The purpose of this article is to briefly summarize for you how an LLC operates and the tax advantages for you to consider.
1. What is an LLC?
An LLC is one of the most popular business entities used for estate tax planning purposes. It is a hybrid entity that provides individuals with protection from personal liability in property ownership but is treated as a partnership for income tax purposes.
In the estate tax arena, the LLC also provides estate tax advantages through gifting of interests in the LLC.
2. How is the ownership in the LLC structured?
The owners of an LLC are known as “members” and can be individuals, trusts, corporations, or partnerships. The LLC interest has two essential components: the management component and financial component. Unlike a shareholder of a corporation, whose management and financial rights in the corporation are based solely upon the number of shares owned, a member of an LLC could have both management and financial interests or only one of the two. Thus, it has elements that are similar to a limited partnership. Those members who hold only financial interests generally have no management rights.
3. What are the income tax implications?
An LLC can also provide its principals with a significant tax advantage. A general corporation is taxed on its earnings, and when these funds are distributed to the shareholders, the distributions are taxed to the shareholders as income. This is known as the “double layer of taxation.” In the alternative, partnerships are not taxed as an entity. All profits and losses are passed through to the partners, and such income is taxed at the partner’s individual tax rates.
Unlike the corporation, an LLC can elect to be treated as a partnership for state and federal tax purposes. The LLC is not taxed, and all profits and losses from the LLC pass directly to its members for inclusion as income at the member’s individual tax rates.
4. What are the estate tax advantages?
Since an LLC interest can be divided into two components, management and financial, then the LLC can be formed with two or more types of membership interest. The membership would be in a tiered class structure. Class A members would have the highest interest in the LLC, both the management and financial interests. Class B members will not have any management rights but only a financial interest until the death of the Class A members or termination of the LLC. If distributions of profits are made to the members, then Class B members receive a distribution of profits. There can also be various other types of interests, such as limited management but priority type of financial interests. These membership interests are generally given to investors in LLCs, who expect a priority return on their interest before profits are distributed.
Since the Class B memberships are significant limited, particularly by not having management rights, the Internal Revenue Service has viewed these interests as not “marketable” (can be sold to third party for fair market value) and has allowed gifts of these interests to qualify for a discount in valuation.
5. What protections does an LLC provide its members?
Another advantage to the formation of an LLC is that members of an LLC receive the same liability shield as shareholders of a corporation. Members of an LLC are not personally liable for the debts of the LLC unless said members personally guarantee such debts. Of course, to the IRS and state taxing authorities, you will be liable for the payment of all payroll and sales taxes, if applicable.
6. How is the LLC formed?
As for the formation of the LLC, a certificate of formation is filed with the Department of Treasury, which sets for the name, registered agent and registered office of the entity. Under New Jersey law, LLCs file annual reports and must comply with the business registration requirements of all New Jersey businesses. The “controlling” document of an LLC is an Operating Agreement. This Agreement not only outlines the management and financial interests (division of profits and losses) of its members, it also provides for what happens upon the occurrence of certain events (i.e. death, disability, withdrawal or retirement of a member). It also addresses the taxation and dissolution issues of the entity. Although the enclosed Agreement may seem lengthy, the advantage of the LLC is that all of the important issues are addressed in one Agreement rather than in separate documents as a corporation.
The information presented in this article is not legal advice and does not create an attorney-client relationship with Bourne, Noll & Kenyon.