LLC and LLP Issues for Small,
Privately Owned Businesses

By Robert M. DiGiantommaso, CPA, MST, North Attleborough, MA,
Member of the AICPA Tax Division’s Tax Practice Improvement Committee

One of the most important decisions a small business owner makes is choice of entity. From the instant he or she decides on a business venture, entity selection is critical.

To assist these clients, tax advisers need to address every form of business entity available—sole proprietorship, general or limited partnership, limited liability company (LLC), limited liability partnership (LLP), S corporation, professional corporation and C corporation. This discussion should included tax, nontax, accounting and recordkeeping issues, with consideration of Federal, state and local regulations for each type of entity.

Because of the increasing use of LLCs and LLPs by small, privately owned businesses, this item (1) pro-vides general guidance for clients who use—or are thinking of using—these business forms; and (2) discusses some of the common problem areas.

Tax advisers should be familiar with the LLC and LLP rules, so as to advise clients on their advantages and disadvantages. Because LLCs and LLPs are governed by different laws, rules and regulations, practitioners need to analyze how each entity affects contributions, loans, distributions, withdrawals and other potential business activities.

What Is an LLC?

An LLC is a business entity organized under state law. Every state and the District of Columbia has LLC statutes. An LLC is made up of members, not partners. The managing member is responsible for the company’s operations. LLCs provide the protection of a corporation and the flexibility of a partnership. They protect their members from entity-level liabilities and claims, while allowing them to allocate and distribute profits and losses under various economic standards. In most states, a business can be owned by a single-member LLC (SMLLC).

An LLC is taxed as a partnership unless it elects to be taxed as a corporation, by filing Form 8832, Entity Classification Election, and checking the tax classification box. Absent an election, an SMLLC is taxed as a sole proprietorship and files Form 1040, Schedule C.

LLCs are usually required to file annual reports and pay annual fees to maintain status.

What Is an LLP?

An LLP is a business entity organized under state law, usually a uniform partnership act. Every state and the District of Columbia has LLP statutes. An LLP is comprised of partners; it must have more than one. LLPs provide partners with liability protection from errors and omissions of other partners and partnership employees under another partner’s supervision. They are taxed as general partnerships, but may be treated as limited partnerships in some states; LLPs are an excellent entity choice for businesses that provide personal services.

LLPs are usually required to file annual reports, pay annual fees and carry liability insurance to maintain status.

Potential for Problems

Often, clients do not fully understand their choices of entity. With small, privately owned businesses, they do not always give the tax adviser a chance to be involved from inception. Sometimes, a client creates an LLC or LLP and does not involve the CPA, but chooses an entity based on current trends, not on comprehension of the tax and accounting issues. Or, the practitioner is consulted after year-end, just to prepare tax returns.

Occasionally, new clients retain a CPA to correct tax or accounting problems stemming from their choice of entity. These issues might have been avoided had they consulted their CPA tax adviser before selecting an entity, especially with LLCs and LLPs. Such entities are relatively new; the small business community is still learning how to make LLCs and LLPs work and how to handle specific items.

Payroll/Compensation/Fringe Benefits

Many problems arise in managing payroll, compensation and fringe benefits.

Payroll: LLCs taxed as partnerships, and LLPs, cannot pay their owners as employees. Nor can these owners participate in some employee benefits programs (e.g., Sec. 125 plans, group-term life insurance, disability insurance and meal and lodging arrangements).

Compensation: Individual LLC members and LLP partners compensated for their participation must be paid via guaranteed payments. These payments are allocated based on services performed, not on ownership percentage. For the entity, these deductions are specifically allocated and, thus, separately stated. Guaranteed payments are determined without regard to entity-level profits and are subject to self-employment (SE) taxes, but not income tax withholding.

Thus, members and partners must pay special attention to their estimated taxes. Because there is no Federal or state withholding on payments, CPAs should monitor their member/partner clients’ estimated tax filings and be sure to include SE taxes.

Further, to use the annualized income method, the LLC or LLP must generate adequate interim financial statements for member/partner use.

Determining whether the income of members/partners is subject to SE tax is often problematic. If services are performed, an LLP general partner and any LLC member acting as a general partner will be subject to SE tax.

In an LLC or LLP with nonservice activities, a member or partner will be treated as a limited partner and, thus, not subject to SE tax, if he or she:

1. Has no personal liability for entity debt.

2. Has no authority to contract on the entity’s behalf.

3. Does not participate in entity operations for more than 500 hours during the entity’s tax year.

An LLC member acting as the managing member is subject to SE tax.

Fringe benefits: While Subchapter K makes no mention, LLC members and LLP partners generally do not qualify for fringe benefits, absent an employer-employee relationship.

Rev. Rul. 91-26¹ clarified the treatment of employee fringe benefits to partners. Such benefits are additional compensation and, thus, guaranteed payments under Sec. 707(c). This means that the payments are treated as if the partner paid for them individually; thus, he or she may be able to deduct the cost on his or her own return (e.g., self-employed medical insurance premiums).

Other Issues

A tax adviser may encounter the following additional problems when working with LLCs and LLPs:

1. Trouble with banks. Banks should be able to apply corporate lending policies to LLC and LLP loans; however, they often require personal guarantees by members/partners.

2. Nonemployee compensation. Issuance of annual Forms 1099-MISC, Miscellaneous Income, for nonemployee compensation may cause problems when a vendor operating as an LLC is a partnership or corporation (or, if an SMLLC, a sole proprietorship). In case of doubt, Form 1099-MISC should be issued.

3. Loss limits. Rules under Secs. 704(d) (basis), 465 (at-risk) and 469 (passive losses) may prevent LLC losses from being deducted by members.

4. State filings. Some LLCs and LLPs are organized in one state (e.g., Delaware), but operate elsewhere in the U.S. Does the entity have filing or registration requirements as a foreign LLC in the state(s) of operation? Are annual filing/registration fees applicable? Some state fees can be expensive. Tax advisers need to do research and advise clients accordingly.

5. State returns. In which state(s) does an LLC have to file state income tax returns? Is there a sales tax filing requirement?

6. Adding new members. According to Rev. Rul. 99-5,² an SMLLC not taxed as a corporation is classified as a partnership on the day it adds a second member. The entity needs to apply for a new tax identification number when the second member is added.

Conclusion

The use of LLCs and LLPs by small, privately owned businesses is becoming more and more popular; however, these entities have significant tax, accounting and business issues. The tax adviser needs to be aware of the rules to properly counsel existing and potential new clients, to help them accomplish their goals.³