Also in this Issue:
-Limited Liability Companies:
An Introduction and General Overview
-Estate Planning with Family Partnerships
and LLCs
-Real Estate Investment Using LLCs:
Not Always a No-Brainer
LLCs: ASSESSING THE TAX PROS AND CONS
by Jeff Detwiler detwiler@ddrs.com
The LLC has fast become the nationwide structure of choice for small to medium sized business ventures and closely held real estate ownership. In addition to the liability protection offered by the LLC form, the tax treatment of an LLC and its members is touted as providing distinct advantages over the regular corporation (also known as a "C" corporation) or the S corporation. Following is a brief review of those advantages as well as some mention of possible disadvantages of the LLC in certain situations.
General Source of Advantages Over the C Corporation. The tax advantages of the LLC over the regular corporation stem from the taxation, for both federal and California purposes, of LLCs as partnerships; that is, the LLC and its members are taxed only at the individual or member level. Unlike the regular C corporation, the LLC pays no income tax, but simply reports the income to the taxing authorities and each of its members. The members then report their shares of LLC income (or loss) and pay tax at their individual tax rates on income passed through the LLC. Thus, the business and its owners avoid the double tax burden imposed on the regular corporation and its shareholders. Among the specific advantages or disadvantages of the choice of an LLC over a regular corporation are:
First Year Losses. If the business generates losses, losses in the LLC pass through to individual taxpayers who, in some circumstances, can use the losses to offset other income. (Advantage - LLC)
Loss. If the business venture fails, the loss in a C corporation is a capital loss to the investors. The loss from the LLC is ordinary and can offset other ordinary income. (Advantage - LLC)
Tax Rates. The first level of tax on income of a C corporation is imposed at federal rates from 15% to 35%. (The combined federal and California tax rate, taking into account the benefit of deduction of state taxes from federal taxes, is from 22.5% to 40.75%.) The single level of tax on income of an LLC is imposed at the marginal rates of the members, which for individuals runs from 15% to 39.6% federal (combined federal and California rate of 22.9% to 48.9%). Whether the LLC rate is better than the corporate rate on the first level depends on the taxable income of the business and the tax brackets of the owners. If the business expects relatively modest levels of income and will plow the income back into the business, the C corporation may offer an advantage, especially if the owners are in maximum individual tax brackets. This potential advantage disappears if the corporation distributes dividends to shareholders, incurring a second tax, or if the business generates a tax loss which could have been passed through to offset owner income in the LLC. (Advantage - Unknown-Requires further analysis)
Double Tax. With regard to regular earnings, the double tax hit is theoretically significant. If the C corporation receives $100 that is taxed at maximum rates, the corporation pays $40.75 in tax. If the corporation distributes the remaining $59.25 as a dividend to shareholders who are taxed at maximum rates, an additional $28.97 is paid at the shareholder level, leaving a meager $30.78 out of the original $100. This translates to an incredible tax rate of 69.22%. Even at more modest tax rates, once the business actually distributes funds to the owners, the LLC members come out far ahead. (Advantage - LLC)
The profitable C corporation often adopts strategies for avoiding double tax, such as payments to owners of management fees, rents, sizable bonuses or other items characterized as deductible expenses, all of which are risky at high profit levels and cannot be reflected in binding contracts. These schemes are not necessary and thus are not a problem in the LLC. (Advantage - LLC)
Exit Strategies. The most telling difference in tax treatment of LLCs and C corporations is in the sale of a business. Most exit strategies for a C corporation involve double tax (e.g., asset sale to acquirer) which can result in a total tax in the 50-60% range. The LLC has only one level of tax at approximately 28% combined federal and California. The tax calculation which creates this dramatic difference in outcome is set forth in the example below:
The Calculation
Assumptions:
Sale of business for $1,000,000
Corporate tax basis in business assets is $0
Shareholder Basis in Shares is $20,000
Corporate Tax Rates:
Fed.-34% Calif.-9.3% Combined-40.14%
Individual Tax Rates:
Fed. Capital Gains-20% Calif.-9.3% Combined-27.44%
|
Sale of Assets by Regular Corporation Corporate Tax Shareholder Tax Overall Tax LLC Single Level Tax Effect on Owner |
$1,000,000 $1,000,000 $1,000,000
$1,000,000 |
In this example, the tax rate difference of almost 30% is very dramatic. In situations in which the assets of a C corporation have a higher tax cost basis, the differences are reduced somewhat.
