Partnerships and LLCs
Limited Liability Company, Limited Partnership or “S” Corporation: Which Entity Do I Select in California?
This article addresses various legal, tax and practical issues faced by many of our clients who own or will acquire existing operating companies or California-income producing real property. Clients should inquire whether a California (i) limited liability company (“LLC”), (ii) limited partnership (“LP”) with a corporate or LLC general partner or (iii) S corporation (“S Corp”) should be utilized. There are many issues when choosing the appropriate form of entity. Below are some of the many issues to consider when choosing the appropriate form of entity:
Pass-Through Entities. The LLC, LP and S Corp are all pass-through entities. There is no federal income tax associated with the operations conducted in these entities. Rather, the income is allocated directly to the members, partners or shareholders. This article addresses the California taxes and fees attributable to these type of entities.
Limited Liability. The vast majority of our clients appreciate the benefit of utilizing an entity which provides limited liability protection to its beneficial owners. Whether an LLC, LP or S Corp is utilized, limited liability can be achieved provided adequate capitalization and proper formalities have been adhered to. Thus, creditors of these entities will generally only be able to reach the assets within such entities. That is in contrast to owning a business or income producing real property in an individual capacity, where all assets of the owner are exposed to claims of creditors.
LLC. The California LLC is a limited liability entity. You do not have to create a separate limited liability entity to be the general partner, as in the case of an LP. Therefore, your accountant will only need to prepare one tax return since only one entity is utilized. The LLC files IRS Form 1065, which is a partnership return. At the state level, California Form 568 is utilized.
Both an LLC and LP are required to pay an $800 annual tax to the Franchise Tax Board (“FTB”).
In addition, the FTB imposes a privilege fee for LLCs based on gross revenues. The FTB fee is for the privilege of doing business in California and is calculated on the gross revenues of the LLC. This fee structure is as follows:
The FTB franchise fee can be onerous, especially if the LLC nets little or no cash. For illustrative purposes, assume that the LLC owns a 300-unit multi-family apartment complex . The annual gross rents received by the LLC could easily exceed $5,000,000. Yet, if such apartment complex were purchased for a cost of $150,000 a unit, it is conceivable that after all expenses (including non-cash expenditures such as depreciation) the LLC could in fact have a net loss. Still, the FTB franchise fee would be $11,790. This is in addition to the minimum $800 tax referred to above. If an LP were the owner, only the $800 minimum tax (and the $800 minimum tax for its corporate or LLC general partner, which are used to avoid general partner liability) would be incurred.
LP. The limited partnership with a corporate general partner strategy has been employed by competent legal and tax professionals for the past several decades. In the early 1990s, various legal and tax professionals throughout the country started recommending LLCs due to their simpler operating format. However, in light of the FTB franchise fees imposed on LLCs, the utilization of the traditional LP is currently recom-mended by many professionals, including this author, in many situations.
Although there is an additional tax return associated with either a corporation or LLC which serves as the general partner for the LP, the FTB franchise fees associated with the LLC are completely eliminated in most circumstances. Although additional start-up and tax compliance costs are associated with the creation of the general partner entity, these costs are mitigated by the substantial savings that can be realized over utilizing an LLC to own the operating company or rental income producing property if gross revenues are significant enough to trigger a high privilege fee.
S Corporation. The S Corp is another type of entity which has its place on the menu. Typically, we recommend that S Corps be utilized for operating companies but not for companies owning income-producing real property. This is because upon distribution of appreciated property by an S Corp, the S Corp tax rules require recognition of gain to the S Corp’s shareholders (i.e. taxable income) to the extent the fair market value of the asset distributed exceeds the adjusted basis of the asset in the hands of the S Corp. The same tax treatment would apply upon a liquidation of an S Corp. Conversely, if appreciated property is distributed to a partner of an LP, generally no gain is recognized upon such distribution unless the adjusted basis of the distributed asset exceeds the partner’s tax basis in his/her LP interest.
One drawback of S corps is that the FTB taxes the net income earned by the S Corp at the rate of 1 _%, with a minimum S Corp annual tax of $800. The 1 _% tax is based on the S corporation’s net income. Therefore, when trying to compare whether to use a California LLC, LP, or an S Corp for an operating company, one of the questions that will need to be addressed is whether the entity will have net income (as compared with gross receipts). Often in the operation of an S Corp, an owner may be able to zero out net income through the payment of officer wages (which may not be the most tax economical approach since withholding taxes will be incurred, but will result in lowering the S Corp’s net income).
LLCs also have a number of distinct advantages over S Corps for many businesses. There are no limits on the number or kind of shareholders, giving LLCs greater access to capital. LLCs are not restricted to a single class of stock as S Corps are, so LLC members have a greater ability to allocate gains, losses, deductions, and credits. LLCs have a lot more estate planning flexibility than S Corps, too.
With all of the factors to consider, should your business or real estate be held in LLC, LP or S Corp? The answer depends on your particular set of facts and circumstances. Also, established corporations with appreciated assets might find the tax cost of conversion to an LLC or LP to be prohibitive. Typically, your commercial real estate should be owned in an LLC or LP.
All existing proprietorships should definitely consider conversion to one of these entities; that way the owner’s personal assets can be better protected from any financial problems that may arise in the business. Many existing partnerships and even some S Corps also should consider making a switch.
Although this article provides a general overview of certain of the issues that are involved in determining which limited liability entity to utilize, it only scratches the surface of various legal and tax issues to consider. We welcome the opportunity to address any of your questions. Questions or comments concerning this article can be directed to Rick S. Weiner at The Busch Firm, (949) 474-7368 Ext. 105, email: [email protected].