At least once a month, we encounter a new client that formed an LLC because that’s what they heard they should do. It’s usually unclear from where or who they heard that this was the right choice for their endeavors. Chalk it up to the flavor of the day, perhaps. Maybe it’s due to the explanation some of the online formation services offer. This general statement is true – “An LLC offers the same level of insulation from liability as a corporation, without the requirements of corporate formalities.” It’s an easy sell. I don’t want the “formalities” of a corporation, so the LLC is obviously the right choice. But, is it?
Another true statement – “An LLC allows for income to flow through to the individual and avoids ‘double taxation’ which occurs at the corporate level.” AND…. Another true statement – “An S-Corporation allows for income to flow through to the individual and avoids ‘double taxation which occurs at the corporate level.” Well, both statements are sort of true, at least in California. California was a late adopter in the line of states recognizing the LLC as a legal entity and took an approach taken by some other states regarding a “bonus payment” due to the state, otherwise known as the Gross Receipts Tax. That sounds awful, doesn’t it? The LLC must pay an additional tax based on its gross receipts. Luckily, that number is capped at just under $12k depending on the income bracket which the company falls into. It’s usually a matter of doing the math in each situation to determine which might work out better in terms of tax liability. There are disadvantages to having all income flow-through to the individual. You’re going to pay tax whether you see the money or not. CPAs are encouraged to play along at this juncture.
Ok, I’ve heard way too much of the corp-this and the LLC-that, but what’s right for me? There are dramatic differences in the operation, management, and tax treatment of the different business entities and it’s not something to be chosen hastily. Formality can be good and, to be honest, there isn’t a great deal of “formality” involved in running a small corporation. The shareholders and directors of the corporation must have annual meetings and those meetings should be documented and kept in the records of the company. Certain officers have to be in place. There are duties imposed on the directors to act in the best interests of the shareholders and the company. Members of an LLC don’t ever have to meet. Shareholders of a corporation don’t owe each other any duty or responsibility. Members of an LLC owe each other a fiduciary duty, a high form of trust under the law. The LLC offers greater flexibility in allocation of profit and loss, or discretionary distributions that aren’t tied to the percentage of ownership as in a corporation’s distribution of dividends. Asset protection can differ dramatically between the two as well. A judgment creditor can effectively take ownership of someone’s shares in a corporation to satisfy an obligation. Conversely, they cannot take over the membership interests of an LLC because the law is generally unwilling to impose the fiduciary duty on someone (unless it’s a single member LLC, in which case the duty is to yourself and can pragmatically be imposed on a new single member). And that’s just a few!
The fast-food version of the choice of legal entity has done some damage. We constantly see operating agreements (similar to the bylaws of a corporation, the document that governs the rights of the LLC members) that, due to their “universal” application, don’t provide for many of the concerns that business owners have. We don’t see a shareholder agreement when there clearly should have been one. You can spend more money on reinventing the wheel than buying a better wheel to begin with. There’s an old saying among attorneys - “No one cares what a contract says until everyone cares what a contract says.” It’s true, when problems arise, attorneys earn a lot of fees by dissecting documents like an operating agreement and finding an angle. We like to define the angles according to the wishes and needs of the client from the very beginning.