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Should your company operate as an LLC?
Ask someone a few years ago what a limited liability
company was and chances are they would just scratch their head. Now,
limited liability companies (LLCs) have become very popular. This form
of business entity is a hybrid that features the best characteristics of
other forms of business entities, making it a good choice for both new
and existing businesses and their owners.
A limited liability company (LLC) is a legal entity
existing separately from its owners that has certain characteristics of
both a corporation (limited liability) and a partnership (pass-through
taxation). An LLC is created when articles of organization (or the
equivalent under each state rules) are filed with the proper state
authority, and all fees are paid. An operating agreement detailing the
terms agreed to by the members usually accompanies the articles of
organization.
Choosing the LLC as a Business Entity
Choosing the form of business entity for a new company
is one of the first decisions that a new business owner will have to
make. Here's how LLCs compare to other forms of entities:
C Corporation: Both C corporations and LLCs
share the favorable limited liability feature and lack of restrictions
on number of shareholders. Unlike LLCs, C corporations are subject to
double taxation for federal tax purposes - once at the corporate level
and the again at the shareholder level. C corporations do not have the
ability to make special allocations amongst the shareholders like LLCs.
S Corporation: Both S corporations and LLCs
permit pass-through taxation. However, unlike an S corporation, an LLC
is not limited to the number or kind of members it can have, potentially
giving it greater access to capital. LLCs are also not restricted to a
single class of stock, resulting in greater flexibility in the
allocation of gains, losses, deductions and credits. And for estate
planning purposes, LLCs are a much more flexible tool than S
corporations
Partnership: Partnerships, like LLCs, are
"pass-through" entities that avoid double taxation. The greatest
difference between a partnership and an LLC is that members of LLCs can
participate in management without being subject to personal liability,
unlike general partners in a partnership.
Sole Proprietorship: Companies that
operate as sole proprietors report their income and expenses on Schedule
C of Form 1040. Unlike LLCs, sole proprietors' personal liability is
unlimited and ownership is limited to one owner. And while generally all
of the earnings of a sole proprietorship are subject to self-employment
taxes, some LLC members may avoid self-employment taxes under certain
circumstances
Tax Consequences of Conversion to an LLC
In most cases, changing your company's form of business
to an LLC will be a tax-free transaction. However, there are a few cases
where careful consideration of the tax consequences should be analyzed
prior to conversion. Here are some general guidelines regarding the tax
effects of converting an existing entity to an LLC:
C Corporation to an LLC: Unfortunately, this
transaction most likely will be considered a liquidation of the
corporation and the formation of a new LLC for federal tax purposes.
This type of conversion can result in major tax consequences for the
corporation as well as the shareholders and should be considered very
carefully.
S Corporation to an LLC: If the corporation was
never a C corporation, or wasn't a C corporation within the last 10
years, in most cases, this conversion should be tax-free.
Partnership to LLC: This conversion should be
tax-free and the new LLC would be treated as a continuation of the
partnership.
Sole proprietorship to an LLC: This conversion is
another example of a tax-free conversion to an LLC.
While considering the potential tax consequences of
conversion is important, keep in mind how your change in entity will
also effect the non-tax elements of your business operations. How will a
conversion to an LLC effect existing agreements with suppliers,
creditors, and financial institutions?
Taxation of LLCs and "Check-the-Box" Regulations
Before federal "check-the-box" regulations were enacted
at the end of 1996, it wasn't easy for LLCs to be classified as a
partnership for tax purposes. However, the "check-the-box" regulations
eliminated many of the difficulties of obtaining partnership tax
treatment for an LLC. Under the check-the-box rules, most LLCs with two
or more members would receive partnership status, thus avoiding taxation
at the entity level as an "association taxed as a corporation."
Under these new
regulations, no action will be necessary on the part of most new LLCs.
If an LLC has more than 2 members, it will automatically be classified
as partnership for federal tax purposes. If the LLC has only one member,
it will automatically be classified as a sole proprietor and would
report all income and expenses on Form 1040, Schedule C. LLCs wishing to
change the automatic classification must file Form 8832, Entity
Classification Election.
LLCs in existence prior
to the new regulations effective date (January 1, 1997) would be
classified according to their established federal classification as long
as there are 2 or more members. Existing LLCs with only one member would
be subject to the new regulations and would be treated as a sole
proprietor for federal tax purposes, even if they had previously
attained partnership treatment. However, sole proprietors may elect to
be classified as a corporation.
Keep in mind that state
tax laws related to LLCs may differ from federal tax laws and should be
addressed when considering the LLC as the form of business entity for
your business.
Since the information
provided is general in nature and may not apply to your specific
circumstances, please contact the office for more information or further
clarification.
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