Entrepreneurs ready to expand their companies but short on capital often find that forming an LLC can open doors. The appeal is twofold, says John M. Saada Jr., a corporate attorney with Jones Day in Cleveland: First, the owners' liability is limited to the company's assets. Their personal holdings are generally safe. Second, an LLC structure confers numerous tax advantages. The most dramatic is that earnings from the LLC are taxed just once, when they're passed through to the owners. Another feature of LLCs, the ability to designate different classes of owners, makes it easy to bring in outside investment while keeping control of your company.
Some entrepreneurs should be wary of the LLC structure, however. If your company is extremely profitable, you could get hammered on your personal taxes. That's because an LLC's profits are reported on the owner's personal tax returns. "Many owners don't realize they have to pay tax on the profits whether or not they take any cash out of the business," says Lisa Osofsky, an accountant with Weiser LLP in New York. And venture capitalists don't like to invest in LLCs. They're accustomed to buying Series A Preferred stock, which they understand better, says Saada. "They often won't pursue investment in an LLC unless it converts to a C corp," he says.
But for many companies in search of tax-efficient, flexible growth, an LLC is worth a look. "They've become a growth engine for American small businesses," says Carl Allegretti, Midwest tax managing partner at Deloitte & Touche. Since 1998, when the Internal Revenue Service allowed some profits of LLCs to be taxed as capital gains, conversions to LLCs have jumped. According to the IRS's most recent figures, there were 718,704 LLCs in 2001, compared with just 118,559 as recently as 1995.CLASS DIFFERENCES
The LLC structure is extremely flexible in allowing different classes of ownership. Each class can represent different voting rights, allocations of profits, or stakes in a company. In 2003, Eric Rosenfeld and Robert Ward employed an LLC for their Portland (Ore.) seed-capital fund, Capybara Ventures, because it allowed the two partners to pool money from 20 investors but still keep control of their company. "We were able to place all decision-making authority with the fund's management and ensure that our own liability is limited," says Rosenfeld. Also, Rosenfeld and Ward will receive some of the fund's net capital gains as a management fee, and they want to make sure that money is taxed just once -- as capital gains, not ordinary income. Rosenfeld spent about $12,000 getting Capybara Ventures set up and describes the fund's legal documents as "short and straightforward." Establishing Capybara as a limited liability partnership could have cost as much as $100,000, he says.
Tidwell Dewitt, a Tuscaloosa (Ala.) accounting firm, has used the flexibility allowed by LLCs as a powerful growth tool. Since Tidwell Dewitt was founded in 2000, the $7.5 million company has grown from 15 to 60 employees through three mergers, and it expects to complete two more by yearend. Allowing different classes of members means "we can attract sophisticated talent as partners more readily," says Ray G. Dyer Jr., managing tax partner. Tidwell Dewitt has two classes of members: those who have voting rights and also buy equity in the company, and those who do not have voting rights and whose stake is limited to the company's profits.
Scott Berrie, on the other hand, regrets setting up shop as an LLC. Revenues at Scojo Vision, his 13-employee eyewear company, have been doubling annually. But profits come at a price. "We've had some whopping personal tax bills," says Berrie. His tax adviser suggested Scojo take out a loan to pay off Berrie's personal bills. "I never anticipated that the company would grow at 100% a year, and I don't have an exit strategy," says Berrie.
Therein lies an important lesson: It's never too early to think about how you could leave the business. If you plan to exit in a tax-free reorganization or initial public offering, a C corp may be appropriate. But if you're going to sell your assets, look hard at LLCs, says Louis J. Marett, tax partner at Boston law firm Testa, Hurwitz & Thibeault. Having a plan for where you hope to take your company -- how far and how fast -- will help you get off on the right foot. For many entrepreneurs, that means setting up an LLC. By Ann Therese Palmer