Most entrepreneurs realize that when starting a new small business, the smart approach is form a business entity through which to conduct the business. While Virginia offers a number of different options, the limited liability company has emerged over the past 25 years as the most popular choice of entity in the small business community…and for good reason.
This post describes some fundamental features of LLCs that will help you decide whether an LLC is the right choice for your business.
What is a Limited Liability Company?
A limited liability company (LLC) is a type of business entity that is a cross between a partnership and a corporation. Like a corporation, an LLC is separate and distinct from its owners. It provides the same level of limited liability protection of a corporation, but it also allows for a more flexible business relationship between the owners such as one might find in a partnership.
LLC Terminology: Members and Managers
The owners of LLCs are known as “members.” LLC members typically have the right to manage the business of the LLC, receive a pro rata share of LLC profits as well as any assets left over after the LLC has been dissolved.
The members can also choose to have the LLC business managed by “managers” who are appointed by the members. The managers manage the day-to-day business of the LLC. Managers are often given titles that are similar to the officers of a corporation (e.g. President, CEO, etc.). Who gets to make what decisions, who gets to vote, and related governance logistics are typically addressed in a written contract between the LLC and its owners called an “Operating Agreement.”
LLCs are not subject to the same statutory formalities and requirements as corporations. They are not required to elect a board of directors, hold board meetings, file annual reports, or keep any records of company meetings. Relatively speaking, LLCs are very “low maintenance” when it comes to paperwork and SCC compliance.
Why are LLCs Popular?
An LLC is often the an appropriate choice for closely held businesses or for real estate ownership. An LLC can also be used for subsidiary companies within a larger business for asset protection, governance, or other strategic purposes.
An LLC is usually NOT going to be the best choice in situations where key employees are to receive options to buy into the business, the owners plan to take the company public in a few years, or the company plans to raise equity capital from institutional investors. In those cases, a stock corporation will typically be the entity of choice.
Unlike a corporation, the ownership interests of an LLC are usually not freely transferable. A member may transfer his or her economic interest (e.g., the right to receive profits), but members usually have to get the unanimous approval of the other members before a transferee can participate in the management of the LLC business as a full member. LLC owners will typically address ownership transfer issues in the Operating Agreement to preserve the sanctity of the ownership group and provide an efficient mechanism for addressing a variety of common situations that arise during the life cycle of a business (e.g., death, disability, disagreement, etc.).
On a related note, a member wanting to withdraw from the LLC must also get approval from the other members. This often comes as an unpleasant surprise to a disgruntled owner who wants to “walk away” from a struggling or dysfunctional business.
Formation of an LLC
Before you actually file any paperwork, you must choose a name for your LLC. This comes with certain requirements, and it’s best to take the time to consider them up front.
In Virginia, the State Corporation Commission requires an LLC name to be “distinguishable.” What does that mean? It means that the name of your LLC has to be unique from the name of every other existing business in the SCC’s database. The actual formation of an LLC begins with the filing of Articles of Organization with the SCC by an incorporator. You can file these in person, by mail, or online. All LLCs must also have a registered agent on file to receive official documents from state agencies and service of process if litigation is filed against the LLC. In Virginia, the filing fee for the Articles of Organization is $100.
Once the Articles are filed and approved by the SCC, the LLC legally exists as a matter of Virginia law. Still, you will need to navigate a few other steps to complete the LLC startup process to fully comply with applicable law and protect yourself and your business interests. For example, you will need to apply for a Federal taxpayer identification number (“EIN”) with the IRS, follow a similar tax registration process at the state level, obtain any and all business licenses or permits required to operate in your city or county, open a business bank account, and—perhaps most importantly—prepare a written Operating Agreement.
Key LLC Formation Documents
The Articles of Organization are a standard document with basic information about the company: LLC name, registered agent, and principal office address. You can include other provisions, but typically only legally required information is included in the Articles of Organization because it is a public document.
However, each business relationship is unique, and the LLC members will need to determine among themselves their relationships to the company and each other. The members of an LLC should enter into a carefully drafted Operating Agreement. Similar to bylaws and buy-sell agreements for a corporation, the Operating Agreement should address key elements of the management, operation, and economics of an LLC such as allocation of profits, decision-making and voting, ownership transfers, and dispute resolution.
Other documents may be required to address the various other contractual relationships your business will be involved in during the normal course of business. Examples of common agreements for small business owners include employment agreements, independent contractor agreements, confidentiality agreements, noncompete agreements, and license agreements.
How Are LLC’s Taxed?
When forming an LLC and drafting its organizational documents,, the founding owners must also consider how they want the LLC to be classified for tax purposes. Depending on the number of members, an LLC can opt to be taxed as one of four types of businesses:
· Sole Proprietorship (i.e. disregarded tax entity),
· S corporation,
· C corporation.
