more important, why it is inappropriate for most of the small and micro business entities being formed. We will also discuss alternatives to using an LLC as a business structure and potential solutions for existing business entities already formed and doing business as an LLC.

What is an LLC? Before we can even get into why the LLC structure is wrong for your for your business we should look into what an LLC actually is, how it came about and what purpose it serves.

A Limited Liability Company (LLC) is a hybrid of a partnership and a corporation. LLCs closely resemble and are taxed like partnerships, but, like corporations, offer the benefit of limited liability.

An LLC is formed by registering a unique name through the Secretary of State in the state where the business is headquartered. Each state has its own specific rules regulations and fee schedule for forming an LLC. The cost of forming an LLC is significantly more expensive in NYS because of the requirement to publish a notice of intent. As I stated in my opening paragraph state laws vary on filing requirements and fees.

TAX STATUS OF AN LLC

For each legal form of doing business there is a tax status associated with that form and different rules and regulations pertaining to each type of entity. Although the legal liability implications are not the subject of this article I must make some note of it here to bring to light the thinking behind why people choose to form an LLC and why it may not be the right choice.

Here is a summary of the basic forms available to small businesses.

Sole Proprietor - The most basic business structure. An unincorporated business entity with one owner. The owner has no legal separation between themselves and the business. In other words, unlimited legal liability. A sole proprietor files their business return on a schedule C and is part of their personal tax return.

Partnership- Another unincorporated business entity and the same unlimited legal liability as a sole proprietor. A partnership has more than one owner (the owner does not have to be an individual but I want to keep this simple) and files its tax return on form 1065. Each partner receives a K1 showing the pass-through income, expenses and other items that the partner will report on their own tax returns.

C-Corp- A corporate entity that is separate from its' owners. Owners enjoy limited legal liability meaning that for the most part, the owners do not share in the risk of doing business beyond what they have invested in the business. Keep in mind that there are always exceptions to these rules and I am not covering legal liability matters here. The simple fact is that a small business owner does not have to worry about corporate creditors coming after their personal assets. Lets keep it at that. Most corporations file form 1120 and the corporation pays its own tax. Distributions from profits are considered dividends and the shareholder reports that as income on their personal return. Hence the term double taxation. The same income is taxed at the corporate level and then the individual level.

S-Corp- The same as a C-corp but with the tax attributes of a partnership. There is no corporate level tax. The shareholder receives a K1 from the corporation and reports the income, deductions and other items on their personal tax return. You get the limited liability of a corporation without the double taxation.

Now we come to the LLC. A Limited Liability Company is just that. The owner/s enjoy the same limited liability protection as a corporate shareholder. This is great until we get to the tax part. You see an LLC does not have any tax classification. The IRS gives LLC what we call "default" classifications. There is no tax form for LLC's because they will use what ever their default classification forces them to use. There are really only two default classifications which is a single member (owners of LLCs are called members) LLC defaults to sole proprietor tax status and everyone else (more than one member) becomes a partnership for tax purposes. Now this is fine if this was your plan which was thought out with a crafty tax adviser. My experience shows me that the sometimes devastating tax implications they have created is not what they intended. Many times it's to late to fix.

Let me explain a few tax facts here. A single member LLC defaults to sole proprietor status for tax purposes. There are three major drawbacks to this. First, sole proprietors are much more likely to face an IRS audit then a corporate entity. Second-all the profits are subject to social security tax. Third-there are limited tax planning options available to sole proprietors as compared to corporate entities.

Now lets take the case of an LLC with more than one member. The default classification is partnership which will file its' return on form 1065. Again all the profits are subject to social security taxes, even if the partners did not receive the money. Please note that the social security is imposed on "active" income and does not apply to activities such as real estate. Again the partnership does not enjoy all of the same tax planning options available to C and S-Corps.

An LLC is very appropriate in certain situations such as when buying real estate. I think the problem is that people are choosing to be an LLC because it sounds cool. Its' the new thing. They don't understand the tax implications until its to late. Most of the time the most appropriate form of doing business for a small business is as an S-Corp. The decision should be made before forming the entity with the help of an informed tax adviser.

Relief is possible with IRS form 8832 entity classification election. The form must be filed within seventy five days of forming the entity and there is potential late election relief if it was not filed on time. Check the instructions for the form to see if you qualify.