A few things to consider
Are you thinking about forming an LLC but don’t know if it is best for your goals? This article will give you some things to consider and be aware of when making the decision. Please note that this article does not include everything that should be considered but it is a starting point to help in choosing the proper entity.
1. Compare and analyze with other forms of entities
Pros of LLC: flexibility, choice of how it is taxed, asset protections, easy and inexpensive to operate
Cons of LLC: complexity of operating agreement, gross receipts tax; member withdrawal or assignment of interest can cause dissolution, member interest may be subject to transfer restrictions
Pros of Corporation: limited liability for all stockholders, free transferability of stock, stock can be publicly traded
Cons of Corporation: shareholders subject to double taxation, corporate formalities must be followed, management structure is fixed, fiduciary duties for directors
2. Review tax considerations
A single-member LLC can be taxed as a disregarded entity which means there is no separate tax return. The income is reported on the owner’s Form 1040 on Schedule C.
It is key to get a CPA/accountant involved in the beginning to assist in understanding the tax considerations.
3. Review and understand asset protection issues
Inside-out protection v. outside-in protection
Inside creditors are those where the claim is against the business operations or real estate which is in the LLC.
It is not absolute. If the company is under-capitalized, lacks separate books or there is co-mingling of funds, a creditor can attach the LLC. (Be sure to check out our blog post Does your Corporate or LLC Protect you From Personal Liability? )
Outside creditors are those claims that arise outside of the business entity and are asserted against the owner personally.
Generally, single-member LLCs have no outside-in protections. Multi-member LLCs and Limited Partnerships (LPs) have the best outside-in protection.
4. Review and chose the best state for your business goals
Most favorable states for single member LLCs are Nevada and Wyoming which have a 0% corporate tax rate. Others are Alaska, South Dakota, Florida, Nevada or Montana.
5. Understand the concept of “Sweat Capital” (multiple-member LLCs)
For example: two people form a real estate LLC with one partner providing the property and the other partner providing the services (“sweat”). To avoid the sweat partner having to pay income tax on the capital interest in the entity, give the sweat partner a profit interest instead of equity interest.
6. Analyze management structure - member managed vs manager managed
A manager-managed LLC is more like a limited partnership with a general partner and passive limited partners. This management structure may be better for asset protection as the manager can resign and appoint a successor if manager sued.
7. Provide for Additional Members and the Exit of Members
When creating the LLC, there should be an assumption that there will be more members in the future. This should be addressed in the operating agreement because it’s much easier to get additional members to join the LLC if it’s already addressed in the agreement.
Also, be sure to address the exit of members in the operating agreement by including a provision for buy/sell arrangements for disability, bankruptcy, divorce, etc.
A final note
We’ve only touched on a few of the areas you really must consider when establishing the right business entity for your situation. It’s not as simple as pulling something off of Google, tweaking it and you’re done.
By working with qualified legal and tax advisors in choosing and setting up your LLC or corporation, you’re getting the huge benefit of experience and foresight into areas that you haven’t even thought of. Address these complexities upfront in your agreements and corporate structure and it will save you headaches down the road.