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PERSONAL BUSINESS

4.6.99  
Structuring Your Company? Look at the Benefits of LLCs
No double taxes, liability protection, and sales appeal

When David Collins started Obik in 1995, he structured the Princeton, (N.J).-based career-development and -transition company as a C corporation -- the same as most big U.S. companies. He soon realized that he had done himself a disservice.

Obik was in the red, but Collins couldn't deduct its losses from his personal income taxes. Worse, he faced the prospect of being taxed twice on profits: The company would have to pay corporate tax. And as a shareholder, he would pay personal income tax when profits were distributed. After two years, Collins converted Obik to a limited liability company -- an LLC -- and he wouldn't go back.

Now, he only pays taxes once -- on the income he takes home. The LLC also gives him more flexibility in choosing investors and in compensating them and employees both. And when it comes time to sell out, the LLC may be more attractive to other closely held suitors. Best of all, his personal assets still have the liability protection a corporation affords. "I can't imagine why you would want to do it any other way," says Collins, Obik's chief executive. As an LLC fan, he has plenty of company. Though there are still more C or S corporations than LLCs, a growing number of entrepreneurs are forming LLCs -- and using them for almost any type of startup.

It's important to consult with an attorney or accountant before taking the LLC plunge: In some situations a C or S corporation may be a better choice, says Lawrence Bober, managing director of American Express Tax & Business Services in Chicago. That could be true, for instance, if your ultimate goal is to go public and you have no profits to tax. Also, the tax savings afforded by an LLC vary with your tax bracket: While C corporation earnings would likely be taxed at a corporate rate of 34%, your LLC earnings can be taxed at individual rates as high as 39.6%. If you ever expect to have financing from tax-exempt institutional investors, moreover, you may want to avoid an LLC so these investors don't get hit with something called the Unrelated Business Income Tax on earnings.

22-YEAR HISTORY. LLCs were introduced in 1977 in Wyoming, which aimed to become a more business-friendly state by eliminating double taxation and creating a business structure that, unlike an S corporation, allows for foreign investors. Today, you can form an LLC in all 50 states and the District of Columbia.

LLCs didn't catch on at first because it was unclear whether they would be treated as corporations or partnerships for tax purposes. In 1997, though, the Internal Revenue Service decided that LLCs would be treated as partnerships. Since then, small businesses have jumped on the LLC bandwagon. In 1996, nearly 1.7 million LLCs filed tax returns. That number is projected to reach more than 1.9 million in 1999. The figures don't include single-member LLCs, whose owners don't file separate forms for their companies.

It's hard to exaggerate the benefits of eliminating double taxation. An LLC's profits are exempt from federal corporate taxes and usually from state taxes as well. (Local tax treatment varies.) Instead, profits -- and losses -- are passed through to owners of the LLC. These members, as most states call them, pay personal income tax on their earnings from the LLC or take a deduction for losses. That's why Alan M. Meckler set up Internet.com, his Westport (Conn.) Web business, as an LLC last year. "I'm able to take a deduction from losses that the LLC is having right now against my regular income," says Meckler, who is Internet.com's CEO.

EXIT STRATEGY. An LLC may also work for you if you plan to sell your company eventually: Private companies prefer to buy assets rather than stock so they can use the depreciation in the value of the assets over time to lower their taxes. In other words, the buyer not only purchases $1 million worth of assets, but also $1 million worth of tax deductions. A purchase of stock, on the other hand, can't be depreciated.

The rub is that corporations that are being acquired don't want to sell assets because of double taxation -- on profits from the sale and on shareholders when the gains are distributed. In effect, the seller prefers to sell stock, and the buyer prefers to buy assets. The LLC avoids this conflict because of its single-taxation nature. Thus it typically can command a higher price in a sale of its assets, and LLC members will keep more of the proceeds than if the company were a C corporation.

Should you change your mind after creating an LLC, moreover, you can convert it to a C corporation without having to pay corporate tax on any appreciation in value since the LLC was created. That's something to keep in mind if you're planning to go public, for example. "We recommend that startup ventures give strong consideration to the LLC to avoid unnecessary taxes on exit," says Chris Loiacono, a tax partner at Richard A. Eisner & Company LLP in New York.

If a C corporation converts to an LLC, by contrast, you have to pay taxes on any increased value of the assets. Collins didn't face tax consequences when he changed Obik from a C corp to an LLC because the company was losing money at the time, and had no appreciation.

FLEXIBILITY. Another virtue of LLCs is that they permit multiple classes of stock -- for founders, key employees, and each venture capital round. And you can allocate profits differently for each class of stock. There's no limit on the number or types of investors you can have. And individuals can take payment for services in the form of an interest in the LLC in a tax-free transaction. (Outright grants of stock may be taxable, though.)

Here's how this works: Party A contributes $1 million to start an LLC, while Party B contributes only services. After two years, the LLC makes a $100,000 profit, which is split 50-50 by the parties, effectively giving Party B a partnership interest in the company. Party B would be taxed on its share of earnings, but not on the value of its overall stake -- though normally if you receive property for services you're taxed on the value.

Compare that with S corporations, which have only one class of stock and can allocate profits and losses only by stock-ownership percentage: If you own 10% of the stock, you get 10% of the income, which is usually taxed twice. And an S corp is limited to 75 shareholders, all of whom must be U.S. citizens or residents, or certain types of trusts that are allowed to invest in corporations. A C corporation avoids many of these restrictions, but it still incurs double taxation.

That's why Peter Tepperman changed his Carlstadt, (N.J.)-based real estate company, Patterson Plank Realty, from a C Corp. to an LLC three years ago. His reason was simple: "It's a less restrictive form of organization that still provides limited liability."

By Laura Castañeda in Philadelphia

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