Business Entity Selection
Sole Proprietorship
General Partnership
Corporation (C)
Corporation (S)
Limited Liability Company (LLC)
Professional Limited Liability
Company (PLLC)
Series Limited Liability Company
(SLLC)
Single Member LLC & Single
Member PLLC
Choosing the appropriate legal structure for a business venture is a critical decision which requires careful analysis by the entrepreneur. The legal form of a business can have a significant impact on the success and profitability of the business. Therefore, a general understanding of the fundamental aspects of the basic types of business structures is an important first step. The options typically include one of the following four categories: Sole Proprietorship, Partnership, Corporation (C or S), and Limited Liability Company.
Sole Proprietorship
A sole
proprietorship is a business owned directly by one individual. The enterprise
is merely an extension of the individual owner. This is the default business
form for one person engaged in a trade or business. Agents and employees may be
hired, but the owner carries all of the responsibility. Additionally, all of
the profits and losses of the business are directly attributed to the owner.
Advantages
§ Control: Owner has complete
control over the actions of the business.
§ Inexpensive
Creation: No filing fees or legal fees are required to form.
§ Ease of Formation
and Operation: Very few legal requirements are necessary for formation. Owners
simply need to obtain a business license and/or permit from the city and
county.
§ No Double
Taxation: The sole proprietorship is simply a conduit to the individual
taxpayer, therefore, there is only one level of taxation.
Disadvantages
§ Unlimited
Personal Liability: The sole proprietor is exposed to unlimited liability
regarding his or her business and personal assets. Owner is subject to all
debts and legal liabilities of the business.
§ Fringe Benefits: Fringe Benefits
are not typically tax free to the sole proprietor, however, hiring a spouse as
an employee and providing tax advantaged health benefits to the spouse/employee
with coverage then applying to the whole family is an option.
§ Capitalization: The ability to
raise capital is limited to the individual's personal assets or assets the
individual can secure personally.
§ One Owner: Entity is limited
to only one owner.
Taxation
§ Pass-Through
Federal Taxation: Business income is reported on owner's personal tax
return on Schedule C of Form 1040. Business income is only taxed once.
§ Self Employment
Tax:
Federal Self Employment Tax is imposed on net earnings from self employment
income at a rate of 15.3%. Schedule SE of Form 1040 is required.
§ Payroll Tax: If you have one or
more employees, you must deduct the employee's part of Social Security and
Medicare taxes from their wages (7.65%) and report these deductions, along with
payment of the employer's part of these taxes (7.65%) and all deductions of
income taxes made from the employee's wages to the IRS. Each employee must fill
out an IRS Form W-4. In order to avoid costly mistakes in payroll processing,
hiring a payroll service is highly recommended.
§ Tennessee
Franchise and Excise Tax: A Sole Proprietorship is not subject to the tax.
§ Tennessee Hall
Income Tax: A Sole Proprietorship is not subject to the tax.
General Partnership
A general
partnership is a business enterprise, entered into for profit, that is owned by
more than one person. The persons in the business are called partners. A
general partnership may be created by a written agreement, an oral agreement,
or by a simple handshake. No express agreement is necessary to create a general
partnership. The general partnership is the default business form when two or
more persons carry on a business for profit. Each of the partners is an owner
and has a right to share in the profits of the business. As with a sole
proprietorship, each partner is personally liable for any losses suffered by
the partnership business. Therefore, partners are subject to unlimited legal
liability regarding the debts and obligations of the business.
Advantages
§ Inexpensive
Creation: No filing fees or legal fees are required to form.
§ Ease of Formation
and Operation: Very few legal requirements are necessary for formation or operation.
Owners simply need to obtain a business license and/or permit from the city and
county.
§ Unlimited Number
of Partners: A partnership can have any number of partners.
§ Capitalization: Because there are
two or more persons who can contribute assets to the business, it is easier to
raise capital for a General Partnership compared to a Sole Proprietorship. However,
the LLC and Corporate forms offer even greater ability to raise capital than a
partnership.
§ No Double
Taxation: The partnership is simply a conduit to the individual taxpayer,
therefore, there is only one level of taxation.
Disadvantages
§ Unlimited Personal
Liability: Each partner's personal assets are exposed to unlimited liability
regarding the debts and obligations of the business.
§ One Partner Can
Legally Bind the Others: When one partner takes action in the name of the
business, the other partners are legally bound by such action. Therefore, each
partner is personally responsible for the acts of other partners who act in the
name of the business.
