As we have discussed before, the question of what is the best form of business entity to operate your new company is complicated and based on your specific business objectives and business plan. The options include a form or corporation, a partnership or limited liability company. Each form of entity has its advantages and disadvantages.
The primary considerations in choosing a business entity is (1) the degree to which the entrepreneurs’ personal assets are protected from the business’ liabilities, (2) the availability of favorable tax strategies (like maximizing the tax benefits of start-up losses, avoiding multiple layers of taxation, and converting ordinary income to long term capital gains), (3) the company’s attractiveness to potential investors and lenders, (4) the availability of attractive equity incentives for employees and consultants, and (5) the costs of starting-up and operating the enterprise.
A limited liability company (“LLC”) combines the pass through federal tax treatment of a partnership with the liability protections of a corporation. The owners of an LLC have no personal liability for the obligations of the LCC. For all practical purposes, an LLC operates as a limited partnership without the legal requirement of having a general partner who bears ultimate liability for the obligations of the partnership. An LLC is not limited to 100 members or members that have particular attributes like subchapter s-corporations. An LLC is not the best form of business entity to offer equity incentive programs to employees and consultants because the tax code does not allow LLCs to offer incentive stock options (“ISO”) to employees, and the value and appreciation of a membership interest in an LLC are not easily explained to employees. LLC’s can provide a good form of business entity for real estate investments, motion picture or other entertainment focused enterprises.
With respect to taxes, in California an LLC must pay the minimum tax of $800 per year. Unlike corporations, in addition to the statutory minimum tax, an LLC must pay an annual fee based on gross revenues derived from or attributable to California ranging from $900 for gross revenues of $250,000 or more to $11,790 for gross revenues of $5 million or more. The LLC is not taxed on contributions to capital. Members may contribute property or cash to the LLC tax-free. An LLC is not a form of business entity that can take advantage of tax code provisions that provide favorable treatment for certain losses or gains for qualified small business stock.
A member of an LLC who contributes services to the company in exchange for a profit interest in the company, is not subject to tax. A member who seeks a capital interest (i.e. equity) in the company is subject to tax, but that tax may be deferred. An LLC can use the cash method of accounting. An LLC is typically not subject to double taxation upon liquidation.
An LLC may not be suitable for businesses financed by VC funds because frequently there are tax restrictions on investments that can be made by the funds’ tax-exempt partners. An LLC may be very attractive for businesses financed by corporate investors, and to some extent by wealthy individuals.
An LLC is a good entity for a start-up entity seeking flow through losses to its investors because (1) unlike a limited partnership it offers protection against personal liability for its members, (2) it can have corporations and partnerships as members and is not subject to any other limitations that apply to S corporations, (3) losses can be specially allocated entirely to cash investors (in an S corporation losses are allocated to all owners based on share ownership); and (4) an LLC can be incorporated tax free at any time.
Before you decide on the form of business entity you select for your new business venture, contact us at Finkel Law Group to discuss the options. You can reach us at (415) 252-9600 or www.finkellawgroup.com.