What is an LLC?
An LLC (Limited Liability Company) is a type of business entity that is formed or registered at the state level. LLCs are hybrid entities that combine aspects of sole proprietorships, partnerships and corporations. Like a corporation, an LLC provides liability protection to its owners so their personal assets are generally not at risk if the business is sued. However, prior to S Corp Election, LLCs are structured likesole proprietorships or partnerships in terms of taxation - profits and losses pass through to the owners who report them on their personal tax returns.
LLCs are more flexible than corporations in how they are structured and managed. The owners operate under an operating agreement that outlines the LLC's organization and provisions. LLCs do not have shareholders nor do they issue stock. Ownership is divided into membership interests which can be owned by one or more individuals and entities.
Unlike corporations, LLCs do not need to adhere to formalities like holding board meetings and recording meeting minutes. However, they still need to keep financial records and report profits/losses on tax returns.
Why does Collective prefer LLC-based S Corps?
Collective prefers an LLC-based S Corp for several reasons:
Tax Benefits: An S Corp is a tax election that allows businesses to determine how they'll be taxed. The business' net income is not taxed at the business level but is "passed through" to the owners' personal tax returns. This allows owners to earn a salary as well as take distributions of profits, which are subject to different tax treatments.
Limited Liability Protection: An LLC provides its owners with limited liability protection. This means that the owners are not personally responsible for the company's debts and liabilities.
Flexibility: LLCs are known for the flexibility they provide to business owners. Depending on the situation, an LLC may elect to use corporate tax rules instead of being treated as a partnership.
The Complications of Multi-Member LLCs
Multi-member LLC taxes mirror partnership taxation much more closely than single-member LLC taxation. This creates additional complexity. Here are some key differences in how taxes work for multi-member LLCs compared to single-member LLCs:
Default Tax Status - By default, a multi-member LLC is taxed as a partnership whereas a single-member LLC is taxed as a sole proprietorship.
Self-Employment Taxes - Members of a multi-member LLC have to pay self-employment taxes on their share of LLC income, similar to a partnership.
Issuing K-1s - Multi-member LLCs must issue a Schedule K-1 to each member annually reporting their allocable share of income, deductions, credits, etc.
Reporting Requirements - A multi-member LLC may need to file a partnership tax return (Form 1065) each year, depending on its circumstances.
Greater Complexity - With multiple members, allocations and distributions create more tax accounting complexity.
Basis Tracking - Members must track their outside basis (contributions - distributions) which determines the deductibility of losses.
Management Structure
An LLC’s management structure can be either member-managed or manager-managed. Member management vests power in the members, while manager management vests day-to-day power in dedicated managers. The optimal structure depends on the LLC's specific circumstances.
Here are the main differences between member-managed and manager-managed LLCs.
Member-Managed LLC:
Each member has equal rights in managing the company. There are no separate non-member managers.
Management is handled directly by the members, similar to a partnership. Major decisions often require consent of a majority of members.
Members have authority to act as agents of the LLC and bind it to contracts and debt in the ordinary course of business.
Less common once there are multiple members, since it can become inefficient.
Manager-Managed LLC:
The LLC has appointed non-member managers who handle the company's day-to-day operations.
This management structure is more like a corporation, with managers in charge of running the business.
Only managers can act as agents of the LLC and make decisions binding the LLC. Regular members have limited authority.
More common for multi-member LLCs because it centralizes management decisions.
Managers have fiduciary duties to the LLC and can be held liable for mismanagement.
Members still vote on major decisions like electing managers, amending the operating agreement, or merging/dissolving the LLC.
Spouses
There are some important differences between a spouse being an employee of a business versus being a co-owner. The appropriate role depends on the spouse's desired involvement and legal protections. Co-ownership is riskier but can provide greater rewards. Employment status provides more legal protections.
Employee Spouse:
The spouse is hired by the business owner and treated like any other employee. They have no ownership stake.
The spouse must be paid a reasonable salary and wages for any work performed.
Payroll taxes like FICA must be withheld and the spouse receives a W-2.
The employed spouse may be eligible for certain employee benefits like health insurance.
Business owners can deduct the compensation paid to the spouse as a business expense.
Income earned by the spouse comes from their employment, not business ownership.
Co-Owner Spouse:
The spouse has an ownership stake in the business, acquired either through investment or grant.
The co-owner spouse shares in profits and losses on their ownership percentage.
The spouse is not entitled to compensation and benefits as an employee. Any money withdrawn is owner distributions, not payroll.
Payroll taxes are not paid on distributions to the co-owner spouse.
Business profits pass through to the spouse's personal tax return based on ownership share.
Co-ownership can complicate divorce if community property rules apply.
May allow bigger tax benefits but less employee protections.
Please note that Collective services are currently limited to single-member LLCs. Some exceptions may exist for members located in community property states. Those states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
Disclaimer: The information contained in this document is provided for informational purposes only and should not be construed as financial or tax advice. It is not intended to be a substitute for obtaining accounting or other financial advice from an appropriate financial adviser or for the purpose of avoiding U.S. Federal, state or local tax payments and penalties.