By Michael Krul, Esq. and Stefan Rubin, Esq.
You or someone you know has probably formed a limited liability company (LLC) for some purpose. In fact, the number of LLCs created in Florida has increased every year over the last decade-from 1,391 in 1995, to 19,186 in 2000 and 100,070 in 2004.
By comparison, just over 170,000 for-profit corporations were formed in Florida in 2004. A major reason why LLCs have become so popular in recent years is the flexibility they allow their owners.
An LLC can provide the personal liability protections of a corporation and can enjoy the tax advantages of a partnership, all without being subject to various IRS restrictions imposed on S corporations. Although Florida has a Limited Liability Company Act setting forth default statutes applicable to LLCs, most LLC owners enter into a written operating agreement governing the LLC which may vary substantially from statutory defaults. In the operating agreement, an LLC can be structured to be managed more like a general partnership where each owner has an equal vote in day-to-day operations, or it can be structured more like a corporation where the owners merely elect one or more managers, and the managers can either run the business or provide only broad governance and appoint officers to run day-to-day operations. Because all of these provisions can be set forth in an operating agreement at any time after the LLC is formed, the LLC owners need not make these decisions when they form the entity.
Many factors come into play when deciding what choice of entity to use for a new business, such as how the owners want to structure the entity’s management, distributions of cash, allocations of income and loss for tax purposes, and restrictions on transfers of ownership interests. Regardless, in almost all circumstances it is advisable to use an entity which limits the liability of the individual owners. This article does not attempt to replace the advice of a business lawyer or accountant as to any particular situation, but is intended merely to discuss certain general advantages and disadvantages of the various business entity forms in Florida.
Limited Liability of Owners
Almost any form of business entity used in Florida can be structured to limit the owners’ personal liability for company debts to the amount the owners actually invest in the company. By law, owners of Florida corporations and LLCs enjoy limited liability, as do limited partners of a limited partnership. Since 1999, Florida general partnerships and limited partnerships can also limit the liability of their general partners by filing a simple Statement of Qualification with the Florida Division of Corporations and paying a nominal filing fee. Therefore, limiting the liability of owners should almost always be done, and should not be a determining factor in selecting a form of business entity.
Income, Employment and Intangible Taxes
Florida LLCs may have as few as one owner, whereas partnerships by law require at least two owners. For federal income tax purposes, an LLC with only one owner is disregarded as a tax reporting entity, and its profit or loss flows directly to its sole owner’s tax return. The LLC need not even file an informational return with the IRS. It is in essence treated as a sole proprietorship, for tax purposes, yet because the LLC is not a sole proprietorship, its owner enjoys limited liability whereas a sole proprietor does not. If your business is best structured by having a holding company with numerous wholly owned subsidiaries, then having each subsidiary be a single-member LLC owned by one holding company LLC results in each single-member LLC being disregarded for federal income tax purposes – which simplifies accounting and tax reporting for the business enterprise.
An LLC with two or more owners can “check the box” to be taxed as a partnership, or it can elect to be taxed as a corporation or even as an S corporation. For purposes of this discussion, assume that all LLCs elect to be taxed as partnerships. An LLC taxable as a partnership enjoys “pass through” income tax treatment similar to an S corporation (discussed in more detail below). However, LLCs are not subject to IRS restrictions on S corporations. Also, IRS rules for partnerships are similar, but not identical, to those for S corporations, so depending on your particular circumstances one form may be better for your business. For instance, the partnership and S corporation tax laws vary on “at-risk” rules and basis issues, which is too complex to discuss in this article but should sometimes be considered in choosing a form of entity. Unlike S corporations, LLCs (a) can have entity owners (including corporations, other LLCs, investment retirement accounts (IRAs), pension plans, etc.), (b) can have foreign resident owners, (c) are not limited in the total number of owners, and (d) can have more than one class of ownership interests.
While the State of Florida does not impose a tax on personal income, it does impose a corporate tax at the rate of 5.5% on the income of corporations (and certain other entities) which are also subject to federal income tax. Thus, S corporations and partnerships are not subject to the tax. Prior to 1998, LLCs were subject to Florida’s corporate tax, but since then LLCs taxable as partnerships or S corporations for federal income tax purposes are not subject to Florida’s corporate tax. However, if an LLC elects to have its income taxable as a C corporation1 for federal purposes, it would also be subject to Florida’s corporate tax.
Also while C corporations are subject to double taxation – meaning that the corporation pays federal income taxes on all of its profits (up to 35% tax rate}, and the corporation’s shareholders pay federal income taxes on any profits which they receive as dividend distributions from the corporation (usually 15% tax rate) – S corporations, LLCs and partnerships are not subject to double taxation. These entities are “pass through” entities for federal income tax purposes, meaning that the entity merely files an informational return with the IRS, but does not pay any income taxes. Instead, the entity’s profits are allocated to its owners, typically pro rata in accordance with their ownership percentages, and the owners are responsible for payment of the applicable federal income taxes on those profits (typically at a rate close to the 35% tax rate). Although the owners must pay the taxes on the entity’s profits, the profits are taxed only once. This brings an additional 15% to the bottom line by not g to pay income tax on the distributions of money from the entity to its owners.
Advantages of LLCs over S corporations:
• LLCs can have other entities as owners ouch as other LLCs. IRAs, pension plans, etc).
