Negative aspects to using LLCs for operating companies.

• Author: Baptiste, Phillip J.
• Position: Limited liability companies

Now that all but two states have limited liability company (LLC) laws, the choice of entity for a closely held business has become less clear. Previously, when limited liability was a desired result, the only real options for an operating business were S corporations and C corporations. Although limited partnerships could be structured to provide limited liability, generally they were not and still are not used extensively to run operating businesses.

LLCs taxed as partnerships have very desirable characteristics. They have the tax attributes of partnerships (which provide tremendous flexibility in the allocation of profits and losses), no double tax on the sale of assets and no potential dividend issues. On the other hand, they have limited liability for their owners. For these reasons, LLCs make sense for a wide variety of family businesses. However, because there are certain negatives to their use, LLCs are not the natural choice in all cases. Many family businesses continue to operate as S corporations, for some of the following reasons.

Sec. 401(k) Plans

Sec. 401(k) plans of partnerships or LLCs are treated differently from Sec. 401(k) plans for S corporation employee-owners. Both have the same limitations on salary deferrals and both contain family attribution rules. However, a Sec. 401(k) plan of an LLC or partnership treats employer-matching contributions as if they were employee deferrals for partners or members (Regs. Sec. 1.401(k)-1(a)(6)(iii)). Thus, if an owner of a family business is used to deferring the maximum amount into his Sec. 401(k) plan and also receiving an employer match of another several thousand dollars, under a partnership or LLC Sec. 401(k) plan the matching contribution will be included with the elective deferral from his pay, potentially causing the deferral limit to be exceeded. In addition, even if the maximum amount is not exceeded, the employer match will be included as an employee match for the highly compensated for purposes of calculating the average deferral percentage. This may also result in a cutback in the amount of money that may be deferred on behalf of an owner of the company.

The government is grappling with this distinction. The preamble to the Sec. 401(k) regulations indicates that the differences were not intended and invites public comment. However, until these differences are resolved, this problem will continue.

Self-Employment Tax

In an S corporation, an active owner must pay himself...