§ Fringe Benefits: Owners can take advantage of
fewer tax-favored and tax-free benefits than those that would be available as
fringe benefits for employees of a C corporation. However, some fringe benefits
are still available to partners in partnerships on a tax-free or tax favored
basis. Even if the fringe benefit is included in the partner's taxable income,
deductions may apply on the partner's individual income tax return Form 1040.
The double taxation disadvantages of a C Corporation often outweigh its fringe
benefit advantages.
§ Accidental
Formation: two or more persons who want to be involved in business together may
not intend to be partners, however, if they meet the definition of a
partnership, then they are bound by Tennessee Partnership Laws.
Taxation
§ Pass-Through
Federal Taxation: Partnership income and losses pass - through the
partnership to the partners individually. IRS Form 1065 must be filed with a
Schedule K-1. Partners report income or loss on their individual income tax
returns. Therefore, business income is only taxed once.
§ Self Employment
Tax:
Federal Self Employment Tax is imposed on net earnings from self employment
income at a rate of 15.3%. Schedule SE of Form 1040 is required.
§ Payroll Tax: If you have one or
more employees, you must deduct the employee's part of Social Security and
Medicare taxes from their wages (7.65%) and report these deductions, along with
payment of the employer's part of these taxes (7.65%) and all deductions of
income taxes made from the employee's wages to the IRS. Each employee must fill
out an IRS Form W-4. In order to avoid costly mistakes in payroll processing,
hiring a payroll service is highly recommended.
§ Tennessee
Franchise and Excise Tax: A General Partnership is not subject to the tax.
§ Tennessee Hall
Income Tax: A General Partnership is not subject to the tax.
Corporation (C)
A C Corporation is
an entity separate and distinct from its owners. It is an organization formed
with state government approval which is designed to act as an artificial person
to carry on a business. A corporation can acquire, hold, and convey property in
its own name. It can also sue and be sued in its own name. Ownership interests
in a corporation are represented by shares of stock, therefore, the owners are
called shareholders. The shareholders periodically elect a board of directors
who oversee the affairs of the business. The board acts under the leadership of
a chairman and elects corporate officers who manage the business. Tennessee
requires corporations to have at least two corporate officers, those being the
offices of president and secretary. For small business corporations, one
individual may act as the sole shareholder, chairman of the board of directors,
and president of the corporation. However, one individual may not act as
president and secretary simultaneously (unless there is only one shareholder).
One benefit of a C Corp is that its liability for damages or debts is generally
limited to its assets, so that shareholders and officers are protected from
personal claims. Corporations are typically divided into publicly held and
close corporations. A close corporation only issues shares to family members or
persons who know one another, whereas, a publicly held corporation sells shares
to public investors.
Advantages
§ Limited Liability: Because the
corporation is a separate legal entity, the shareholders are not personally
liable for the debts and obligations of the corporation, assuming corporate
formalities are properly followed.
§ Separation of
Powers:
Power and control of a corporation is shared amongst the officers,
shareholders, and board of directors.
§ Attracts
Investors: The issuance of corporate stock to investors may allow the
corporation to add much needed capital to the business.
§ Employee Stock
Options: Employees can be offered stock in the company as an incentive.
§ Unlimited
Shareholders: An unlimited number of shareholders may be owners in the corporation.
§ Filing Fee: A $100 filing fee
payable to the Tennessee Secretary of State is required upon formation. An
annual filing fee of $20 is also required. While filing fees are less than the
LLC, the costs associated with adherence to corporate formalities may negate
the savings.
§ Multiple Classes
of Ownership Interests: A corporation may offer multiple classes of stock, for
example: common stock, preferred stock, voting stock, and nonvoting stock.
§ Fringe Benefits: Corporations can
deduct fringe benefits for its employees such as group life insurance, medical
plans, and deferred compensation plans. Therefore, the employee is not
personally taxed for the value of the employment benefits.
Disadvantages
§ Double Taxation: The business
income from a Corporation is subject to "double taxation". First, the
corporation must pay income tax on its earnings, and then shareholders and
employees must pay tax on their dividends and wages. Employee wages are
typically a tax deductable expense for the corporation while shareholder
dividends are subject to taxation. A tax professional can help a corporation
minimize its corporate income tax liability by paying the owners/employees
additional wages and compensation as opposed to dividends. However, IRS rules
and limitations must be strictly followed when doing so.
