A Blueprint to Limit Liability and Cut Taxes

There’s no one legal structure that works best for all businesses. The most favorable choice depends on a number of factors, including the number of owners, your tax situation, and whether or not you have employees. A limited liability company (LLC) may be a good choice because it provides flexibility, low maintenance, favorable tax treatment, and most importantly, limited liability protection to keep your personal assets safe.

LLCs can work well for family businesses that have exposure to product or other liabilities, real estate enterprises, and service companies.

Discuss the specific benefits of various business structures with your attorney, keeping in mind that the laws regulating LLCs vary from state to state. Here is a list of general LLC issues to consider:

Tax Treatment

Federal and State
Limited liability companies avoid double taxation. Like an S corp or a partnership, an LLC is a tax “pass-through” structure - it files a federal tax return, but passes through all of its tax profits or losses, to its members, who then pay tax on their personal returns. Under a C corporation structure, your company pays taxes on its earnings and then you pay again if the company’s post-tax earnings are distributed to you as dividends.

Employment
LLCs, like S corps and partnerships, distribute income to their members and the money isn’t considered wages by the IRS so there are no employment taxes. However, a member who is active in the business and treated like a partner has to pay self-employment taxes. And, if the IRS thinks you’re trying to avoid self-employment taxes, you can expect to hear the taxman at your door. Of course, you must pay employment taxes for your employees.

Setting Up

Formation
It’s fairly easy to form an LLC: You file an Articles of Organization form with the state and pay a fee. You also create an operating agreement among the members. This document establishes members’ rights, the percentage of ownership and the share of profits. Owners can include corporations, partnerships, other LLCs or trusts. An operating agreement should also contain provisions for the company’s management structure and any other financial details you want, such as ways to use the LLC in estate planning.

Management
In nearly every state, you can form an LLC with just one person but there’s no limit on the number of members you can have. In theory, all members can participate in managing the company. But smooth operations normally depend on a centralized management to ensure good communication and the ability to reach consensus. In your operating agreement, you can designate one or more owners (or even an outsider) to take on daily management responsibilities.

Operations

Limited liability
LLC members aren’t personally liable for the company’s debts or obligations. However, this is not blanket protection. Members may still be liable for debts if they personally guarantee them. And they’re liable for their own professional malpractice, if they personally injure someone, don’t deposit taxes withheld from employees’ wages, or use the company to conduct personal business. Beyond that, members are liable only up to the amount of their capital contributions and the amount they agree to contribute to the firm’s capital.

Continuity
Depending on state law, an LLC could go out of business upon the death, insanity, bankruptcy, retirement, resignation or expulsion of a member. The remaining members would have to wind up business and distribute assets among themselves. You can avoid this by including in your operating agreement a “buy-sell” provision to provide guidelines in the event a member is no longer involved.

An LLC’s tax advantages, combined with corporate insulation from liability and estate-planning benefits, can make it a suitable and cost-effective alternative to other business models. Talk it over with your attorney.

Dodging a Double Tax Hit

An LLC can help avoid double taxation if you sell the company or some of its assets. Let’s say your company buys a warehouse and later makes a profit selling it.

As a C corporation: You’re liable for a combined federal and state tax bite of as much as 40 percent. Now you can take the gain left over after paying corporate level taxes as salary or a dividend distribution. If you take the money as a dividend, your company loses a deduction and you pay personal taxes on the cash. Add your personal tax bill to the corporation tax bill to find out how much was paid in combined taxes. If you take the money as salary, your company keeps its deduction, but now payroll taxes kick in.

As an LLC: You are taxed only on your personal return and at low capital gains rates. A properly-organized LLC combines some of the aspects of partnerships and corporations into one entity. For example, partnerships and sole proprietorships generally have no insulation from liability. But by statute, a member of an LLC has limited liability and no personal responsibility for the debts or liabilities of the entity or the other members.