This flexibility is one of the most appealing aspects of the LLC as it allows owners to optimize their business entity to suit their particular needs and circumstances.
A single-member LLC will by default be taxed as a sole proprietorship. You do not need to file anything with the IRS, but to be taxed as a disregarded tax entity (i.e. sole proprietorship), it must be a single-member LLC.
For IRS purposes, a sole proprietorship is a disregarded tax entity. This means that no distinction is made between the tax status of the business entity and the owner. The income and expenses of the LLC pass through to the tax return of the owner. Hence, such structures are often referred to as “pass through” entities.
A multi-member LLC (i.e., LLCs with more than one member) will by default be taxed as a partnership. Owners would report personal income on Schedule C of Form 1040, but the LLC would also file a Form 1065 with the IRS and issue K-1 statements to all LLC members. Again, this would be known as a pass through entity.
The previous sections covered the default tax schedules for single- and multi-member LLCs. However, LLC members can elect for corporate taxation as well, either as a C corporation or an S corporation. To be taxed as an S corporation, an LLC must file Form 2553 with the IRS. S corporations are still pass through entities, however, and are not subject to double taxation like C corporations. LLCs electing S corp. status has become a common strategy in the small business community and is worth discussing with your small business attorney and accountant during the LLC formation process.
By electing S corporation tax status, LLC owners may be able to avoid other taxes that a sole proprietor must pay, such as self-employment taxes (i.e., Social Security and Medicare). For 2019, the self-employment tax rate is 15.3% (up to $128,400 net income), meaning that the owner of a single-member LLC with $100,000 in net income would have paid $15,300 in self-employment taxes for the year.
By opting for S corporation status, an owner who is actively involved in the business magically converts from a self-employed individual for into an employee of the LLC and has to take a reasonable salary. The salary is still subject to the 15.3% tax, but the owner’s share of remaining profits over and above that salary are not. As a simple illustration, an LLC owner taking a $60,000 salary means the owner would pay $9,180 in self-employment taxes, but would save approximately $6,120 overall thanks to the S corp. election.
The tax savings can quickly be offset by the increased costs to the owner in payroll and accounting fees, additional bookkeeping costs, or filings for corporate and payroll tax returns. You should weigh the costs and benefits against one another. But, in short, the higher your net income, the likelier that S corporation tax status will benefit you. Again, be sure to consult with your accountant or other tax advisor to make an informed decision whether S corporation tax status would suit your business needs.
It is also worth noting a few additional conditions that your LLC must satisfy in order to qualify for S corporation tax election.
· Non-U.S. citizens are forbidden from ownership stake in S corporations. So, your LLC cannot elect S corporation tax status if one of its members is a foreign investor or another company.
· Multi-member LLCs that wish to opt for S corporation tax status will also be restricted to 100 members. LLCs generally don’t have restrictions on the number of members allowed, but S corporations are allowed no more than 100 shareholders.
· S corporations are allowed to issue only a single class of stock. If your LLC issued membership interests of different classes (e.g. preferred and common), it cannot qualify as an S corporation. Note, however, that the IRS does allow an S corporation to have voting and nonvoting classes of stock.
An LLC could also opt for C corporation tax status by filing Form 8832 with the IRS. Doing so, however, subjects them to one of the biggest downsides of forming a C corporation, double taxation.
All of the tax classifications discussed above are pass through entities, taxed once, at the personal level. A C corporation’s profits, however, are taxed both at the corporate level and at the personal level. For an LLC to truly benefit from electing C corporation tax status, the business should generate significant revenue. But with the recent changes to the tax code and the reduction of the corporate tax rate to 21%, perhaps more LLCs will opt for C corporation tax structure.
What Are the Ongoing Entity Maintenance Costs of an LLC?
The SCC charges an annual fee of only $50 for an LLC to remain active. In addition to the SCC annual fee, an LLC that has elected S corporation or C corporation tax status may also incur accountant’s fees for preparation of an annual tax return.
Overview of LLC Benefits
As a business entity, an LLC provides business owners with the personal liability protection against debts and obligations of the business. LLCs also offer far more flexibility and creativity when it comes to designing the ownership, economic, and management structure of the business, while at the same time imposing fewer entity maintenance requirements and statutory formalities.
Get Help from a Pro
A wise entrepreneur will plan ahead of time with his or her business partners and an experienced small business attorney. Consider each of the founding owner’s goals and expectations for the company and use that discussion as a guide toward choosing the right legal entity for your business and effectively navigating the small business startup process. Perkins Law is pleased to offer a flat fee package for LLC formations. (include link to LLC Flat Fee Package flyer).