§ Corporate
Formalities: In order to maintain its status as a separate legal entity, a
corporation must strictly adhere to corporate formalities such as annual
shareholders meetings, formal board of directors meetings, and documentation of
meeting minutes. In general, the corporate form includes more paperwork and
accounting requirements than an LLC. For many businesses, the complexities of
corporate formalities are cumbersome and impractical.
§ No Capital Gains
Treatment for Real Estate: Gains from real estate owned by Corporations will be
subject to corporate tax rates. Whereas, gains on real estate for LLCs will be
taxed at the more favorable Capital Gains Rates (currently 15% for Long Term
Capital Gains).
§ Hall Income Tax: Tennessee imposes
a six percent (6%) income tax on dividends from stocks. Therefore, income of
the Corporation distributed to shareholders as dividends will be subject to
this additional tax.
Taxation
§ Double Taxation: The business
income from a Corporation is subject to "double taxation". First, the
corporation must pay income tax on its earnings and file its own tax return on
Form 1120. Secondly, the shareholders and employees must pay tax on their
dividends and wages. Shareholder dividends are taxed at capital gains rates,
which are currently 15% for long-term capital gains and ordinary income tax
rates for short-term capital gains. Employee wages are subject to ordinary
income tax rates. Current corporate income tax rates are as follows: $0-$50,000
is taxed at 15%, $50,000-$75,000 is taxed at 25%, $75,000-$100,000 is taxed at
34%, $100,000-$335,000 is taxed at 39%, and $335,000-$10M is taxed at 34%.
§ Personal Services
Corporations: When a corporation has employee-owners performing services in the
fields of law, health, engineering, architecture, accounting, performing arts,
or consulting, then the corporation income is subject to a 35% flat tax rate
rather than the graduated rates above.
§ Payroll Tax: If you have one or
more employees, you must deduct the employee's part of Social Security and
Medicare taxes from their wages (7.65%) and report these deductions, along with
payment of the employer's part of these taxes (7.65%) and all deductions of
income taxes made from the employee's wages to the IRS. Each employee must fill
out an IRS Form W-4. In order to avoid costly mistakes in payroll processing,
hiring a payroll service is highly recommended.
§ Filing Fees: $100 upon
formation and $20 annually.
§ Tennessee Excise
and Franchise Tax: The excise tax is a tax imposed on the privilege of doing business in
Tennessee. General partnerships and sole proprietorships are not subject to the
tax. The tax is based on net earnings or income for the tax year (Tenn. Code Ann.
§ 67-4-2007). The franchise tax is also levied upon the privilege of doing
business in Tennessee and is based on the greater of net worth or the book
value of real or tangible personal property owned or used in Tennessee. For
this purpose, net worth or property values at the end of the taxable period are
used (Tenn. Code Ann. § 67-4-2104). All persons (LLCs and Corporations), except
those with nonprofit status or otherwise exempt, are subject to a 6.5%
corporate excise tax on the net earnings from business done in Tennessee for
the fiscal year. The franchise tax rate is 25 cents per $100, or major fraction
thereof, of a taxpayer's net worth at the close of the tax year covered by the
required return. The minimum franchise tax payable each year is $100. The
appropriate Franchise, Excise Tax Return Form FAE 170 or FAE 174, along with
instructions and appropriate schedules, are mailed to all registered franchise
and excise taxpayers by the Department of Revenue based on the ending date of
the taxpayer's fiscal year (typically April 15th). All persons
subject to the franchise and excise tax must register with the Tennessee
Department of Revenue by completing and filing the registration form prescribed
by the department. This form must be filed within 15 days after the date the
person becomes subject to the tax (online registration is available at http://www.tennesseeanytime.org/bizreg/).
§ Tennessee Hall Income Tax: The individual income tax, originally called the Hall
Tax, is imposed only on individuals and other entities receiving interest from
bonds and notes and dividends from stock. The tax rate is 6% of taxable income.
The tax is due annually on April 15th. Taxpayers receiving dividends
from corporate stock are subject to the tax.
Corporation (S)
An S Corporation, or
Subchapter S corporation, is a small corporation whose owners have elected to
be treated as a partnership for federal tax purposes. An S Corporation election
is made by filing Form 2553 with the IRS. Unlike a C Corporation, an S
Corporation does not pay taxes at the corporate level. Instead, the S Corp
files a Form 1120S and then passes its income, losses, deductions, and credits
to its shareholders for inclusion on their personal income tax returns. S Corporations must strictly adhere to
IRS regulations in order maintain S Corp taxation status.
