RLLPs and LLCs: Practical Considerations About Limited Liability Partnerships and Companies
By Byron F Egan *
Key elements in deciding among business entities are (1) how the entity will be taxed and (2) who will be liable for its obligations. The entity itself will always be liable to extent of its assets and so the question is who will be liable, if anyone, if the entity's assets are not sufficient to satisfy all claims. These two elements tend to receive the principal focus in the entity choice decision, although management, capital raising, interest transferability, continuity of life and formation issues such as cost and timing can be critical in many cases.
If the owners are content to pay federal income taxes at the entity level and then pay taxes on earnings distributed to them, the choice is easy - regular business corporation without an S-corporation election.
If the owners do not want the entity's earnings to be taxed twice, the entity selection process becomes more complicated and the choices are:
- general partnership
- LLP
- limited partnership
- LLC
- S-corporation
A. If limited liability of the owners is unimportant, the choice is a general partnership in which partners are jointly and severally liable for all partnership liabilities.
B. If the owners are willing to accept liability for their own torts but want to avoid liability for contracts and torts of other partners for which they have no culpability, the LLP becomes the entity of choice.
C. The limited partnership will provide tax flow through without the S-corporation restrictions discussed below, with no self-employment tax on income of limited partners, and with limited liability for limited partners, but has its own limitations:
1. must have a general partner which is liable for all partnership obligations -- contract and tort, but under Check-the-Box Regulations capitalization of general partner not important and a limited partnership can elect to also be an LLP which has the effect of limiting the liability of the general partner
2. limited partners who participate in management of business become liable as general partners, but statutes generally allow a degree of participation and no liability unless reliance upon the limited partner as a general partner
3. the threat that the next legislature will cause limited partnerships to be taxed as corporations subject to the franchise tax
D. The LLC can be structured to have tax flow through and limited liability of S-corporation or limited partnership without any of the drawbacks for them, but:
(i) subject to Texas franchise tax as a corporation
(ii) self-employment tax issues
(iii) as result of newness, questions regarding
- state income taxation issues;
- the extent to which other states will recognize statutory limitation of Members' liability and the related questions of whether/how to qualify as a foreign LLC.
E. The S-corporation will give limitation of owner liability and federal income tax flow through (even when there is only one owner) but an S-corporation is subject to the Texas franchise tax and there are limitations on its availability under the Code: S-corporation status is not available where the entity:
1. has more than 75 equity holders
2. has more than one class of stock
3. has among its shareholders any
- general or limited partnership
- trust (certain exceptions)
- non resident alien
- corporation (exception for "qualified subchapter S subsidiary")
The following chart compares the taxes that result to different entities and their owners. In each case, the entity earns $100 of net income that is of a type subject to self-employment taxes (i.e., is income from a trade or business) and distributes the entire amount (after taxes) to its owners. It is also assumed that the owner will have earned income or wages in excess of the base amount for the tax year and will therefore be subject to only the 2.9% Medicare tax (and not the 12.40% social security equivalent tax to a base of $68,400).
|
Item |
C Corporation |
S Corp or Limited Liability Company* |
General Partner in General or Limited Partnership* |
Limited Partner in Limited Partnership* |
|
Entity Level Income Franchise Tax Taxable Income Of Entity Fed. Income Tax (at 35%) Income After Taxes |
100 4.50 95.50 33.43 62.07 |
100 4.50 95.50 0 95.50 |
100 0 100 0 100 |
100 0 100 0 100 |
|
Owner Level Distribution & Share of Income Self-Employment Tax Taxable Income of Owner Fed. Income Tax (at 39.6%) Amount Received After Taxes |
62.07 0 62.07 24.58 37.49 |
95.50 2.77# 94.11† 37.27 55.46 |
100 2.90 98.55† 39.03 58.07 |
100 0 100 39.60 60.40 |
* Assumes the entity is treated as a partnership for federal income tax purposes.
# A non-managing member of an LLC may not be subject to the self-employment tax; a shareholder of an S-corporation is not subject to self-employment tax on actual or constructive dividends but would be subject to self-employment tax on compensation received.
† One-half of the self-employment tax is deductible against the individual's income.
* Copyright © 1999 by Byron F. Egan. All rights reserved.
Byron F. Egan is a partner of Jackson Walker L.L.P. in Dallas, Texas. Mr. Egan is a former Chairman of the Texas Business Law Foundation and is also former Chairman of the Business Law Section of the State Bar of Texas and of that Section's Corporation Law Committee.
The author wishes to acknowledge the contributions of the following in preparing this paper: Daniel G. Easley, Steven D. Moore, Janie L. Treanor, Bradley L. Whitlock and John R. Williford of Jackson Walker L.L.P.; Elizabeth S. Miller of Baylor University School of Law; and Carmen Flores and Lorna Wassdorf, Office of Secretary of State of Texas.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
