Understanding Limited Liability Company (LLC) Taxation

Once you’ve decided to form a limited liability company (LLC), your next decision is most likely going to be “how am I going to be taxed?” An LLC is not a tax entity. Instead, the IRS considers the LLC “disregarded” and applies tax laws that apply to sole proprietorships, corporations, and partnerships to the LLC. But, to avoid an esoteric discussion of tax law, I hope I can give you enough information in this article to help you in determining which tax entity is best for you.

If your LLC has one owner, it may elect to be a C corporation or S corporation, otherwise it will be a Disregarded Entity.  “Disregarded Entity” means the IRS ignores there is a legal entity between you and the income, losses, assets, etc. for tax purposes. A single owner disregarded entity will be treated as a sole proprietorship. If your LLC has multiple owners, it may elect to be a C corporation or S corporation, otherwise it will be a Disregarded Entity. A multi-owner disregarded entity will be taxed as a partnership.

To be or not to be… Disregarded

          Sole Proprietorships

The single member LLC, when disregarded, is analogous to a sole proprietorship. That is to say, you are your business and your business is you. Per the IRS, as a consequence of not making an election you will report your income and deductions, from your LLC, on a Schedule C, on your Form 1040. This is the simplest form of taxation and provides for single-level taxation. “Single” or “Double” taxation, as you’ll read later, refers to how many times the federal government gets to tax your “income.” With a sole proprietorship the only income tax that applies would be your individual income tax. But, the drawback of the sole proprietorships is that you have to pay Self-Employment Tax on all the income you make from the business. So keeping that in mind, you are going to pay income and self-employment tax on the profit you’ve made.

How much is self-employment tax? Generally it’s 15.3% on the first $117,000. Anything above $117,000 is subject to a 2.9% Medicare tax. There is an Additional Medicare Tax 0.9% tax for income over a threshold amount. The threshold amounts vary by filing status, but if you’re married filing jointly it is $250,000.

So in addition to your self-employment tax of 15.3%, you’re going to pay personal income tax. Assuming a 20% effective personal income tax rate, that’s a whopping 35.3%. Keep in mind that personal tax rates range from 0% to 39.6%, and possibly higher with the investment tax. As my good friend George says, the IRS is not my business partner, and luckily for him and for you there is a tax planning opportunity here.

C and S Corporations

The IRS allows for single members LLCs to elect, according to the check the box rules, to be taxed as a corporation. When you elect to be taxed as a corporation you are electing to be taxed under subchapter C of the internal revenue code, hence the nomenclature “C Corporation.” C corporations pay income tax on their income, though at preferential graduate tax rates. That means the overall tax brackets are lower than individual brackets. The profits stay in the company until there is a distribution. Typically, you’re going to distribute money from the corporation in the form of a dividend. Dividends are taxed at different rates than your income is taxed, typically much lower, at “capital gain” rates of 15-20%. But, you’re paying tax twice. Which is why this generally isn’t used as a tax structure, but the C Corporation’s brother, the S corporation is much more useful in reducing federal taxes.

Subchapter S corporations give the benefit single taxation at the individual level, while relieving some of the self-employment tax. Thus, instead of paying a corporate income tax, the S corporation pays nothing. In exchange, all of the income is deemed to have been distributed to the shareholders, unlike a C corporation, which only taxes its distributions when actually distributed. This is known as “phantom income.” The S corporation shareholders, whether or not they received the distributions, will pay taxes on that amount. One major benefit is that the shareholders do not pay self-employment tax on the income that is considered a distribution. This has the potential to greatly lower your tax bill. But, you have to approach this structure with caution. An S corp. does have to employ someone to do work. So if you’re doing all the work, you do have to pay yourself a “reasonable salary,” and you and the corporation will share the self-employment tax on your amount of compensation and file employment tax returns, Forms 941/944 and Form 940. Individuals get in trouble when they pay themselves too little and all the income as distribution. As in the case of Mr. Watson who found himself in court after paying himself $24,000 in wages and taking $203,651 in distribution.  While paying yourself a less than reasonable salary will lower your tax bill, it places you at risk. Nonetheless, any amount of money on which you do not have to pay employment tax, will reduce your taxes. Here’s an oversimplified example:

You’ve taxable income is $150,000 as an individual and you’re married. As a sole-proprietorship, you pay $39,528 in federal income tax plus $17,901 self-employment tax for a whopping $57,435. You keep $92,565.