• LLCs can have multiple classes of ownership interests, each with different rights and preferences.
• LLCs avoid risk of “pass through” tax status inadvertently being terminated.
• LLCs, if structured with one or more wholly owned subsidiaries, simplify tax reporting and accounting.
• LLCs offer less restriction on amount of entity losses that are deductible by the owners.
• LLCs are not limited to 75 owners.
When making the choice of entity, most people’s tax considerations stop here. However, other federal and state taxes should also be considered. For example, federal employment tax requirements may vary across different entities. Many small business owners operating through an S corporation pay themselves a salary for their services as an officer or employee of their corporation, and then declare dividend distributions of remaining available cash. In this scenario, only the reasonable salary amount is subject to federal employment taxes of 15.3% (social security and Medicare taxes) on the first $90,000 of salary and 2.9% (Medicare tax only) on all additional salary amounts2. However, IRS rules for partnerships and LLCs are not as clear, and sometimes require that the entire amount received by an owner, whether from salary or distributions from the partnership/LLC, be subject to employment taxes at the 15.3% tax rate. So, an individual operating through an S corporation may be entitled to save 2.9 cents on every dollar received from their company above $90,000, and save 15.3 cents on every dollar by which their reasonable salary is less than $90,000. However, IRS rules in this area are still evolving and are interpreted differently by various accountants and lawyers. In addition, the IRS is increasing efforts to investigate and collect employment taxes from those who unreasonably abuse the laws. See Congress & IRS Aim to Tighten Screws on Employment Tax Enforcement, Pg. 7
The Florida Department of Revenue also imposes a tax on intangible assets, such as stock of corporations and member interests of LLCs, but not on limited partnership interests (so long as the partnership interests are not registered with the SEC}. The intangible tax is assessed at the rue of $1 per $1,000 of asset value, with an annual exemption to each person and entity for the first $250,000 of asset value. A common misperception is that the tax is only imposed on stock if the stock is of a publicly held corporation. In fact, the tax applies to the stock of any corporation and also to membership interests of any LLC as well as several other intangible assets, so many small business owners may unexpectedly find themselves subject to intangible tax.
Therefore, if you expect your business will have assets worth more than $250,000 – which can happen immediately if the business will acquire and/or develop real estate – a limited partnership (LP) or limited liability limited partnership (LLLP) form of entity should be considered. However, the annual filing fee for LPs and LLLPs in Florida can be substantially greater than that of a corporation or LLC, so the financial benefits depend upon the individual circumstances.
Third Party Creditors
Partnership interests, LLC interests and corporate stock are all considered personal property in Florida. Although the creditors of an owner of corporate stock can typically seek to foreclose upon the stock in full or partial satisfaction of its owner’s liabilities, Florida’s partnership, and presumably LLC laws limit a creditor of an owner to only obtaining a charging order against the partnership or LLC interest owned by the debtor owner3. A charging order entitles the creditor to receive distributions otherwise payable to the owner, but does not entitle the creditor to take title to the ownership interest, vote on behalf of the interest, sell the interest or force a liquidation of the company’s assets. Regardless, in most circumstances a corporation can attempt to avoid such consequences by having all its shareholders enter into a written shareholders agreement restricting certain transfers or providing the other shareholders a first right to purchase the debtor shareholder’s stock before it transfers to a creditor. While such agreed restrictions will typically be upheld in state court, it is uncertain whether they would be upheld in a federal bankruptcy court.
Future Business Issues
Expectations of the business’s future operations, financial need and growth are additional factors in selecting a form of entity. For instance, if you expect your business will seek venture capital financing in its early stages, you would not want to form an S corporation because the venture capital investing entity would not be an eligible owner under IRS regulations. Because venture capital groups historically could only invest in C corporations, when business owners first started using LLCs, venture capitalists were reluctant to become involved. Today, venture capitalists commonly invest in LLCs. If you intend for your business to grow by acquiring other businesses, IRS regulations allow for certain tax-free reorganizations where both the acquiring company and the target company are C corporations. Unfortunately, only C corporations can take advantage of these tax-free transactions, so S corporations, LLCs and partnerships are unable to benefit.
If you seriously expect that your company will be a candidate for an initial public offering (IPO) one day, then you should consider the C corporation. Almost every advisor during the IPO process will expect and advise that the entity be a C corporation. However, many companies end up making their “public” debut by selling their assets to an existing public company and not actually going public themselves. When this happens, a C corporation would subject all its profits from the asset sale to double taxation, whereas any other form of business entity would not. In order to get the best of both worlds, the company can begin operating as an LLC. Then, if and when A becomes time to go public, because the IPO is a long process the LLC’s first step in the process can be to merge or convert to a C corporation.
In conclusion, the Florida LLC can be structured to incorporate the best aspects of both partnerships and corporations. But can you truly have your cake and eat it too? As discussed above, depending on the particular circumstances of your business, the LLC form may not be best for your business. That is why the process of choosing a form of entity often becomes a balancing test as you determine which advantages of the various entity forms outweigh their disadvantages, all with respect to your particular situation.
1 A corporation which has not made the “S” election with the IRS to have its income taxed as a “pass through” entity.
2 Based on 2005 limits, but subject to change annually.
3 Florida law is unclear on whether a creditor of an LLC owner would be limited to only obtaining a charging order.