Last week’s post discussed some important tax issues entrepreneurs should be aware of when forming and operating California partnerships. As we discussed, one of the most important factors to consider when forming a new enterprise is whether the business is initially expected to generate profits or losses and the tax consequences of those profits and losses on the founders and other investors. The tax effect of the profits earned and losses suffered by your new enterprise will have an impact on whether you decide to form a taxable entity of a pass through entity. One form of pass through entity you may wish to consider for your new enterprise is a limited liability company (“LLC”) because it can elect to be taxed as either a corporation or partnership under federal and state law.
An LLC is treated as a partnership for income tax purposes unless it elects to be treated as a corporation. As a flow-through entity, the income and losses of the LLC flow through to, and are taxed to or deducted by, the individual members. Income and losses normally retain the character they had in the LLC. Thus, an LLC choosing partnership characteristics can avoid double taxation. Losses may be fully deductible by the individual members, but not in excess of each member’s adjusted tax basis in the company. As with a partnership, flow-through tax treatment can be disadvantageous to the owners of a profitable LLC that reinvests a significant portion of its profits, since the members will be taxed on their allocable share of the profits without receiving cash distributions from which to pay the tax. An LLC that elects corporate tax characteristics may be subject to double taxation and other tax characteristics of a corporation.
An LLC’s distributions to its members generally are not taxable either to the LLC or the individual members. If, however, the value of the distribution by the LLC exceeds the individual member’s adjusted tax basis in his LLC interest, gain will be recognized by the individual member to the extent of the excess. As with a partnership, a member who contributes property with built-in gain may be required to recognize all or part of that gain if, within five years of the initial contribution, either the LLC distributes the contributed property to another member, or the LLC distributes different property to the contributing member. In addition, gain may be recognized to the individual member when an LLC distributes marketable securities or certain unrealized receivables or appreciated inventory. A member’s adjusted tax basis in his LLC interest is reduced by the distributions made to the member. Generally, a member will take an adjusted tax basis in any property distributed by the LLC to the member equal to the LLC’s adjusted tax basis in the property immediately prior to the distribution.
Because LLCs are taxed as partnerships unless they elect to be taxed as corporations the consequence of disposition or liquidation of an interest in an LLC is the same as partnerships or corporations, depending on whether or not the election is made.
If your new business is expected initially to generate losses, then a tax flow-through entity may be the entity of choice because it allows the owners of the company to deduct the losses from their taxable income. For example, information technology or biotechnology companies frequently operate at a loss because of the high costs of developing products. This is particularly true of biotechnology companies, which must incur the cost of developing products, conducting clinical trials and obtaining approval from the U.S. Food and Drug Administration before generating its first dollar of revenue. IT and biotech companies may experience several years of substantial losses before becoming profitable. Depending on the investors who have bankrolled the new enterprise, a flow-through entity may be attractive because it allows the investors to deduct the start-up losses against taxable income. Otherwise it may be several years before the business earns a profit and can use tax loss carry forwards to reduce its tax burden.
This post discusses just some of the most significant tax issues you should consider when selecting a California LLC for your new business venture. Before you make a final decision, we strongly recommend that you consult with knowledgeable corporate and tax counsel, and a knowledgeable tax accountant, to make sure you have thought through all the possible tax consequences that could flow from your new business, at least as you’ve contemplated the venture in your business plan.