Advantages
§ Limited Liability: Because the
corporation is a separate legal entity, the shareholders are not personally
liable for the debts and obligations of the corporation, assuming corporate
formalities are properly followed.
§
Pass-Through Taxation: Taxed as
a partnership or sole proprietorship on the federal level, therefore, corporate
profits are taxed at the owner level only and avoid double taxation (unlike a
"C" Corporation).
§ Attracts
Investors: The issuance of corporate stock to investors may allow the S
corporation to add much needed capital to the business.
§ Filing Fee: A $100 filing fee
payable to the Tennessee Secretary of State is required upon formation. An
annual filing fee of $20 is also required. While filing fees are less than the
LLC, the costs associated with adherence to corporate formalities may negate
the savings.
Disadvantages
§ Corporate
Formalities: In order to maintain its status as a separate legal entity, a
corporation must strictly adhere to corporate formalities such as annual
shareholders meetings, formal board of directors meetings, and documentation of
meeting minutes. In general, the corporate form includes more paperwork and
accounting requirements than an LLC. For many businesses, the complexities of
corporate formalities are cumbersome and impractical.
§ Payroll Taxes: An S Corporation
must withhold Social Security and Medicare from its employees pay and timely file
payroll tax returns with the IRS. The owners of the S Corporation are
considered employees, therefore, payroll applies to them as well, even if the S
Corporation does not have any non-owner employees. Payroll taxes typically mean
added expenses for the business as well.
§ Limited to One
Class of Stock: Only one class of stock is permitted and the owners of the stock are
entitled to their pro-rata share of the corporation's profits.
§ Limited Number of
Shareholders: There can be no more than 100 shareholders.
§ Shareholder
Limitations: The S Corporation cannot have shareholders who are not individuals,
with the exception of estates and certain trusts, and there can be no
nonresident alien shareholders.
§ Ineligible
Corporations: Certain financial institutions, insurance companies, and domestic
international sales corporations cannot be S Corporations.
§ Fringe Benefits: Owners can take advantage of
fewer tax-favored and tax-free benefits than those that would be available as
fringe benefits for employees of a C corporation. However, some fringe benefits
are still available to substantial (more than 2%) shareholders of S
corporations on a tax-free or tax favored basis.
§ Hall Income Tax: Tennessee imposes
a six percent (6%) income tax on dividends from stocks. Therefore, income of
the Corporation distributed to shareholders as dividends will be subject to
this additional tax.
Taxation
§ Pass-Through
Federal Taxation: S Corporation income and losses pass - through the
corporation to the owners individually. The S Corporation files Form 1120S and
distributes K-1's to its shareholders. The shareholders then report their
pro-rata share of income or loss on their individual income tax returns.
Therefore, business income is only taxed once, unlike a C Corporation.
§ Self Employment
Tax:
S Corporations owners do not pay self employment taxes. However, S Corporations
do not avoid paying into the Social Security and Medicare system (see Payroll
Tax immediately below).
§ Payroll Tax: If you have one or
more employees (including S Corporation owner-employees), you must deduct the
employee's part of Social Security and Medicare taxes from their wages (7.65%)
and report these deductions, along with payment of the employer's part of these
taxes (7.65%) and all deductions of income taxes made from the employee's wages
to the IRS. A shareholder who is actively engaged in the business is treated as
an employee and must be paid a reasonable salary which is subject to payroll
taxes. However, the employer's part of the taxes (7.65%) is deductible by the S
Corporation before it is distributed to the shareholder as income. In an LLC,
half of the 15.3% self employment tax (7.65%) is deductible by the member, but
only after the LLC income is reported on the members personal tax return. Each
employee must fill out an IRS Form W-4. In order to avoid costly mistakes in
payroll processing, hiring a payroll service is highly recommended.
§ Filing Fees: $100 upon
formation and $20 annually.
