What is a Limited Liability Company (LLC)?
Imagine that an employee of the new business you own acts negligently and seriously damages customer property; the customer sues and wins. Imagine that the damage is not covered by your business insurance (for whatever reason). Can the customer require that YOUR personal home be sold to cover the damage caused by the employee?
The answer to this question depends on (1) whether your business is established in a form of entity, such as a limited liability company, that protects the business owners’ personal assets from the liabilities of the business and (2) whether you are treating that entity properly as a separate business.
So, if your business is not established as a LLC or corporation, your personal assets are at risk.
Why Choose An LLC?
Management Structure Flexibility. An LLC can choose its management structure, rather than having its management structure imposed by law. For example, an LLC can choose a multi-layered management structure like a corporation, OR it can have a simpler, owner-managed structure akin to a partnership.
More Choice in Method of Taxation. A multi-member LLC (Note: Owners of an LLC are called “members”) can choose to be taxed as a partnership (the default) OR a C-corporation or a S-corporation. Corporations cannot choose to be taxed as a partnership.
No Annual Meetings. Utah laws do not require that LLCs have formal annual meetings of the members. Corporations must have annual meetings. Why Not Choose an LLC? (Is a corporation the better choice?) Perceptions. Some financial institutions might not regard LLCs as favorably as corporations, believing that LLC owners may not be as serious about their business endeavors as corporation owners. You can always overcome any such initial bias with your actual (and presumably impressive) financial record. But, if first impressions with financial institutions are important to your business, you might consider a corporation. If your business will be seeking funding in the future from a venture capitalist firm (a group of wealthy investors), you might consider a corporation. Some venture capitalists prefer to invest in corporations, but it is only one factor. In the end, the right business will get investment regardless of its form of entity.
Is my LLC Required to Have an Operating Agreement?
We recommend that all LLCs have an Operating Agreement, but LLCs formed in Utah are not required by law to have one. Operating Agreements contain the terms of the business agreement between the members (i.e., the owners) of an LLC. Important issues are addressed in an Operating Agreement, such as: what limitations will we place on a member’s ability to sell his or her membership interest (i.e., our ownership) in the business to someone else? or what happens if a member dies? or what percentage of votes will it take to agree to add a new member or sell the business? If your LLC does not have an Operating Agreement, state laws will decide these and other important questions for you, possibly in a manner that you do not like.
What is an S Corporation?
An “S Corporation” is a corporation or another type of business entity that has chosen an IRS taxation category for its business that is commonly referred to as “S Corporation”. The S stands for small. Business entities that choose to be taxed in the S Corporation tax category do not pay income taxes directly. Instead, the income taxes of the business are paid by the owners of the business. An LLC can choose to be taxed as an S Corporation, in the same way that a corporation can choose to be taxed as an S Corporation.
Can being taxed as an S Corporation save me taxes?
In some situations, choosing to be taxed by the IRS as a S Corporation can be used to reduce the self-employment (or FICA) taxes paid by the business’ owners. However, considerations other than the owners’ saving on self-employment / FICA taxes might dissuade your business from choosing to be taxed as an S Corporation. In fact, many of the business owners we assist with their business entity formation do not choose S Corporation taxation.
Here is a very basic explanation of how the potential tax savings is achieved for some businesses owners of S Corporations: When your business is taxed as an S Corporation, the business will pay money to you (the owner) in two ways: (1) As a salaried, W-2 employee/officer, with a regular paycheck, and (2) As an owner, with a dividend or distribution. Paycheck payments to you as an employee are subject to both income tax and FICA taxes. Dividend payments to you as an owner are subject only to income tax (not FICA taxes or self-employment tax). However, the IRS requires that you receive a reasonable salary as an employee for your services rendered to the business, in order to allow the dividend payments to avoid FICA/SE tax. What constitutes a reasonable salary is not defined in the code or regulations, but courts have looked at various factors, including (but not limited to) what comparable businesses pay for similar services, training and experience, duties and responsibilities, time and effort devoted to the business, dividend history, and payments to non-shareholder employees.
How Do I Choose Between Forming an LLC or S Corporation?
The decision between forming a limited liability company (LLC) or corporation or another type of entity can be complex. You will want consider the current and future ownership and management structure of the business, future plans of the business, and taxes, among other things.
Contact LeBaron & Jensen for more information on setting up a business, and selecting the right one for your situation.