Your Entity Menu : Part 9

Own Your Own Corporation : Why the Rich Own Their Own Companies and Everyone Else Works for Them
by Garrett Sutton, Esq.

(Page 9 of 11)

3. Negative capital account paybacks. Any members with a negative capital account balance must return their account to a zero balance upon the sale or liquidation of the LLC, or when the owner sells his interest. It should be noted that complying with the special allocation rules and qualifying under the safe harbor provisions is a complicated area of the law. Be sure to consult with an advisor who is qualified to assist you in this arena.

Flow-Through Taxation

As has been mentioned throughout, one of the most significant benefits of the LLC, and a key reason for its existence, is the fact that the IRS recognizes it as a pass-through tax entity. All of the profits and losses of the business flow through the LLC without tax. They flow through to the business owner's tax return and are dealt with at the individual level.

Again, a C corporation does not offer such a feature. In a C corporation, the profits are taxed at the corporate level and then taxed again when a dividend is paid to the shareholder. Thus, the issue of double taxation. Still, with proper planning, the specter of C corporation double taxation can be minimized.

In an S corporation, profits and losses flow through the corporation, thereby avoiding double taxation, but may only be allocated to the shareholders according to their percentage ownership interest. As described above, LLC profits and losses flow through the entity and may be freely allocated without regard to ownership percentages. As such, the LLC offers the combination of two significant financial benefits that other entities do not.

Lack of Precedent

One of the drawbacks to the LLC is the fact that it is a new entity. As such, there are not many court decisions defining the various aspects of its use. With corporations and partnerships, on the other hand, you have several hundred years of court cases creating a precedent for their operation.

Most legal commentators anticipate that the courts will look to corporate law to define the limited liability and corporate features of the LLC and to partnership law to define the partnership aspects of the entity. In time, a cohesive body of LLC law will emerge.

Until that day arrives, owners of an LLC must be cognizant that the courts may interpret a feature, a benefit, or even a wrinkle of LLC law in a way that does not suit them. If you are on the fence between selecting a limited partnership, a corporation, or an LLC and do not like the uncertainty associated with a lack of legal precedent, you may want to consider utilizing an entity other than an LLC.

Rich Dad Tips

California residents must be cautious when considering the use of an LLC. The fees are onerous.

In addition to the annual LLC tax of $800 the state of California hits LLCs with a fee based on their gross income. This fee has nothing to do with whether your company is profitable or not. It is only based on revenue generated, so you can lose money and still owe the fee.

On gross income of $250,000 to $499,999 the fee is $1,042. The fee gradually rises to $9,377 on gross income of over $5 million. Be sure to consider this fee when analyzing which entity to use in California.

Limited Partnership

A limited partnership is similar to a general partnership with the exception that it has two types of partners. The first type is a general partner who is responsible for managing the partnership. As with a general partnership, the general partner of a limited partnership has broad powers to obligate the partnership and is also personally liable for the business's debts and claims. If there is more than one general partner involved they are all jointly and severally liable, meaning that a creditor can go after just one partner for the entire debt. However, a corporation or an LLC can be formed to serve as a general partner of a limited partnership, thus isolating unlimited liability in a good entity.

The second type of limited partnership partner is a limited partner. By definition, a limited partner is "limited" to his contribution of capital to the partnership and may not become actively involved in the business of the partnership. A limited partner may then be owner but have absolutely no say in how the entity operates. This was exactly what Jim wanted.

Case No. 5-Jim

Jim was the proud father of three boys in high school. Aaron, Bob, and Chris were coming of age. They were active, athletic, and creative boys almost ready to embark upon their own careers. The problem was that they were sometimes too active, too athletic, and too creative.

Aaron was seventeen years old and every one of the seemingly unlimited hormones he had was shouting for attention. He loved the girls, the girls loved him, and his social life was frenetic and chaotic. Jim knew his son was smart but worried whether he would ever settle down enough to complete one homework assignment, much less go to college.

Bob was sixteen years old and sports was all that mattered. He played sports, watched sports, and lived and breathed sports. Bob was hoping to get a college scholarship to play football and/or baseball. But Jim worried that if a scholarship wasn't offered whether Bob would ever get into or be interested in going to college.

Chris was fifteen years old and the lead guitarist in a heavy metal band known as Shrike. When Shrike practiced in Jim's garage the neighbors did not confuse them with the Beatles. The members of Shrike had pierced appendages, graphic tattoos, and girlfriends who looked like wild animals. Jim worried about the company that Chris kept. When you could hear the lyrics, Shrike's songs made frequent reference to school as a brainwashing tool of the elite. And while Jim may have also believed that to be true when he was fifteen, he worried that Chris would still embrace the idea at age twenty-one.

Copyright © 2001 by Garrett Sutton, Esq.

About the Author

Garrett Sutton, Esq. has over twenty five years experience assisting and advising entrepreneurs, families and business in selecting the appropriate corporate structures to limit their liability, protect their assets, build their credit and advance their personal and financial goals through real estate investments and other means of wealth creation. Sutton is the owner of Sutton Law Center, Sutton Law which has offices in Reno, Nevada, Jackson Hole, Wyoming and Sacramento California.