§ Tennessee Excise
and Franchise Tax: The excise tax is a tax imposed on the privilege of doing business in
Tennessee. General partnerships and sole proprietorships are not subject to the
tax. The tax is based on net earnings or income for the tax year (Tenn. Code
Ann. § 67-4-2007). The franchise tax is also levied upon the privilege of doing
business in Tennessee and is based on the greater of net worth or the book
value of real or tangible personal property owned or used in Tennessee. For
this purpose, net worth or property values at the end of the taxable period are
used (Tenn. Code Ann. § 67-4-2104). All persons (LLCs and Corporations), except
those with nonprofit status or otherwise exempt, are subject to a 6.5%
corporate excise tax on the net earnings from business done in Tennessee for
the fiscal year. The franchise tax rate is 25 cents per $100, or major fraction
thereof, of a taxpayer's net worth at the close of the tax year covered by the
required return. The minimum franchise tax payable each year is $100. The
appropriate Franchise, Excise Tax Return Form FAE 170 or FAE 174, along with
instructions and appropriate schedules, are mailed to all registered franchise
and excise taxpayers by the Department of Revenue based on the ending date of
the taxpayer's fiscal year (typically April 15th). All persons
subject to the franchise and excise tax must register with the Tennessee
Department of Revenue by completing and filing the registration form prescribed
by the department. This form must be filed within 15 days after the date the
person becomes subject to the tax (online registration is available at http://www.tennesseeanytime.org/bizreg/).
§ Tennessee Hall Income Tax: The individual income tax, originally called the Hall
Tax, is imposed only on individuals and other entities receiving interest from
bonds and notes and dividends from stock. The tax rate is 6% of taxable income.
The tax is due annually on April 15th. Taxpayers receiving dividends
from corporate stock are subject to the tax.
Limited Liability
Company (LLC)
The Limited Liability Company
("LLC") has become the dominant form for newly-created small
businesses in most states in America. In fact, 68% of newly formed for profit
business in Tennessee during 2008 were LLCs, while formation of Corporations
has dropped for 5 years in a row. It is clear that LLC is the entity of choice
for Tennessee's entrepreneurs.
The LLC has become so popular
due to the fact that it gives business owners several advantages of the various
business forms in one package. It
is a hybrid which combines the flexibility and taxation benefits of a
partnership with the limited liability protection of a corporation. Much like a corporation, an LLC is a
legal entity which exists apart from its individual owners. The individuals therefore are not
personally liable to creditors of the business, nor are they personally liable
for torts which arise from the business. The Tennessee Revised Limited Liability Company Act §
48-249-114 specifically provides that " A member, holder, director, manager,
officer, employee or other agent of an LLC does not have any personal
obligation, and is not otherwise personally liable, for the acts, debts,
liabilities or obligations of the LLC."
Financially, this effectively
limits an individual member's financial liability to no more than their
investment in the LLC. This limit
on financial liability for the business owner is very attractive considering
that his or her personal assets cannot be touched in order to satisfy the debts
of the LLC (assuming business formalities are correctly followed). Only the LLC itself is liable for its
financial obligations.
From a risk standpoint, an
LLC offers similar protection from tort law suits to the individual owners or
members as a corporation does. This simply means that the members of an LLC are
not held liable in legal suits for the wrongs that his fellow member(s) commit
against third parties. Additionally, an LLC limits the liability of an
individual from lawsuits brought by fellow members, directors or managers of
the LLC.
Advantages
§
Limited Liability: The
members of the LLC and their personal assets (house, car, personal property,
etc.), are protected from liability for the acts and debts of the LLC.
However, liability protection will
not extend to situations where: loans or debts are made with a personal
guarantee, the owners fail to operate the LLC as a legitimate business apart
from their personal affairs, an owner commits a criminal act, or an owner
commits a tort (negligent or intentional act or omission) which injures
another's person or property.
§
Organizational Flexibility:
LLC owners can choose whether they want the operations of the business to be
flexible and informal like a general partnership or rigid with formal
procedures like a corporation. For
the small or medium sized business, the formalities of a corporation such as
formal board meetings to make decisions, minutes taken at board meetings, and
annual shareholder meetings may not make much sense. The formalities may be simply impractical to apply to the
daily operations of an LLC consisting of only a few individuals. A Tennessee LLC may choose one of three
forms of government: (1) member-managed, in which case the management of the
LLC will be vested in its members; (2) manager-managed, in which case the
management of the LLC will be vested in a manager or managers; or (3)
director-managed, in which case the members will elect a board of directors in
whom management will be vested. In sum, the LLC owners choose to create a
business entity that is either formal or informal in its operation and the
owners can tailor the conduct of the business to their liking.
§
No Double Taxation: Assuming
the owners of the LLC choose to be taxed as a partnership or sole
proprietorship, profits are taxed at the member level only (via pass-through
taxation) and avoid double taxation (unlike a corporation). LLCs by default are
treated as pass-through entities, therefore, the entity itself is disregarded
for tax purposes. Under the "check the box" regulations, an LLC can elect to be
taxed as an S Corporation or a C Corporation. However, choosing S or C
Corporation taxation is not typically advantageous in Tennessee.
