Small Business Associates, Inc.

Why you should NOT be an LLC?

Since ~ 1997, when the IRS finally clarified how the federal government would tax LLC’s, this type of entity has grown rapidly as the entity has grown rapidly as the entity of choice for many small to medium sized closely held businesses.  There are many good reasons for this:

• With the IRS “Check The Box” rules there is flexibility in how they can be taxed at the federal level and in most states.  Depending upon the number of “Members”, this can be taxed as a Sole Proprietor or equivalent, as a  Partnership, as a regular or C Corporation, or even as a S Corporation.
• They, in theory, enjoy the same or similar limited liability as a corporation has in the courts.  I say in theory, in that while corporate law has been evolving since 1776, the equivalent LLC body of law is still being written.  While most attorneys believe it should follow corporate law decisions and protection, some attorneys and inter-state issues have raised some questions regarding this equivalency.
• In many states there is some simplicity regarding formation and operation, such as no requirement for regular ownership meetings and minutes as in the case of corporations, no requirement for the issuance of ownership or stock certificates as in the case of corporations, and other subtle differences.
• Because LLC’s evolution from partnerships, some of the flexibility typical of partnership can be extended to other non-managing or limited members.

However, there are some businesses that are more suited to LLC’s and some that should not be LLC’s.

The ownership of rental real estate is one that an LLC fits like a glove, in the many cases.  However it all depends on the situation, but an LLC likely might be a good choice to consider.

How the LLC should be taxed and whether it should ever be a single member are topics for another article.

However, if the business is of a type, in an industry, or in a location that the risk of failure at some point is relatively high, an LLC might NOT be a good choice of entity.  A business that deals with  very changeable market, a retail location that might be in a potentially declining neighborhood, a restaurant or tavern, or other business that after an assessment of the potential failure risks, is less than a sure thing, should consider incorporation rather than forming an LLC.

WHY?

Probably the one functional difference between LLC’s and corporation and might be the most important, but is rarely considered, is Section 1244 of the IRS code.  What is called Section 1244 stock might be the most valuable aspect of being a small, closely held corporation.

If the corporation meets the following conditions, (LLC’s cannot qualify), then the shareholder/owners would qualify for the Section 1244 stock advantages that I will touch on below:

1. 1. 1. Only applies to corporations; C Corps and S Corps
         1. The stock must be in the hands of the shareholder to whom it was originally issued
            1. That is received directly from Corporation not purchased from another shareholder.
         2. Only applies if stock has actually been issued, generally does not include Paid In Capital, or loans to corporation!
      2. When putting money into your closely held corporation
         1. Need to issue actual stock certificates and record the shares in the stock record book
      3. Only domestic corporations qualify
      4. Only if businesses incorporated after 11/6/1978
      5. Shareholder cannot be another corporation
      6. Stock must have been issued in exchange for money or property
      7. Only for small corporations that meet a Gross Receipts test

This Section 1244 stock designation becomes the equivalent of “failure Insurance”  in the event that the business goes “Belly Up” or fails. In this case the owner has closed the business, and hopefully because of the limited liability that comes with a corporate structure, is protected from the corporation‘s creditors.

However, the owner of the stock, would like to at least be able to deduct the loss of the value of his stock on his tax return. While it would be bitter sweet, it is at least a way to recover something for his/her loss.

If the above Section 1244 requirements are meet, the owner could deduct, in the year of the failure, a $50,000 capital loss, or in the case of a jointly filed personal return, a $100,000 loss.

In the case of an LLC, Section 1244 does not apply. While the owner could deduct a capital loss, it would fall under the normal capital loss limits of a $3,000 per year net capital loss. Consequently, a $100,000 business loss could take 33+ years to deduct if they have no capital gains to use as an offset.

For this reason to qualify for a Section 1244 stock loss deduction could be real factor in forming as a corporation (C or S) and not a LLC.