LLC: Legal Attributes

In addition to the corporate entities discussed, one entity which is frequently used is a hybrid that mixes the best features of corporations and partnerships––the Limited Liability Company (LLC). Although there are exclusions in particular states, most states that allow an LLC to organize per statute, like California, also permit the entity to elect taxation as either a corporation or partnership (for a detailed discussion see LLC: Tax Attributes below). LLCs are governed by the California Revised Uniform Limited Liability Company Act under the California Corporations Code, Title 2.6.  In light of the LLC being a more recent entity conception, statutory and case law is less developed as compared with the longstanding corporate law; thus, although providing more freedom it comes at the cost of less certainty.

Each owner––also called a member––of an LLC has limited liability like a shareholder of a corporation. However, unique to the LLC is the ability of the LLC to shield the LLC’s assets from its members’ personal liabilities.[1]  LLCs allow any entity, including individuals, partnerships, trusts, estates, corporations, or other LLCs to be owners. Upon formation, LLCs offer greater flexibility and less tedious formalities as compared with a corporation. Specifically, LLC agreements can provide for special allocations of income, deduction, gain, or loss. Notably, the members of an LLC need contribute only “any benefit” to the LLC in return for membership interest whereas corporate shares can be issued only in return for money, property, past services, or cancelled debts/securities. Lastly, LLCs can elect the tax advantages of a partnership––i.e., pass-through taxation.

LLC: Formalities

The formalities required to organize an LLC are much less tedious, consisting merely of filing the Articles of Organization with the Secretary of State and drafting an operating agreement (optional but recommended if more than one member).  In fact, most business owners are drawn towards the LLC because of its simple formalities (for a better idea see the segment on corp formalities). Keep in mind that the LLC form of business entity is not available to most businesses rendering professional services in California (Professional services may only take on the LLP or Professional Corporation form). Further, a statement of information must be filed within 90 days of organization and must be filed biannually[2] thereafter (Form LLC-12: Fee $20; Penalty for late filing: $250). Finally, with respect to the issuance of securities, a member-managed LLC’s interests are not considered securities; however, in a manager-managed LLC the interests are securities. Consequently, if the LLC is offering securities, this will implicate complex state and federal securities laws unless an exemption applies. Any failure to comply with the LLC formalities can result in non-recognition of the entity, potentially resulting in personal liability.

LLC: Formation Start Up Cost

The initial CA state-filing fee for the Articles of Organization lists at $70. For service of process, an agent must be designated that is either an individual who resides in California or a California registered corporate agent. Please use the following Comparison Chart for side by side comparison.

LLC: Tax Attributes

Under the IRS rules, an LLC is classified by default as either a sole proprietorship, if it has only one member, or a partnership, if it has more than one member. A single-member LLC (“SMLLC”) is considered a disregarded entity if it does not elect to be taxed as a C-corp or S-corp. A disregarded entity is considered the same entity as the owner for tax purposes but not for liability purposes. There is a popular misunderstanding that Sole Proprietorships are similarly treated as disregarded entities, however, this is not true because although the Sole Proprietor is considered the same entity as the owner for tax purposes it is not considered a separate entity for liability purposes like the SMLLC.

The benefit of being considered the same entity as the owner for tax purposes is the ease associated with tax filings; the business income is added on Schedule C personal tax filing and does not require a separate tax filing as typically required with a separate entity. In contrast, an LLC with multiple members is treated like a partnership; that is, it must declare its operating losses and profits through IRS Form 1065, Schedule K-1 and analogous state forms and then file individual taxes (similar to an S-corp).

As an LLC, the entity itself is exempt from federal taxation but still subject to two state level taxes. The first state level tax is the annual $800 franchise tax fee.  The second state level tax is a unique LLC fee; it is akin to a progressive tax in that it only applies in a graduated manner to gross receipts of the LLC that exceed $250,000. Once the LLC’s expenses and state taxes have been deducted, the remaining balance of profit is allocated to the members.

Recently, the Internal Revenue Service indicated in a private letter ruling that members of an LLC will be treated as partners for self-employment tax purposes and that the members’ distributive income shares are not excepted from net earnings from self-employment. See CCA 201436049. Consequently, the LLC members pay state and federal personal income tax and self-employment tax on all profits.  In contrast, corporate shareholders can benefit from allocating profits as between salary and distributions since they can avoid self-employment taxes on the distributions.

This self-employment tax is made up of the Federal Insurance Contribution Act (FICA) tax and Federal Unemployment Tax Act (FUTA). The FICA tax of 15.3% consists of a 12.4% Social Security tax on the first $118,500 of net salary and a 2.9% Medicare tax which applies to the entire salary. Additionally, some taxpayers face an additional Medicare surtax of 0.9% of Medicare wages on self-employment income exceeding $250,000 for married couples or $200,000 for filing as single. For California residents there is also a 0.9% tax that goes to the State Disability Insurance fund. It should be taken into account that any self-employed entrepreneur is also eligible to deduct half of their self-employment taxes from their federal taxable income. While it does not reduce your self-employment tax, it reduces the total amount of tax you pay by lowering your taxable income (this is included in the Entity Selection Cheat Sheet formulas).

Nevertheless, the option still remains for an LLC to elect taxation as a C-corp by filing IRS Form 8832 or as an S-corp by filing IRS Form 2553. Upon the effective date of the election, the company loses its status as a disregarded entity. Under a separate heading, I address the potential benefits of having your entity formed as an LLC from a legal standpoint but as an S-corp for tax purposes.

Please use the following Entity Selection Tax Cheat Sheet to predict your tax liability.

[1] For details see my discussion titled: LLC Protection for Members Personal Debt.

[2] Unlike the corporate filing, the biannual filing must be sent via mail.