Unlimited Possibilities With Limited Liability
January 7, 2008
There is a relatively new business structure on the block. While the S corporation remains the most-used type of small business entity, the limited liability company (LLC) is increasingly the entity of choice for both new and existing HVACR businesses.
LLCs are popular entities for operating an HVACR business because, as with any incorporated business, owners have limited liability for the debts and actions of the LLC. Other features of LLCs are more in line with a partnership, providing management flexibility and the benefit of pass-through taxation.
Owners of an LLC are called “members” and since most states do not restrict ownership, members may include individuals, corporations, other LLCs and even foreign entities. There is no maximum number of members and most states also permit “single member” LLCs, those having only one owner. Only a few types of businesses cannot be LLCs, such as banks, insurance companies, and nonprofit organizations.
LLC DEFINEDAn LLC is a business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. As is the case with owners in partnerships or sole proprietorships, LLC members report business profits or losses on their personal income tax returns; the LLC itself is not a separate taxable entity.
Like owners of a corporation, however, all LLC owners or members are protected from personal liability for business debts and claims - a feature known as “limited liability.” This means that if the business owes money or faces a lawsuit for some other reason, only the assets of the business itself are at risk. Creditors usually cannot reach the personal assets of the LLC members, such as their house or car.
Unlike S corporations, LLCs have no limit on the number or nationality of members, can own subsidiaries, and can have more than one class of interest - a good method of unequally dividing income and losses. A limited liability company (yes, company not corporation) can select varying forms of distribution for profits. Unlike a common partnership where the split is 50-50, LLCs have much more flexibility. LLC profits are taxed only once, at the owners’ tax rate when earned by the entity.
Sound like a partnership? Well, not quite. LLCs protect all members’ personal assets from debts and lawsuits. Even a limited partnership (LP) has one party who assumes liability, the general partner, and that partner usually must have substantial net worth. Furthermore, limited partners who participate in managing the HVACR business risk losing their limited liability.
VIVA THE DIFFERENCESCorporations are required to keep formal minutes, have meetings, and record resolutions. The LLC business structure requires no corporate minutes or resolutions and is easier to operate. In fact, in some states, LLCs can be created with just one natural person involved. All business losses, profits, and expenses flow through the HVACR business to the individual members. You avoid the double taxation of paying corporate tax and individual tax. Generally, this will be a tax advantage, but circumstances can favor a corporate tax structure.
Probably most importantly, owners of an LLC have the liability protection of a corporation. An LLC exists as a separate entity much like a corporation. Members cannot be held personally liable for debts unless they have signed a personal guarantee.
Admittedly, this limited liability is not foolproof. Both LLC members and corporate shareholders can lose this protection by acting illegally, unethically, or irresponsibly. Plus, many courts are increasingly reaching behind the corporate veil into the pockets of members and shareholders who have not kept the business entity fully separate from their personal finances.
Other disadvantages include, but are not limited to:
• Limited life. While corporations can live forever, an LLC is dissolved when a member dies or undergoes bankruptcy.
• Going public. Owners of HVACR businesses with plans to take their company public, or issuing employee shares in the future, may be best served by choosing a corporate business structure.
• Raising capital. It may be more difficult to raise capital for an LLC, as investors may be more comfortable investing funds in the better-understood corporate form with a view toward an eventual IPO.
• Complexity. Running a sole-proprietorship or partnership usually involves less paperwork and is less complex. Under federal tax laws an LLC may be classified as a sole-proprietorship, partnership or corporation for tax purposes. Classification can be made on the tax return thanks to the so-called check-the-box question on the tax return. If not selected, a default often applies.
Also on the downside, the laws of various states governing limited liability companies vary - no uniform law prevails, making doing business in more than one state difficult.
Like partnerships, LLCs do not have perpetual life. Some states stipulate that the HVACR business must dissolve after 30 or 40 years. Technically, an LLC venture dissolves whenever a member dies, quits, or retires.
FORMING THE LLCIn most states, an LLC can be formed simply by filing ‘articles of organization’ with the state’s LLC filing office, usually the Secretary of State’s office, and paying a filing fee. Many states, in fact, provide a fill-in-the-blank form that takes only a few minutes to prepare.
The operating agreement, for the most part, contains any procedures and rules that the parties desire and, once put into place, can just sit there, maintenance-free. The operating agreement explicitly states the rights and responsibilities of the LLC members. Without a written LLC operating agreement, the LLC laws of your state will govern the inner working of the LLC. Generally, it is preferable to clarify your business arrangements and decide how your LLC will be run, rather than having the state dictate its terms.
No one needs any more red tape in his or her life. Under the LLC rules in most states, there is no need to keep exhaustive minutes, hold meetings, or make resolutions to, in effect, stay legal. This is often a trap for the unwary and is the first place the IRS or an aggressive attorney will attack when attempting to “pierce the corporate veil,” and go after the shareholders personally. If the records are not maintained perfectly, the corporate protection may be lost.
SWITCHING TO AN LLCIn most situations, an HVACR contractor or business operating as a partnership can quickly, and inexpensively convert to an LLC. Partnerships can usually convert without tax consequences, with the new LLC continuing to file a partnership tax return with the IRS. Because of the similarity of the structure, the IRS does not usually look at the conversion as a taxable event.
A corporation can also convert to LLC status, although it may not be a wise move for the shareholders of many incorporated businesses. Generally, it is not feasible for an HVACR business operating as a corporation, either as a regular or as an S corporation, to convert to LLC status. IRS regulations require that the incorporated business liquidate first, thus creating considerable tax liability.
To convert, a corporation must first be liquidated and pay tax on any gain in its fair market value. Even a corporation with depressed values that converts would have to be prepared to prove its estimate to the IRS. That could mean a costly appraisal.
As with many good things, there are tax questions surrounding the use of an LLC to operate the HVACR business. For starters, there is the Self-Employment Tax Act (SETA). Limited partners and S corporation shareholders generally are not subject to self-employment taxes - a 2.9 percent Medicare levy on all salaries and 12.4 percent FICA (Social Security) tax on income up to $97,500 (in 2007) - but are passive LLC members?
The IRS’s position, subject to change, is that LLC members who participate in management are subject to employment taxes. If LLC members are legitimate, passive members, according to the IRS, should not be subject to those employment taxes.
THE LLC IS OK SOMETIMESLLCs work for startups, for HVACR operations branching out, and in lieu of LPs for such financial entities as trading pools and hedge funds. Lawyers are increasingly recommending them for estate planning; reorganize assets or the family business as an LLC, and you can gradually give most of the shares to your heirs while retaining management control.
The LLC is rapidly becoming the entity of choice for many contractors, business owners, shareholders, and partners in every realm. The LLC will continue to gain momentum as more and more people learn of its existence. You might be well advised to consider its many benefits - and its possible pitfalls - for your HVACR business. Once all of the pros and cons are considered, many HVACR contractors and business owners have discovered the so-called limited liability company is the most profitable operating entity.
Publication date: 01/07/2008