§ No
Corporate Formalities/ Streamlined Operation: Assuming
the owners choose to be taxed as a partnership and operate under a
member-managed or manager-managed structure, the LLC will generally require far
less administration recordkeeping and paperwork compared to a Corporation. LLCs
are not required to adhere to corporate formalities such as annual shareholders
meetings, formal board of directors meetings, and documentation of meeting
minutes (Although not required, an annual meeting of the members and minutes
are encouraged for every LLC in order to legitimize the separate nature of the
entity). The streamlined day to day operation that an LLC offers is one of the
many reasons entrepreneurs choose the LLC.
§ Attracts
Investors: Venture Capitalists and Investors have traditionally preferred to
purchase corporate stock. However, with the popularity of the LLC, savvy
investors are accustomed to purchasing ownership interests in LLCs.
§
Multiple Classes of Ownership Interests:
An LLC can create multiple classes of ownership interests with both voting and
non-voting rights. The majority of LLCs only need one class of ownership
interest which includes voting rights. However, if desired, the LLC has the
flexibility to assign various ownership interests and various voting rights in
its Operating Agreement. An S
Corporation, however, is prohibited from having more than one class of stock.
§
Single or Multiple Members:
An LLC can be a single member entity or a multiple member entity. Unlike a
corporation, only one (1) person is required to be involved with the business.
There are no restrictions on the number of members permissible. Members can be
individuals, partnerships, C Corporations, S Corporations, trusts, or other
LLCs.
§
Unlimited Duration: LLC
owners can choose for the LLC to exist perpetually, even after the death of the
owners.
§
Interstate Business: All 50 states
have statutes that permit businesses to operate as LLCs. Additionally, other
states recognize the limited liability of foreign LLCs operating within their
state.
§
Professional Image: A legal
business structure, such as a Limited Liability Company, can enhance the
professional image of a business in the eyes of its investors, customers, and
others in the marketplace.
Disadvantages
§ No Corporate
Stock:
LLCs are not able to issue corporate stock through a public offering or offer
stock options to employees as an incentive. Ownership in a LLC is represented
by Membership Interests and not corporate stock. If the owners are looking to
go public on the stock exchange or offer employee stock options, then corporate
formation is necessary. However, forming an LLC in the start up phase and
converting to a C Corporation prior to going public is also an option. LLCs can
also give equity interests (membership interests) to its employees as an
incentive in the form of a 1) profit interest, 2) capital interest, or 3) a
future option to acquire a capital interest. Offering employee stock options is
more straightforward than offering employee equity interest in a LLC.
§ Fringe Benefits: LLC Owners can take advantage of
fewer tax-favored and tax-free benefits than those that would be available as
fringe benefits for employees of a C corporation. However, some fringe benefits
are still available to LLC members on a tax-free or tax favored basis. Even if
the fringe benefit is included in the member's taxable income, deductions may
apply on the member's individual income tax return Form 1040. The double
taxation disadvantages of a C Corporation often outweigh its fringe benefit
advantages.
§ Filing Fees: The required filing fee
payable to the Tennessee Secretary of State for a LLC is $50 per member
(minimum of $300; maximum of $3,000) and the annual filing fee is $50 per
member (minimum of $300; maximum of $3,000). Therefore, all LLCs with 6 members
or less will pay a $300 filing fee and a $300 annual fee. Considering that the LLC
filing fees and annual fees are greater than a corporation's, the cost of
increased filing fees must be weighed against the required formalities and
increased paperwork associated with a corporation.
Taxation
§ Pass-Through
Federal Taxation: For Single Member LLCs, business income is reported on
owner's personal tax return on Schedule C of Form 1040. Business income is only
taxed once. Multi-Member LLCs are treated like Partnerships for federal income
tax purposes. The Member's income and losses pass through the LLC to the
members individually. IRS Form 1065 must be filed with a Schedule K-1 issued to
the members. Members then report income or loss on their individual income tax
returns on Form 1040. Therefore, business income is only taxed once, unlike a C
Corporation.
§ Self Employment
Tax:
Federal Self Employment Tax is imposed on net earnings from self employment
income at a rate of 15.3%. Schedule SE of Form 1040 is required. Members who
are actively involved in the LLC business are not treated as employees of the
LLC and avoid paying Social Security/Medicare through their paychecks,
therefore, they are required to pay a 15.3% Self Employment Tax on the LLC
profits. The 15.3% Self Employment Tax is a combination of 12.4% OASDI and 2.9%
Medicare tax. The 12.4% is paid until the members income is above $106,800 (in
2010; adjusted annually for inflation) and the 2.9% is paid regardless of
income level. Up to half of the members self employment tax paid (i.e. 7.65%)
is deductible on their personal tax returns. S Corporations avoid Self
Employment Tax, however, the owners are treated as employees and their wages
are subject to Payroll Taxes.
