The LLC is not the perfect entity for any business in California. All aspects of the LLC must be considered for each business situation.
An important limitation in California is that most licensed occupations are prohibited from using the LLC. If the business must hold any type of state license, check out the potential licensing limitations on the LLC first. The broad prohibition on using an LLC for state licensed activities has been an unwelcome surprise for many business people.
Another concern in California is that LLCs are subject to the minimum franchise tax of $800, plus a gross receipts tax according to a schedule. The gross receipts tax kicks in at $900 on gross receipts of $250,000 to $499,999, $2,500 on gross receipts of $500,000 to $999,999, $6,000 on gross receipts of $1,000,000 to $4,999,999, and $11,790 of gross receipts of $5,000,000 or more.
In California, S corporations pay a 1.5% tax on their net income. LLCs are taxed on their gross receipts. So depending on the entity’s ratio of gross receipts to taxable income, there may be an advantage to operating as an S corporation. For example, assume a grocery stock with $10,000,000 of gross receipts and profits of $200,000. As an LLC, the grocery store would pay $8,585 in taxes (the maximum for gross receipts, $800 + $11,790, but only $3,000 as an S corporation (1.5% of $200,000). However, if the entity earned $5,000,000 in income, as an LLC it would still pay the maximum of $12,590 in taxes, but as an S corporation, it would pay $75,000 in taxes (1.5% of $5,000,000). Thus, understanding the gross receipts to net income ratio of the entity is extremely important when deciding whether to operate as an S corporation or LLC.
Another drawback is that participants in an LLC may be surprised with the way the entity operates. One such surprise may be the personal taxes due on undistributed taxable income of the entity. Partners, members, or shareholders of any entity that is subject to “flow-through” tax treatment are taxed on profits and other taxable items, whether or not any cash has been distributed to them. Profits that are reinvested in a growing company rather than distributed to the investors often boosts taxable income. An LLC member or S corporation shareholder is often surprised by the burden of taxes resulting from a growing business.
The flow-through income from an LLC is often regarded as “earned income” for tax purposes. Any taxpayer who does not want earned income must approach an LLC (and other flow-through entities) with caution.
In particular, non-U.S. citizens must determine whether this earned income presents a tax issue or immigration law issue for them. Foreign investors must not assume that the LLC is the way to go, since an S corporation may not have shareholders who are non-resident aliens.
Under U.S. tax law, the income distributed to members from small LLCs will often be regarded as earned income. A non-U.S. citizen who wishes to become an LLC member must make certain that income from the LLC will not be treated as his or her earned income unless he or she has the necessary visa or immigration status to earn such income in the U.S.
Another aspect of the LLC which should be regarded as a drawback is the amount of effort required to create an LLC. The flexibility of the LLC means that it can take a great deal of time and effort to structure the entity to include all the features desired by the members. If the individuals involved in the business have different tax situations, if the parties wish to take advantage of the ability to allocate tax consequences to different members, or if the individuals disagree on some aspects of the business structure, it can take a great deal of time and effort to work out the details of the LLC.
In conclusion, the pros and cons of using an LLC should be considered for every new entity. It will frequently be the best choice for operating a business. It may be even more frequently the best choice for real estate partnerships, estate planning, and joint ventures. Nevertheless, because of the flow-through tax treatment, each member must consider the positive and negative aspects of the LLC for that particular member’s financial and tax situation.
Call Mitchell A. Port, attorney, at (310) 559-5259 to discuss this further with a qualified business lawyer.