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
TABLE: How LLCs Compare to Corporations
To: PERSONAL BUSINESS