§ Payroll Tax: If you have one or
more employees, you must deduct the employee's part of Social Security and
Medicare taxes from their wages (7.65%) and report these deductions, along with
payment of the employer's part of these taxes (7.65%) and all deductions of
income taxes made from the employee's wages to the IRS. Each employee must fill
out an IRS Form W-4. In order to avoid costly mistakes in payroll processing,
hiring a payroll service is highly recommended. LLC owners are not treated as
employees, therefore, they are not required to pay payroll taxes on themselves.
However, if the LLC hires employees, payroll taxes are necessary regarding such
employees.
§ Filing Fees: $50 per member (minimum of $300;
maximum of $3,000) and the annual filing fee is $50 per member (minimum of
$300; maximum of $3,000). LLCs with 6 members or less pay a $300 filing fee and
$300 annually.
§ Tennessee Excise
and Franchise Tax: The excise tax is a tax imposed on the privilege of doing business in
Tennessee. General partnerships and sole proprietorships are not subject to the
tax. The tax is based on net earnings or income for the tax year (Tenn. Code
Ann. § 67-4-2007). The franchise tax is also levied upon the privilege of doing
business in Tennessee and is based on the greater of net worth or the book
value of real or tangible personal property owned or used in Tennessee. For
this purpose, net worth or property values at the end of the taxable period are
used (Tenn. Code Ann. § 67-4-2104). All persons (LLCs and Corporations), except
those with nonprofit status or otherwise exempt, are subject to a 6.5%
corporate excise tax on the net earnings from business done in Tennessee for
the fiscal year. The franchise tax rate is 25 cents per $100, or major fraction
thereof, of a taxpayer's net worth at the close of the tax year covered by the
required return. The minimum franchise tax payable each year is $100. The
appropriate Franchise, Excise Tax Return Form FAE 170 or FAE 174, along with
instructions and appropriate schedules, are mailed to all registered franchise
and excise taxpayers by the Department of Revenue based on the ending date of
the taxpayer's fiscal year (typically April 15th). All persons
subject to the franchise and excise tax must register with the Tennessee
Department of Revenue by completing and filing the registration form prescribed
by the department. This form must be filed within 15 days after the date the
person becomes subject to the tax (online registration is available at http://www.tennesseeanytime.org/bizreg/).
Even though the Franchise and Excise taxes apply to LLCs, the way that the tax
is applied differs from a regular corporation. The income of an LLC is reduced
by self-employment income distributable or paid to each member. Therefore, an
LLC may reduce its net earnings by the amount of self-employment income (whether
or not actually distributed) with the result that an LLC engaged in a service
business will incur little, if any, excise tax even if it retains earnings in
the business.
§ Tennessee Hall
Income Tax: Unlike a Corporation, a Tennessee Limited Liability Company is not
subject to the 6% tax on dividends from stock.
Professional
Limited Liability Company (PLLC)
A professional limited liability company is formed under a state professional limited liability company law (T.C.A. § 48-249-1101) and is a company engaged in the rendering of professional services. Basically, it's an LLC whose members are licensed to render professional services in the state of Tennessee. A PLLC is the appropriate form for Doctors, Attorneys, Accountants, Architects, Engineers, Real Estate Brokers, Veterinarians, Sports Agents, and other licensed professionals. Please remember, even though a PLLC offers its members liability protection from the malpractice of the other members, the PLLC does not offer a professional member liability protection from their own malpractice.
Series LLC
A Series LLC is limited liability
company whose Members
and/or Holders desire to divide the business, business assets, and financial
interests of the Company into one or more Series pursuant to T.C.A. § 48-249-309.
A single LLC entity is formed which defines various Series of asset ownership,
with each Series operating independently from the other Series. According to
the statute, the debts, liabilities, obligations and expenses incurred by,
contracted for or otherwise existing with respect to a particular Series shall
be enforceable against the assets of such Series only, and not against the
assets of the LLC generally, or any other Series of the LLC. Traditionally,
when entrepreneurs wanted to keep the debts and liabilities of one property or
business separate from another they would form several separate LLCs. The
Series LLC allows the owner to form one company and have the assets separated
into each Series, while saving the owners from paying annual filing fees and
administrative costs for each separate LLC. The Series LLC is fairly new,
therefore, its tax treatment and asset protection advantages are somewhat
unproven. Due to its recent statutory creation, there is very little case law
interpreting the scope and validity of the Tennessee Series LLC statute.
