Thu 19th Aug 2010
Over the past few years, LLC formation has increased to become one of the top structures selected by start-up businesses. As a partnership structure, LLC’s have been chosen by many for its limited liability protections like a corporation while maintaining its partnership attributes. While partnerships are formed by two or more people, LLC’s are increasingly being formed by single individuals believing the protections of an LLC would benefit them and their businesses. The following discussion focuses on the distinctions between a single-member LLC’s and multi-member LLC’s.
Discussion on Partnerships
Before analyzing LLC’s, it is important to understand the concept of partnership as LLC’s are a partnership style structure. Partnerships are a type of organization formed through a contractual relationship by two or more individuals (or entities). Entities can consist of corporations, other partnerships (and the different forms), and trusts. A partnership can be created by a written agreement or even an oral agreement. Partnerships, being a separate structure, require a separate tax filing from an individual’s return.
However, if two or more individuals (or entities) do not create a partnership arrangement the profits and losses the individual or entity makes is reported on the individual’s or entity’s tax return. For example, if two people agree they are creating an independent contractor relationship but no partnership arrangement exists with respect to a business relationship, each individual will report the profits or losses incurred on their individual returns under a Schedule C.
Member Amounts in LLC’s
Returning to the discussion of LLC’s, what distinguishes a single-member LLC’s and multi-member LLC’s is the number of members in each. Single-member LLC’s have only one member which can consist of an individual or an entity. Multi-member, meanwhile, have more than one member. Therefore, once an LLC has two members it is considered a multi-member LLC. As clear as the distinction is between the two forms LLC’s, so are the differences in the forms of treatment from tax filings and legal protections.
Income Tax Reporting
The first treatment difference concerns tax treatment, specifically income tax and self-employment tax. For the purposes of this article we will not consider the ability to elect different tax treatments such filing the LLC as an S-Corporation. Single-member LLC’s are considered disregarded entities meaning they do not file a separate return from their owner. Concurrently, multi-member LLC’s are regarded entities; thus, they file partnership returns on Form 1065. The profits and losses from the company are then reported on each member’s return through a Schedule K-1. Therefore, while the reporting of taxes is different, ultimately, the tax liability is paid by the owner(s) directly.
The difference in self-employment, however, is much more apparent. Self-employed income by an individual is taxed both for income tax and self-employment tax. The purpose behind self-employment tax is pay for an individual’s Social Security and Medicare Taxes. It is normally calculated after the individual determines his/her net earnings. For single-member LLC’s (a disregarded entity), should the LLC realize a profit not only are the profits subject to owner’s income tax but also self-employment tax on the profits of the LLC.
However, for multi-member LLC’s, only managers and managing members are subject to self-employment taxes for the services rendered on the LLC (normally through guaranteed payments), if the managers and/or managing members are individuals. Non-managing members are only subject to their respective portion of income tax which is notated on the member’s Schedule K-1. Therefore, single-member LLC’s owners are potentially subject to more tax liability than multi-member LLC’s.
Another benefit, if not the benefit, to LLC’s publicized by many deals with the asset protection benefits of LLC’s. LLC’s, like corporations, have limited liability protection for their owners. In other words, LLC members’ liability is limited to the investment they make to the company. However, LLC’s have an additional feature protecting it from the actions of its members. Should a member or group of members act in such a manner that could cause them incurring debt, the creditor(s) could get seek to reach the distributional interest and other monies owed by the LLC to the member. Yet, the creditor(s) could not take control of the voting interests of the LLC only economic interests.
While the asset protection currently exists with multi-member LLC’s, recent court actions have reduced this protection for single-member LLC’s. In Shaun Olmstead v. Federal Trade Commission, the Florida Supreme Court ruled creditors can reach the entire interest of debtors concerning their ownership of single-member LLC’s. As a result of the recent case, the biggest advantage to LLC’s for single-member LLC’s has been eliminated.
When seeking to determine what structure to select it is best to review all the options and not settle on the most popular form. Each business and circumstances surrounding the business is unique and requires a proper review before moving forward with a particular form of organization. Should you consider an LLC a good option but are concerned about being an single-member LLC, a possible solution would be to consider treatment under an S Corporation designation. However, it is important to note a bill is currently being debated in Congress that would lead to a tax on all S-Corporate earnings similar to the self-employment tax. Overall, weigh all your options before making a decision. 68 C.J.S. Partnership 1 (2009).  68 C.J.S. Partnership 5 (2009).  I.R.C. § 6031 (2010).  I.R.C. § 61 (2010), I.R.C. § 6031 (2010), King v. Commissioner of the Internal Revenue, 458 F.2d 245 (6th Cir. 1972)  I.R.C. § 61(a)(2) (2010), I.R.C. § 162 (2010), I.R.C. § 1402 (2010)  Partnerships, Pub. 541 (2008), Tax Guide for Small Business, Pub. 334 (2010).  Partnerships, Pub. 541 (2008).  Partnerships, Pub. 541 (2008).  Id.  I.R.C. § 63, I.R.C. § 1401, Treas. Reg. Sec. 1.1401-1(a) (2010).  Struthers v. U.S., 442 F. Supp. 562, (D.C Minn. 1977)  I.R.C. § 1402 (2010).  Tax Guide for Small Business, Pub. 334 (2010).  Rev. Rul. 69-184, 1969-1 C.B. 256.  Treas. Reg. Sec. 1.705-1(a)(1) (2010), I.R.C. § 705 (2010).  Fla. Stat. § 608.4227 (2010).  Fla. Stat. § 608.433(1) (2010).  Id..  Fla. Stat. § 608.432 (2010).  Shaun Olmstead v. Federal Trade Commission, 35 Fla. L. Weekly S. 357 (Fla. 2010).  H.R. 4213, 111th Cong. (2010).