Question of the Month: Specht of Metis Group CPAs LLC answers, "Is an LLC the correct business entity?"

Is an LLC the Correct Business Entity? You and three business associates just decided to leave the company that you work for so that you could start your own business. The first call is to your attorney to form the new entity. Since there will only be a few owners and the new entity will be privately owned rather than a public company, attorney's advice is likely to be "you should be an LLC." An LLC is a limited liability company and while in many cases that may be the most tax efficient entity, sometimes it is not. As its name implies, an LLC provides its owners with the same limited liability as a corporation. However it does not have the double taxation issue that a corporation absorbs. For an LLC with at least two owners (called members), the default method is to be treated as a partnership. However, one of the benefits of an LLC, is what is termed the "check the box election." If an LLC determines it is more beneficial to be treated as a corporation, it can make an election to be taxed as a corporation rather than a partnership. There is no other type of entity where you can choose the method of taxation. It should be noted that once an entity makes an election to be taxed as other than the default classification, generally it cannot change its classification for a period of 60 months. If a newly formed entity initially chooses a classification other than the default classification it is not subject to the 60-month rule unless it subsequently changes its initial classification. Then the 60-month rule would apply from the time of the first classification change. If the LLC elects to be classified as a corporation, it also has the option of electing to be taxed as an "S" corporation. The "S" corporation allows the entity the same limited liability and lack of double taxation as an LLC. However, there are certain taxation differences between the LLC and the "S" corporation. There are more limitations on the ownership structure for the "S" corporation than the LLC. An example of this is the limit on the total number of owners and the type of entity the owner is. An "S" corporation generally is limited to having no more than 100 stockholders while there is no limit on how many members an LLC can have. Types of entities that cannot be a stockholder of the "S" corporation are partnerships and foreign individuals, IRAs and certain trusts. Both an LLC and "S" corporation are pass-through entities whereby the income, loss, credits, etc. of the entity are passed-through to the owners to be reported on the owners' return. The allocation of this income or loss between an LLC and "S" corporation are also different. The "S" corporation must allocate its income and losses pursuant to the stockholders' ownership percentages. The LLC is not limited to allocations based on percentages and can make specific allocations between its members. Another taxation difference between an LLC and an "S" corporation, which is usually very significant to a real estate entity, is how loans made to the entity are treated with regard to the tax basis of an owner. In a case where the entity generates a loss for a given tax year, the utilization of that loss by the owner is first limited based on the owners' tax basis in the entity. A stockholder of an "S" corporation will receive tax basis from its capital contributions to the entity and from loans it makes directly to the corporation. An LLC member will receive basis for not only its capital contributions but also for its share of recourse loans received by the LLC. In addition, for a real estate entity that obtains a mortgage in connection with its acquisition of the property, an LLC member will have tax basis for its percentage share of this liability while the "S" corporation stockholder will not. Although not applicable to a real estate entity, the member of an LLC will be subject to self-employment tax on all of the trade or business income passed through from the LLC to a non-passive member. However, an "S" corporation stockholder will only be subject to self-employment tax on the salary received from the corporation. This could amount to a large amount of extra tax depending on how profitable the entity is. In conclusion, an LLC is the correct entity in many cases. However, once formed as an LLC, choices are still available relating to the taxation classification of the entity. Michael Specht, CPA, is a member, at Metis Group CPAs LLC, Armonk, N.Y.