The Knee-Jerk LLC

LLCs have too often become the knee-jerk choice for most new businesses over the past few years. However, as the California gross receipts tax has risen (and as clients have expressed dissatisfaction with the cost), it is time to compare the advantages of LLCs with other options. This article examines some of the factors that can be used to determine whether the LLC is the right structure for a particular business.

The California Gross Receipts Tax: The High Cost of LLCs

To do business in California, every LLC must pay an annual tax of $800. California Revenue and Taxation Code Section 17942 also requires that every LLC must pay an annual fee based on total gross revenue. This “gross receipts tax,” can range from $800 (for annual gross receipts less than $250,000) to as much as $12,590 (for annual gross receipts greater than $5 million) per year. Many clients are dissatisfied with the “gross receipts” tax. Corporations and limited partnerships, on the other hand, are subject to a flat $800 annual franchise tax, and new corporations are exempt from the $800 minimum franchise tax, but are still subject to the 8.84% tax on any taxable income.

The Importance of Leverage In Real Estate Ventures
LLCs are widely considered the entity of choice for real estate investors, because the debt of LLCs is included in the basis of a member’s interest. On the other hand, debt of an S corporation is not part of a shareholder’s basis. As tax losses are limited to an investor’s basis, S-Corporations are strongly discouraged for the ownership of real estate.

The LLC’s Flexible Management Structure
An LLC can be managed by its members or by a manager, resulting in an extremely flexible management structure. On the other hand, shareholders of corporations elect directors who in turn appoint officers. Much is made of the great burden of annual minutes for corporations, but the requirement is not terribly onerous for most small businesses. The limitations of limited partnerships, namely the unlimited liability of general partners and the inability of limited partners to participate in management, can also be addressed in a carefully crafted agreement.

Types of “S” Corporation Shareholders
An LLC can also be necessary because of the types and numbers of outside investors. California now permits one member LLCs, and there are no restrictions on the types of individuals or entities that can be LLC members. On the other hand, corporations, partnerships, LLCs, and foreigners generally cannot own stock in an S corporation.

Professionals Are Unable to Use LLCs Under California Law
Professionals and other licensed businesses are not permitted by law to operate through LLCs. This includes real estate and mortgage brokers, doctors, dentists, architects, accountants, attorneys, and some strange others (e.g., martial arts studios, mule racers, ticket sellers). For these types of business, a corporation (and for attorneys and accountants an LLP) is the only practical choice.

Disproportionate Allocations and Distributions
Investors with differing tax or cash needs typically prefer an LLC or partnership because of the ability to craft special allocations of tax items and cash distributions. Cash distributions can also be made based upon business arrangements, such as preferred returns on capital and back-end profit sharing. With an S corporation, all income, loss, tax items, and cash flow must be allocated based on outstanding shares.

Resist the Popularity of LLCs

The following are three basic guidelines for evaluating the LLC for your clients:

1. For (a) a real estate project with anticipated revenues less than $250,000; or (b) a non-real estate project with other entities as investors, an LLC is the likely choice.
2. For a real estate project with anticipated annual revenues greater than $250,000, consider a limited partnership; and
3. For a non-real estate project with individual investors, an S-Corporation is the likely choice.

The LLC is in vogue, but because of its high cost, it should only be used where appropriate.