If you were operating as an S corporation, let’s assume you pay yourself as a wage $75,000 and receive $75,000 in distributions. First, you’d pay self-employment tax on your wages of $75,000, which is $11,475. Reducing your distribution by that amount leaves you with $69,262 (75k for tax purposes) in compensation in your pocket and $69,262 available for distribution. Your income tax will be $35,928 plus 36% over 140,000. The product being $1,534 plus $35,928, totaling $37,426 in taxes. From $150,000 less self-employment taxes paid, take home $101,099 versus $92,565 as a sole proprietorship. A savings of $8,534 in taxes.

One caveat to keep in mind is that an S corporation generally cannot deduct health insurance and term life premiums while a C corporation can deduct up to $50,000 per employee. If you really wanted to make these amounts deductible, you could actually setup two separate entities and get the best of both worlds, primarily using a management contact.

S corporations also cannot make distributions unevenly, this is known as the “single class of stock” rule and have restrictions on ownership, unlike C corporations.

Partnerships

LLCs, with two or more members, who do not elect to be taxed as a corporation, will be taxed as a partnership. Partnerships, like S corporations, are a pass through tax entity. Meaning, the income is passed directly from the partnership to its Partners. Partnerships do not pay separate income taxes like C corporations. Partners of a partnership are not employees and should not receive a salary. There is a rich, legal history in understanding the employment status of partners in partnerships. Here is a detailed history. Otherwise, understand that a partner will pay self-employment tax on all of his income that flows from the partnership. A partnership can make “guaranteed payments,” which look like a salary to the partner. But, the partner will still need to pay self-employment tax on this income. There are several reasons to avoid the self-employment tax, but there are several reasons why you might choose to be taxed as a partnership.

Partnerships offer the most flexibility with a pass-through tax entity. A partnership will undoubtedly need a partnership agreement, or in the case of an LLC, an operating agreement. Both are contracts that govern the relationship between the entity and its members (LLC) or partners. With a partnership you can get creative in how cash will be distributed, who will be allocated income and losses, foreign or domestic, how debts are repaid, etc. For this reason, when there are multiple members who are not even partners, they often choose to be taxed as a partnership. But, to the extent that your entity doesn’t need a complicated structure of distributions or allocations, it is usually advisable not to be taxed as a partnership.

 A Note on Liability

As a general rule, LLC members are not liable for the debts of the LLC. But, in Florida, in accordance with the Olmstead case, the single member or a single member LLC, may become liable for the debts of the LLC, after the creditor secures a charging order. This is not the case for a multi-member LLC. If you are considering a single member LLC, you may consider a Florida Corporation with an S Corporation election, because you will get the limited liability you are searching for and the benefits of pass through taxation.

Need more help?
If you have more questions or need help establishing your entity please call our offices at (813) 999-0199, www.WalkLawFirm.com.

Frank Lago is an attorney at the Walk Law Firm, PA. HE is a graduate of Stetson University School of Law and holds an LLM in Taxation from Georegetown University.

Deadlock is Often the Ultimate Demise of Good Business

Consider this common scenario.

You’ve entered into business with your spouse, friend, or relative. At the inception of your business, you agreed that both of you would serve as the directors or managers of the Company, and you would be equal partners, each allocated fifty percent (50%) of the shares or ownership interest in the Company. Your relationship with your partner is healthy; you trust them; you trust their judgment; you’re excited about your idea, about your business. And life is great until…….

….. You have your first real dispute. The one that does not solve itself nor does it resolve with a drink at the bar.

As the business develops, you’re faced with decisions about the future direction of the business, about major business activities. Eventually, there may be a decision on which you simply cannot agree. And because you have equal control of the Company, your conflicting views ultimately stalemate or deadlock the business until you come to some agreement or decision.

Unfortunately, more often than not, people in this common scenario do not properly plan for or consider the potential for corporate deadlock, and it can lead, not only to the deterioration of a personal relationship, but also a business relationship and a business.

 HOW TO RESOLVE CORPORATE DEADLOCK

Planning for the Future.

