All businesses, even some of the biggest corporations you can think of, started as a small business. They are a major part of the American dream and they allow people to use their creativity to support their local community or build a life for themselves. This concept draws in people from all over the world who do not have the same opportunities as those born in the United States.
There are millions of small businesses in the United States, and they are the bones of the American economy. They create tens of thousands of jobs each year, make up almost all businesses in the United States, and are accountable for a large portion of the country’s economic activity.
That being said, starting a small business is not always easy. It takes a lot of time, money, and personal investment to start a small business and make it successful. It also comes with a lot of decisions on how the company should be structured and taxed.
One of the most common structures for small businesses are Limited Liability Companies, commonly referred to as LLCs.
What is an LLC?
An LLC protects owners from being personally responsible for a company’s debts and liabilities and was created by law.
When there is an LLC with a single owner, it is treated like a sole proprietorship, and when there are multiple owners, they can be taxed as either partnerships or corporations. It is important to talk to your accountant about what is best.
Some of the benefits of an LLC taxed as a partnership include:
- Flexibility: firms that have complex structures of ownership and investment strategies that vary, find that the flexibility in profit distribution, governance arrangements, and structuring ownership interests is very important.
- Pass-through Taxation: Pass-through taxation is when the profits and losses of the firm flow through to the partners or individual member’s personal tax returns. This avoids something called “double taxation,” being taxed twice on the same income, and allows the tax treatment to be aligned with situations of the individual investors.
- Limited Liability Protection: This structure provides limited liability protection, which means that the personal assets of the members or partners and the liabilities of the firm are separate. This is extremely important for private equity firms that engage in investments that are high-risk.
- Operational Flexibility: LLCs also offer operational flexibility. This allows private equity firms to make their own decisions and manage their investments efficiently, to their liking. It allows for the adoption of operating agreements that can be made to meet any specific requirements or needs the firm has.
- Alignment with Investor Preferences: Many investors, including high-net-worth individuals and entities that make investments for other people, actually prefer investing in private equity funds structured as LLCs taxed as partnerships. The pass-through taxation allows the tax treatment to align with the investors’ individual needs and desires, which makes it a lot easier to incorporate the investment into the rest of their tax planning.
- Section 754 Basis Adjustment: By taxing an LLC as a partnership, private equity firms might be able to take advantage of a Section 754 election. This gives the firms the ability to adjust the tax basis of the partnership’s assets when ownership interest goes under transformation, which can be a valuable tool. When private equity firms engage in buying and selling investments, to allocate the stepped-up basis to the acquiring partner and potentially increase amortization deductions or future depreciation. This can be helpful in the private equity industry where there are varying tax bases and holding periods for investments. It provides additional flexibility when managing investments, especially when frequent transfers of partnership interests are anticipated or if there is a diverse portfolio with assets held at varying tax bases. This can possibly result in tax savings and enhanced tax planning opportunities. The benefits are not uniform, and they depend on the unique circumstances of the firm and its investors. It is especially important for private equity firms to examine this carefully and consult with legal and tax professionals to determine what the best option for them is.
Another option for taxing LLCs is by taxing them as an S corporation. This is a selection you have to actively make that has a similar pass-through taxing structure. Therefore, taxing an LLC as an S corporation has some of the same benefits as taxing it as a partnership, but there are differences also.
- Restrictions on Ownership: There are specific eligibility requirements for shareholders. It is limited to one hundred or fewer individuals, select trusts, and estates as shareholders. This can, effectively, limit the flexibility when it comes to raising capital or having certain types of investors.
- Limited Flexibility in Allocations: S corporations are subject to more strict allocation rules than LLCs taxed as partnerships. They have to distribute their profits and losses to their shareholders according to percentage of ownership. This can become a problem if an owner wishes to allocate the profits or losses in a disproportionate way, because of different shareholder agreements.
- Restrictions on Entity Structure: S corporations also have restrictions on what kinds of entities can own their shares. For example, C corporations, partnerships, and most kinds of LLCs cannot be shareholders. This limits the options for structuring more complex business relationships or even pursuing certain investment strategies.
- Limited Fringe Benefits: There may be restrictions on tax treatment of fringe benefits if the S corporation owners own more than 2% of the company’s shares. The owners may also be subjected to additional tax consequences for benefits such as health insurance premiums, medical expense reimbursements, etc.
- Potential Self-Employment Tax: While shareholders of an S corporation might be able to save on self-employment taxes by paying themselves a lower salary and taking the extra profits as distributions, the IRS may scrutinize the salary amount. If it is deemed unreasonably low, they could reclassify a portion of the distributions as wages, making them subject to employment taxes, which can result in additional tax liabilities and potential penalties.
- Termination of S Corporation Status: The requirements of an S corporation must constantly be adhered to, in order to maintain their status. If they are not, for instance by exceeding the limit on the number or having an improper type of shareholder. This can, unfortunately, lead to unintended tax consequences and higher taxes if the corporation ends up being treated as a C corporation.
If you are looking for an attorney who understands business, look no further than The Orlando Law Group. Our firm is led by a serial entrepreneur, Jennifer Englert, who has not only grown the firm from its inception but is also a founder or owner in more than a dozen companies in and around Orlando, Altamonte Springs, Winter Garden and St. Cloud. That experience is critical in giving you legal advice. The Orlando Law Group is not just looking at the law pertaining to your unique circumstance, but it is also looking at your business and what makes your business special.
If you would like to schedule a consultation for any business issue, please reach out to our office at 407-512-4394, fill out our online contact form or save this information in case you ever find yourself or a loved one needing to use it for any of our services, not just business law.
Last Updated on June 6, 2023 by The Orlando Law Group