Creating multiple LLCs to separate assets is still the most proven method to
spread risk. However, the Series LLC may be practical for the cost conscious
real estate investor who desires to separate the liability of several pieces of
property under one entity which only pays one annual filing fee. If multiple
assets are going to be held by the company, and multiple LLC filings are cost
prohibitive, the Series LLC can be a flexible tool for the entrepreneur.
Single Member LLC & Single Member PLLC
The
formation of a single-member LLC and the formation of a single-member PLLC are
permissible under the Revised LLC Act in Tennessee (T.C.A. §48-249-501c). In
fact, all 50 states now recognize single-member LLCs. A single-member LLC is a
disregarded entity for federal tax purposes. Therefore, if the single-member is
an individual, the business
income is reported on the member's personal tax return on Schedule C of Form
1040. A single-member LLC is subject to Tennessee franchise and excise taxes.
However, a single-member LLC may reduce its net earnings by the amount of
self-employment income (whether or not actually distributed) with the result
that a single-member LLC engaged in a service business will incur little, if
any, excise tax even if it retains earnings in the business. In theory, the
single-member LLC provides the owner with the same limited liability protection
available to a multi-member LLC. However, there is some concern that liability
protection identical to that of a multi-member LLC will not be extended to
single-member LLCs. There are a couple of reasons for this. First, when an LLC
is sued for an amount above and beyond its insurance coverage, the plaintiff
will typically try to pierce the "corporate veil" in order to reach the
member(s) personal assets. When a LLC has only one member, it's an easier
argument to claim that the LLC is simply an alter ego of its owner and not a
separate entity. Secondly, although the state statute clearly allows for a
single-member "Limited Liability" Company, there is limited case law regarding
the liability protection of single-member LLCs. Because the single-member LLC
is a new business form, the legal treatment regarding the liability of such
entities is somewhat unknown. However, in a 2009 Tennessee Court of Appeals
Case (Collier v. Greenbrier Developers, LLC), the appeals court ruled that
Tennessee courts "cannot conclude, as a matter of law, that a sole member of an
LLC is ipso facto (by the fact itself), in privity (a connection or mutual
interest between the parties) with the LLC" The court concluded that to hold
otherwise would erode the liability protections afforded by the LLC construct.
Considering that this early case law in the appeals court favors the separation
of the LLC and its sole member in contract matters, the single member LLC will
likely become much more popular to entrepreneurs in Tennessee.
So, is a multi-member LLC the
better choice? Yes. Forming a multi-member LLC is the better option for liability
protection. A single entrepreneur should consider adding another member to
their LLC such as a spouse or relative. However, the added member must be a
legitimate member of the LLC, meaning they must have a right to share in the
profits and losses of the LLC. Also, a 1% owner may not be viewed as
legitimate. It is unclear what % is necessary for a legitimate owner, however,
a very small % of ownership will not suffice. If the entrepreneur is faced with
the choice of remaining a sole proprietor or forming a single-member LLC,
several factors should be considered. First, if the business involves inherent
risks, has employees, or invites the public to its storefront, the
single-member LLC is likely the better choice. Secondly, the entrepreneur must
consider that the single-member LLC offers potential liability protection
(taking into consideration a clear state statute with limited case law
regarding the liability protection), while the sole proprietorship form offers
no liability protection (outside of its business insurance coverage). Thirdly,
a single member LLC must pay an annual filing fee of $300, whereas, a sole
proprietorship does not have filing fees. Lastly, a single-member LLC may
portray more trust and professionalism to potential customers vs. a sole
proprietorship. The entrepreneur should carefully weigh the cost-benefit of
entity formation. If a single-member LLC is chosen, the member should do the
following in order to build a stronger argument for the separateness of their
business and personal assets: have a written operating agreement signed both by
the member in their personal capacity and by the LLC through its member, follow
the provisions in the operating agreement, have an annual meeting with minutes,
document major decisions in writing , keep excellent accounting books, keep a
separate bank account for the LLC and never co-mingle personal and business
funds, sign all documents in the name of the LLC as its member, and buy and
sell LLC property in the name of the LLC.