The best way to avoid corporate deadlock is to plan ahead.  This should be a major consideration when you enter into a business relationship with anyone.  Sit down with your partner and discuss setting up a procedure for what happens if a deadlock arises.  It may not be an easy conversation to have – it may be difficult to imagine disagreeing with your partner. But sit down with your partner early and really consider the following things: (i) the nature of the business; (ii) your business plan; (iii) you and your partner’s individual ideas of the direction of the business; (iv) what problems that could arise in the business, financial or otherwise; (v) each person’s individual skill set. All these things can play a role in your deadlock discussion and the most appropriate procedure for resolving a potential deadlock. These frank conversations are even more important when one party is providing the money and the other is providing sweat equity.

Shareholders’ Agreements and Operating Agreements.

We find a lot of times that people who enter into business with a family member or close friend don’t even have a Shareholders’ Agreement or an Operating Agreement. This might be for a variety of reasons – they didn’t plan for initial legal costs and fees; they feel that they will be able to run the business through oral agreements and understandings; or, they find it uncomfortable to discuss the issues found in corporate governance documents, like transfer upon death, disability, divorce, debt, dissolution, or simply the desire of one partner to monetize and be paid out etc.

We recommend to all our clients, regardless of relationship between partners, shareholders, or members (even husband and wife), that they have some form of Shareholders’ Agreement or Operating Agreement in place establishing the governance of the entity, the rights, duties and obligations of the parties, including, if necessary, provisions addressing potential deadlock scenarios in management or between members or shareholders.

Alternative Provisions.

There are a number of different ways that an entity can resolve deadlock, and, in fact, it may be beneficial to a Company to implement multiple or hybrid deadlock methods. These methods can easily be incorporated into a Company’s governance documentation. Here are a few ways to resolve deadlock:

  1. Create a third party advisory board – either with other Members or Shareholders of the Company, or even an outside third party knowledgeable in the business and/or decision subject to deadlock;
  1. Consider implementing automatic mediation or arbitration – this may not be feasible for all companies or for all deadlocked scenarios – it can be costly and time consuming – but it can be quite effective in preventing dissolution when there is a deadlock for a major decision;
  1. Consider splitting or designating certain decisions to each partner – for examples, this partner has the ultimate decision making authority on banking and property, and the other partner has the ultimate decision making on sales and marketing – this method requires the partners to determine strengths and weaknesses and delineate accordingly – this method is useful when doing some form of hybrid deadlock provision;
  1. Consider a buy-out provision – if the partners cannot agree, one partner can buy the other partner’s shares or membership interest – there are a number of ways to structure a buy-out provision;
  1. If nothing else works, provide for a definitive right to withdraw or force dissolution or liquidation without court intervention. In this instance, you may be left relying on the default solutions contained in the Florida Statutes [Sections 605 and 607] or the decision of a judge who is unfamiliar with your business.

Need help in putting in place a shareholders’ agreement or an operating agreement?

Need help revising your current agreement with some alternative deadlock provisions?

The Walk Law Firm is available to review your current Shareholders’ Agreement or Operating Agreement in order to help you determine if, in fact, it’s appropriate for you and your partner(s).  Document review and drafting can be handled on a Flat Fee or Fixed Fee basis. To learn more, please contact us at the Walk Law Firm.

 

Florida Legislature Passes New Revised Limited Liability Company Act – Important Reading for Members and Managers of LLCs

Intro

On May 3, 2013, the Florida House of Representatives unanimously passed the new Florida Revised Limited Liability Company Act (the “New Florida LLC Act”).  The Florida Senate unanimously passed a companion bill a week earlier.  Governor Scott approved the bill without issue or opposition on June 14, 2013.  Since LLCs are the most common form of business in Florida, this article is important reading for all business owners, especially owners seeking to protect their LLC assets and personal assets as soon as 2014. The New LLC Act will be codified as Chapter 605 of the Florida Statutes and will govern limited liability companies (“LLCs”) within the state of Florida.  The New Florida LLC Act is materially different, in both form and substance, than the Existing Florida Revised Limited Liability Company Act (the “Existing Florida LLC Act”), which is codified in Chapter 608 of the Florida Statutes.  If you or your company is an existing Member or Manager of a Florida LLC, or if you plan to become one in the near future, it is extremely important to understand the New Florida LLC Act and how it may impact your existing and future operating agreements and other governance documents.   The summary below is not a comprehensive review of the new LLC Act and is not intended to replace the advice of an attorney, but rather is designed to help you assess your own LLCs and potential need to take action.

When will the New Florida LLC Act become effective?