The obvious alternative is to have the owner sell stock of the regular corporation to avoid the second level of tax. Unfortunately, because the buyer is not permitted to step up asset values in a stock purchase, the buyer loses the benefits of depreciation deductions in a stock purchase and thus LOWERS the purchase price. This is the reason a cash purchaser almost NEVER buys stock in the current tax environment. (Advantage - LLC)
A Twist on Exit Planning. Unfortunately, the choice to use an LLC is not completely clear, even in the face of the foregoing example. Often for high technology or rapid growth "idea" companies, the exit strategy for the founders or early investors may be an IPO or acquisition by a public corporation. The IPO creates little problem. Although the securities markets show little receptivity to any business structure other than a regular corporation, an LLC can be converted into a corporation when the ability to use an IPO becomes clear. While this conversion may be expensive and burdensome, there is no tax driven reason which prohibits it.
Another common exit strategy is to be acquired by a public company for stock of that company. These transactions are usually advantageous to selling business owners because receipt of the acquiring corporation's stock is tax free under tax free reorganization rules. Unfortunately, a corporation which incorporates on the eve of a merger or reorganization with a larger company likely will not satisfy the requirements for a nontaxable reorganization. An even greater problem arises from current accounting rules relating to "pooling of interests". (This type of accounting allows a public corporation to avoid expensing goodwill of an acquired company. While "pooling" means a loss of some deductions, it also means that earnings will not be lowered by required expensing of goodwill or other intangible assets. Because reduced earnings tend to lower stock prices, there are situations in which a deal which cannot qualify as a "pooling" simply will not happen.) Under current accounting rules, a "pooling" cannot happen with an LLC or with a corporation recently converted from an LLC. (Disadvantage - LLC)
Shifts in Ownership. In the LLC form, one member can be bought out by another member or by a third party and the remaining members can cause the LLC to step-up the basis of the portion of its assets attributable to the transferred interest, thus increasing future depreciation deductions to the members. This is not possible in a C corporation or in an S corporation. (Advantage - LLC)
Consequences on Owner's Death. If an owner dies owning stock of a C corporation, the heirs get a step-up in basis of the stock, but not in the underlying assets. Thus, one level of tax is avoided, but the corporate tax on all appreciation of its assets and business remains, and in one way or another, sooner or later, the heirs will bear the burden of tax on that appreciation. In the case of an LLC, the basis step-up is complete with respect to the deceased member's entire interest (including the community interest of the member's spouse) and the member's proportionate share of the assets of the LLC. Thus, the LLC could sell its assets immediately after the member's death and none of the deceased member's share of proceeds would be taxable to the member's estate. (Advantage - LLC)
Medical Insurance and Employee Benefits. LLCs are subject to the same rules as self employed individuals with respect to employee benefits such as medical insurance and automobile allowances. (Partnerships and S corporations are subject to the same limitations.) Deductibility of these benefits is generally greater for C corporations, although in the area of health insurance costs, this difference is slowly being phased out. (Disadvantage - LLC)
S Corporation Disqualification Issues. While an S corporation offers some of the same pass-through tax advantages of an LLC, the S corporation is a fairly "fragile" entity. The eligibility of an S corporation can be lost by having impermissible types of shareholders (e.g., corporations, partnerships, foreign owners, and most trusts cannot own S corporation stock), too many shareholders (although the permitted number has been increased to 75), or any differentiation in the type of economic relationships of shareholders to the company (i.e., no preferred stock or rights). None of these features affect an LLC. (Advantage - LLC)
These are the major tax considerations (and one important consideration from the accounting arena) affecting the choice of an LLC over a C corporation or an S corporation. As always, the "tax tail should not wag the business dog" and so these considerations should not be considered in isolation.
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