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  • Writer's pictureLangston Tolbert

Why Use the LLC?


An LLC combines the pass-through federal tax treatment of a partnership with the liability protections of a corporation. Under IRS regulations, LLCs are allowed to be taxes as flow-through entities unless they choose otherwise. Additionally, members possess no personal liability for their duties under the LLC—though, they still have personal liability for their individual acts and omissions in connection with the LLC’s business. Moreover, when entering contracts, members will lose their limited liability if they fail to make clear that they are contracting on behalf of the LLC—rather than in a personal capacity. Practically speaking, an LLC operates akin to a limited partnership minus the legal requirement of a general partner bearing all the ultimate liability for the entity’s responsibilities. Unlike an S-Corp, an LLC: (1) is not limited to a certain amount of shareholders (or members); (2) members do not need only be individuals, certain tax-exempt organizations, qualifying trusts, etc.[1]; and (3) can have different classes of membership interests. And unlike a partnership, you may form an LLC with only one member.

An LLC has two principal documents: (1) the certificate of formation (or articles of organization) and (2) the operating agreement. The certificate of formation is a short, one- or two-page document that you file with the secretary of state, setting forth the LLC’s names, address, agent of service of process, term, governance structure (manager-managed or member-managed). The operating agreement is akin to a partnership agreement. It specifies how the LLC will be governed; the financial responsibilities of each member; and how profits, losses, and distributions will be split. An operating agreement should be crafted to fit your specific needs—i.e., avoid using boilerplate documents.

Typically, LLCs are not suitable for businesses looking for venture capital funds due to tax restrictions placed on the venture capital funds’ investors. But LLCs are very attractive for bootstrapped or self-financed businesses, those backed by a corporate investor, or even a wealthy individual. LLCs are perfect for the entrepreneur looking for flow through losses to its investors because (1) an LLC gives liability protection to all its members; (2) an LLC can have partnerships and corporations as members and is not subject to other restrictions applicable to an S-Corp; and (3) losses can be specially allocated to the cash investors in totality (unlike an S-Corp, where losses are allocated to all owners based on share ownership). Moreover, an LLC can be incorporated on a tax-free basis under Section 351 of the Internal Revenue Code at any time. [For instance, after the initial startup losses have been allocated to the early round investors, the LLC could be incorporated to accommodate investment from a venture capital fund in a conventional preferred-stock financing.]

Three Major Reasons to Use an LLC

1. Liability Protection with Rental Property

The most popular reason to create an LLC is to hold rental property. The LLC protects the owner and manager of the property from the operations of the business/rental. To capitalize on this benefit, the manager and owner of the LLC must act responsibly, meaning without negligence and withing the scope of their duties. LLCs may also be used for higher-level asset protection when trying to protect the asset as well as the owner from the liabilities of the rental property—generally referred to as a COPE (Charging Order Protection Entity) and is applicable to LLCs in 20 states.

2. Liability Protection in an Operational Business and Ability to Convert to an S-Corporation Later

An LLC can be a great starter entity for a new business owner who later wishes convert into an S-Corp at a later date. This is because many new enterprises do not make enough of a profit to maximize the potential tax benefits of a S-Corp, but their owners still wish to shield themselves from personal liability. Under tax law, an entrepreneur may initially form an LLC and later retroactively convert it into an S-Corp at an appropriate time. This strategy is typically utilized by a single-member LLC. Of course, make sure you are respecting the corporate veil of the LLC in order to probably protect yourself.

[The self-employment tax is one of the primary disadvantages for operating your business as a sole proprietorship. It is a tax comprised of the [12.4%] Social Security tax as well as the [2.9%] Medicare tax (totaling a [15.3%] tax) to your first [$132,900] of net income. After which, the Medicare tax continues to apply, even raising to [3.8%] after [$200,000] of net income into perpetuity. Though this tax does not apply to passive income (e.g., rent, dividends, interest, or capital gain). Additionally, it is not something to concern yourself with if your business does not make much of a profit. The best way to limit the SE tax is by operating as a S-Corp.]

3. Advantageous for Partnerships

An LLC is a choice business structure for partnerships. It shields each member from the actions of the others as well as allowing for more efficient tax planning. Additionally, an LLC creates a structure to document all the agreements and terms of the partnership. An LLC can be constructed so that every member holds their share in the form of a S-Corp, permitting (among other options) each member to take additional tax write-offs by using their own S-Corp to receive other sources of revenue, create his or her own payroll levels (saving on self-employment taxes), and establish a 401(k) or health plan specific to their needs.

Series LLC

A Series LLC gives members limited personal liability from claims arising from multiple properties or operations without having the extra costs of multiple LLCs. A Series LLC is unique in that it allows owners to create a “series” or “mini-LLCs” within the original LLC (the “parent LLC”). Each mini-LLC can have its own property, assets, objective, and purpose. And the debts, obligations, and liabilities of each series are only enforceable against the assets of that series, not against the assets of the parent LLC or the other mini-LLCs.

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