 The New Florida LLC Act becomes effective on January 1, 2014 for all LLCs formed in Florida on or after January 1, 2014.  For all LLCs in existence prior to January 1, 2014, the New Florida LLC Act will not become effective until January 1, 2015; however, the members of an LLC may elect to have the New Florida LLC Act become effective as early as January 1, 2014. To do so, the governing documents of the LLC will need to be amended.

How will the New Florida LLC Act impact my LLC?

 The New Florida LLC Act, like the Existing Florida LLC Act, and like most business organization statutes, is a default statute, which means that it provides a set of standard rules governing LLCs and how they are organized, how they operate, and how they are governed.  These standard rules may be modified, with limited exceptions, through specific language contained in either the Articles of Organization or the LLC’s operating or management agreement.  Like all LLC statutes, the New Florida LLC Act specifically prohibits the LLC from including language that modifies or supersedes certain statutory provisions (these are often referred to as “non-waivable provisions”).  This is significant because the New Florida LLC Act expanded the number of provisions which are now,  non-waivable and may not be altered by agreement of the members.

What changes were made in the New Florida LLC Act?

Expanded Non-Waivable Provisions.  The New Florida LLC Act has clarified that an LLC’s operating agreement may not remove certain rights, obligations and authority granted by the Act. Some of the provisions which an operating agreement may not change include:

  1.  The ability of the LLC to sue and be sued in its own name
  2. The right of a member to maintain a direct cause of action against the LLC, another member, or a manager in order to enforce such member’s rights and otherwise protect such member’s interest
  3. The right of a member to maintain a derivative action
  4. The right of an LLC to refuse to relieve persons, including members and managers, from liability if such persons acted in bad faith or committed willful, or intentional misconduct or a knowing violation of the law
  5. A Member’s or Manager’s duty of care, duty of loyalty, or obligation of good faith and fair dealing The  power of a member to dissociate from the LLC
  6. Statutory requirements with respect to the  contents of a plan of merger, plan of interest exchange, plan of conversion, or plan of domestication, plan of dissolution, articles of organization, statutory agents and other similar provisions
  7. The applicable governing law of the Florida LLC

Managing Member Eliminated.  Under the Existing LLC Act, there are three potential management options:  (1) Member managed, (2) Manager managed, and (3) Managing Member managed.  The New Florida LLC Act has effectively eliminated the concept of Managing Member managed.  It is possible that your operating agreement may need to be amended in order to avoid confusion, unintended results, and unintended personal liabilities, and to make very clear which of the remaining options you intend to use for your LLC.  For example:  once the New Florida LLC Act becomes effective, for those LLCs that are Managing Member managed, the Managing Member may no longer be able to act alone and may require all authorized actions to be subject to a member vote in accordance with the operating agreement.  In order to avoid an unintended result, you should revise your operating agreement and governance documents to reflect the intent of the members.

New Statement of Authority.

The New Florida LLC Act allows an LLC to file a statement of authority with the Florida Department of State as a way of providing constructive notice to third parties regarding persons authorized to act on behalf of the LLC.  The Statement of Authority will be effective for five years from the last amended or filed Statement of Authority, unless terminated earlier in accordance with the New Florida LLC Act.  You should consult with an attorney to determine the implication of filing a Statement of Authority and whether such Statement of Authority would be beneficial for your LLC.

Other Changes.

  •  Non-US entities are now permitted to domesticate as a Florida LLC
  • Non-economic members (members that don’t or are not obligated to contribute) are now permitted
  • The new Act includes specific service of process rules for LLCs

What should I do with my existing operating agreement?  Moving forward, how will my operating agreements be different?

If you or your company are a member or manager of an existing LLC, or are planning to enter into a new LLC, you need to understand the New Florida LLC Act and all the changes that were recently made.  At minimum, you should review your operating agreement with a qualified business attorney. LLC Agreements need to reflect how the members desire to operate the business. An experienced and practical business attorney will help you navigate the new Florida LLC Act in a way to help you amend your operating agreement to be consistent with your intent and operations.

The Walk Law Firm is available to review your operating agreement and help you understand the impact the New Florida LLC Act will have on your Florida entity. Operating reviews can be handled on a Flat Fee or Fixed Fee basis.   As experienced Florida business and commercial law attorneys, we have studied the New Florida LLC Act and can work with you to revise, amend, restate and draft new provisions for your LLC management and operating agreements eliminating unintended confusion or results.