These days, it seems as if every entrepreneur wants to choose a Limited Liability Company, or “LLC” for their new business entity.  From its humble beginnings in Wyoming in 1977, the LLC has quickly grown to become one of the most popular forms of business organizations.  In many respects, the LLC deserves its popularity as it is a surpassingly flexible form of business organization, but for tax purposes it is not a one-size-fits-all solution to the choice of entity question, especially for operating entities. This article will highlight some of the tax reasons as to when even the flexible LLC comes up short.

An LLC is well-suited as a real estate title-holding entity.  Indeed, an LLC classified as a partnership for federal income tax purposes is a highly tax-efficient landlord.  When an LLC conducts business operations, however, the LLC’s default partnership tax classification can cause tax inefficiencies.  Just as partners cannot be employees of their partnership, LLC members cannot be employees of their LLC if it is taxed as a partnership.  This can result in a member’s entire distributive share of LLC income being subject to self-employment taxes – a situation that could have easily been avoided with a better-counseled choice of entity or tax election.

As an operating entity, an LLC taxed as a partnership faces further tax constraints.  When establishing a Qualified Plan (e.g., a 401K plan), the LLC is unable to avail itself of the more favorable rules available to corporations and is instead subject to the restrictive limitations placed on state-law partnerships.  In particular, LLCs face heightened restrictions on equity-owners making loans to themselves through Qualified Plans as well as stricter limitations on matching contributions.  For small business owners focused on setting aside money for retirement in a tax-efficient manner, the LLC’s Qualified Plan limitations could result in retirement contributions coming up short.

The LLC’s operational tax limitations also reach beyond equity-owners to limit incentive compensation available to non-owner employees.  An LLC cannot create incentive stock options to issue to key employees because, among other reasons, upon exercise the employee would cease to be an employee for tax purposes.  In a similar vein, care must be taken prior to issuing a profits interest in a LLC to a non-owner employee as, upon issuance, the employee ceases to be an employee for tax-purposes and can no longer be paid tax-withheld wages reported on Form W-2.  While there are strategies designed to replicate these incentive compensation arrangements while still permitting employees to retain their Form W-2 status, these strategies can be exceedingly complex to implement and administer, oftentimes resulting in a solution worse than the problem. 

Local expertise can also save tax dollars particularly where states classify LLCs differently than the federal government for income tax purposes.  Many states respect federal income tax classifications and will treat LLCs as flow-through entities, but some states tax LLCs as corporations.  Varying local tax treatment extends beyond income taxes as well.  In Massachusetts, for example, corporations are subject to a uniform tangible property tax in lieu of local property taxes on many types of business property.  LLCs, however, are excluded from the uniform state-level tax and are instead subject to tax at local rates varying across the Commonwealth – often several times higher than the $2.60 per $1,000 rate otherwise applied to corporate taxpayers.

Tax needs can change over time.  An LLC may have been the best-choice to get a business started but, after years of successful operation, especially for estate planning purposes, the LLC can lose some of its appeal.  When crafting an estate plan that involves lifetime transfers of business interests, LLCs are not always the best fit.  The sections of the Internal Revenue Code governing valuation discounts for business interests are not favorable to LLCs.  Under the Internal Revenue Code, transfer and voting restrictions contained within operating agreements and other LLC governing documents are disregarded, resulting in LLC interests being treated for discount purposes as governed by the default provisions of state law – which often reduce potential valuation discounts.  The result is that the LLC can be a poor fit when business valuation and transfers of minority interests enters the picture.

For tax purposes, the LLC form of entity may have some short-comings or it could be the best fit, but overall the LLC is a flexible business entity that is largely deserving of its popularity.  The factors that determine whether an LLC is the correct choice for your next entity depends on issues that the business and tax attorneys at McLaughlinQuinn LLC consider every day in guiding clients towards the best choice of business organization for their unique business needs.  For more information on this article, please contact either Jeffrey B. Ciancolo, Esq., Partner (This email address is being protected from spambots. You need JavaScript enabled to view it.) or Marcus I. Howell, Esq., Senior Associate (This email address is being protected from spambots. You need JavaScript enabled to view it.).