Negative aspects to using LLCs for operating companies.

Now that all but two states have limited liability company (LLC) laws, the choice of entity for a closely held business has become less clear. Previously, when limited liability was a desired result, the only real options for an operating business were S corporations and C corporations. Although limited partnerships could be structured to provide limited liability, generally they were not and still are not used extensively to run operating businesses.

LLCs taxed as partnerships have very desirable characteristics. They have the tax attributes of partnerships (which provide tremendous flexibility in the allocation of profits and losses), no double tax on the sale of assets and no potential dividend issues. On the other hand, they have limited liability for their owners. For these reasons, LLCs make sense for a wide variety of family businesses. However, because there are certain negatives to their use, LLCs are not the natural choice in all cases. Many family businesses continue to operate as S corporations, for some of the following reasons.

Sec. 401(k) Plans

Sec. 401(k) plans of partnerships or LLCs are treated differently from Sec. 401(k) plans for S corporation employee-owners. Both have the same limitations on salary deferrals and both contain family attribution rules. However, a Sec. 401(k) plan of an LLC or partnership treats employer-matching contributions as if they were employee deferrals for partners or members (Regs. Sec. 1.401(k)-1(a)(6)(iii)). Thus, if an owner of a family business is used to deferring the maximum amount into his Sec. 401(k) plan and also receiving an employer match of another several thousand dollars, under a partnership or LLC Sec. 401(k) plan the matching contribution will be included with the elective deferral from his pay, potentially causing the deferral limit to be exceeded. In addition, even if the maximum amount is not exceeded, the employer match will be included as an employee match for the highly compensated for purposes of calculating the average deferral percentage. This may also result in a cutback in the amount of money that may be deferred on behalf of an owner of the company.

The government is grappling with this distinction. The preamble to the Sec. 401(k) regulations indicates that the differences were not intended and invites public comment. However, until these differences are resolved, this problem will continue.

Self-Employment Tax 

In an S corporation, an active owner must pay himself reasonable compensation, on which FICA tax is withheld. Any earnings of the S corporation in excess of that amount are taxed as ordinary income not subject to FICA tax and not subject to self-employment (SE) tax. Ordinarily, if a company is high-earning, the wages paid to the owner as reasonable compensation will be far less than the company's total earnings. Thus, a fair amount of earnings may not be subject to FICA tax, and the combined 2.9% Medicare tax is not paid on that amount. In addition, the income of inactive shareholders may be paid entirely in the form of distributions that are not subject to FICA or SE tax.

An LLC, however, is different. Because it is treated like a partnership, any member who is active in the management of the business will be subject to SE tax on the full amount of income allocable to that member (Prop. Regs. Sec. 1.1402(a)-18). Thus, the FICA and Medicare tax are not limited to the amount of reasonable compensation paid on a Form W-2. For active members of an LLC, in a highly profitable situation this can result in a significantly larger Medicare tax liability. In addition, when family members are inactive but do have some input in the business from time to time, the proposed regulations could conceivably cause SE tax on the earnings allocable to those members, even though they are relatively inactive with respect to the running of the business. This can cause not only additional Medicare tax liability but FICA tax liability as well, and in significant amounts.

While the IRS is studying its proposed regulations, and may at some point modify them, the issue of SE tax in LLCs will continue to be a sticky issue.

Payroll Withholding

An LLC member does not receive payroll in the form of W-2 compensation. Instead, any amounts paid to a member for services rendered to the LLC not in his capacity as an owner are treated as guaranteed payments. Guaranteed payments show up on the individual's Schedule K-1 and the owner does not receive a Form W-2. As a consequence, the owner must begin paying Federal estimates on a quarterly basis. In some cases, this will be a benefit; the estimated amounts are paid at the end of each quarter, while withholding from a W-2 comes out each pay period. The LLC owner will have more money in his pocket for a period of time. However, if the S shareholder did not pay salary ratably during the year, more withholding may be taken out in later periods of the year than during the early period of the year. In this case, the LLC member paying estimates quarterly will find that he has less money in his pocket during the year for investment purposes.

Creating Basis With Debt

One of the appealing attributes of an LLC is that it has many of the favorable tax attributes of a partnership, including a member's ability to take tax losses generated by borrowings made by the entity. However, because of the limited liability aspects of LLCs, members are treated like limited partners with respect to the allocation of debt to create basis. As such, members may have to make up shortfalls in their capital accounts (deficit restoration provision) in order to take advantage of these losses and, thus, give up some of their shelter from limited liability. This is an often overlooked aspect of LLCs.

Complexity

LLCs generally are more complex than S corporations in two ways. The first is in the formation of the entity. Generally speaking, an S corporation is a very simple entity to form. An LLC document is very similar to a partnership document. If a standard boilerplate document is used, an attorney may be able to form an LLC for approximately the same cost as an S corporation. However, part of the appeal of an LLC is its flexibility in the allocation of income and losses. As a consequence, there are very few boilerplate LLC documents being used, particularly in sophisticated family business situations. Thus, the LLC operating agreement generally takes some time to prepare, read and comment on, and change for the desires of the family business owner. This in and of itself should make the formation of the LLC somewhat more costly than a plain vanilla S corporation.

Secondly, the taxation of LLCs mirrors that of partnerships. A partnership tax return is somewhat more difficult to prepare in many situations than an S return, partially because practitioners are not as familiar with these entities. Another reason is that many items of income and expense are treated differently for S corporations and LLCs. Finally, because items of income and loss are not rigidly allocated (as in an S corporation), it is not as mechanical a process to prepare a Form 1065, U.S. Partnership Return of Income, for an LLC as it is to prepare a corporate tax return for an S corporation. As a consequence, client legal and accounting fees could be, at least initially, higher for an LLC than for an S corporation.

Conclusion

These are just some of the negative aspects to using LLCs. When a closely held business is making a choice between an S corporation and an LLC as its choice of entity, these items should be considered. While LLCs are sure to continue to explode on the scene, after practitioners have had several years under their belts, they may not find them as appealing as they once were though to be.