the fact that the IRS recognizes it as a pass-through tax entity. All of the profits and losses of the business flow through the LLC without tax. They flow through to the business owner’s tax return and are dealt with at the individual level.
Again, a C corporation does not offer such a feature. In a C corporation, the profits are taxed at the corporate level and then taxed again when a dividend is paid to the shareholder. Thus, the issue of double taxation. Still, with proper planning, the specter of C corporation double taxation can be minimized.
In an S corporation, profits and losses flow through the corporation, thereby avoiding double taxation, but may only be allocated to the shareholders according to their percentage ownership interest. As described above, LLC profits and losses flow through the entity and may be freely allocated without regard to ownership percentages. As such, the LLC offers the combination of two significant financial benefits that other entities do not.
LACK OF PRECEDENT
One of the limits to the LLC is the fact that it is a new entity. As such, there are not many court decisions defining the various aspects of its use. With corporations and partnerships, on the other hand, you have several hundred years of court cases creating a precedent for their operation.
As the years pass this LLC drawback becomes less and less of an issue to many practitioners. But until a cohesive body of LLC law emerges, owners of an LLC must be cognizant that the courts may interpret a feature, a benefit, or even a wrinkle of LLC law in a way that does not suit them. If you are on the fence between selecting a limited partnership, a corporation, or an LLC and do not like the uncertainty associated with a lack of legal precedent, you may want to consider utilizing an entity other than an LLC.
Rich Dad Tips
• California residents must be cautious when considering the use of an LLC. The fees are onerous.
• In addition to the annual LLC franchise fee of $800, the state of California hits LLCs with a fee based on their gross receipts. This fee has nothing to do with whether your company is profitable or not. It is only based on revenue generated, so you can lose money and still owe the fee.
• On gross income of $250,000 to $499,999 the fee is $900. The fee gradually rises to $11,790 on gross income of over $5 million. Be sure to consider this fee when analyzing which entity to use in California.
Limited Partnerships
A limited partnership is similar to a general partnership with the exception that it has two types of partners. The first type is a general partner who is responsible for managing the partnership. As with a general partnership, the general partner of a limited partnership has broad powers to obligate the partnership and is also personally liable for the business’s debts and claims. If there is more than one general partner involved they are all jointly and severally liable, meaning that a creditor can go after just one partner for the entire debt. However, a corporation or an LLC can be formed to serve as a general partner of a limited partnership, thus isolating unlimited liability in a good entity.
The second type of limited partnership partner is a limited partner. By definition, a limited partner is “limited” to his contribution of capital to the partnership and may not become actively involved in the business of the partnership. A limited partner may then be anb owner but have absolutely no say in how the entity operates. This was exactly what Jim wanted.
Case No. 5: Jim
Jim was the proud father of three boys in high school. Aaron, Bob, and Chris were coming of age. They were active, athletic, and creative boys almost ready to embark upon their own careers. The problem was that they were sometimes too active, too athletic, and too creative.
Aaron was seventeen years old and every one of the seemingly unlimited hormones he had was shouting for attention. He loved the girls, the girls loved him, and his social life was frenetic and chaotic. Jim knew his son was smart but worried whether he would ever settle down enough to complete one homework assignment, much less go to college.
Bob was sixteen years old and sports were all that mattered. He played sports, watched sports, and lived and breathed sports. Bob was hoping to get a college scholarship to play football and/or baseball. But Jim worried that if a scholarship wasn’t offered whether Bob would ever get into or be interested in going to college.
Chris was fifteen years old and the lead guitarist in a heavy metal band known as Shrike. When Shrike practiced in Jim’s garage the neighbors did not confuse them with the Beatles. The members of Shrike had pierced appendages, graphic tattoos, and girlfriends who looked like wild animals. Jim worried about the company that Chris kept. When you could make out the lyrics, Shrike’s songs made frequent reference to school as a brainwashing tool of the elite. And while Jim may have also believed that to be true when he was fifteen, he worried that Chris would still embrace the idea at age twenty-five.
Compounding Jim’s concerns was that he had five valuable real estate holdings that he wanted to go to the boys. His wife had passed on several years before and he needed to make some estate planning decisions. But given the boys’ energy level and lack of direction he did not want them controlling or managing the real estate.
Jim knew that if he left the assets in his own name, when he died the IRS would take 55 percent of his estate, which was valued at over $10 million. And while estate taxes were supposed to be gradually eliminated, Jim knew that Congress played politics in this arena and no certainty was guaranteed. Jim had worked too hard, and had paid income taxes once already before buying the properties, to let the IRS’s estate taxes take away half his assets. But again, he could not let his boys have any sort of control over the assets. While the government could squander 55 percent of his assets, he knew that his boys could easily top that with a 100 percent effort.
Jim asked his friends to refer him to a good attorney who could put together a plan to assist him. The attorney he met with suggested that Jim place the five real estate holdings into five separate limited partnerships.
It was explained to Jim that the beauty of a limited partnership was that all management control was in the hands of the general partner. The limiteds were not allowed to get involved in the business. Their activity was “limited” to being passive owners.
It was explained that the general partner can own as little as 2 percent of the limited partnership, with the limited partners owning the other 98 percent of it, and yet the general partner can have 100 percent control in how the entity was managed. The limited partners, even though they own 98 percent, cannot be involved. This was a major and unique difference between the limited partnership and the limited liability company or a corporation. If the boys owned 98 percent of an LLC or a corporation they could vote out their dad, sell the assets, and have a party for the ages. Not so with a limited partnership.
The limited partnership was perfect for Jim. He could not imagine his boys performing any sort of responsible management. At least not now. And at the same time he wanted to get the assets out of his name so he would not pay a huge estate tax. The limited partnership was the best entity for this. The IRS allowed discounts when you used a limited partnership for gifting. So instead of annually gifting $13,000 tax free to each boy he could gift $16,000 or more to each boy. Over a period of years, his limited partnership interest in each of the limited partnerships would be reduced and the boys’ interest would be increased. When Jim passed on, his estate tax would be based only on the amount of interest he had left in each limited partnership. If he lived long enough he could gift away his entire interest in all five limited partnerships.
Except for his general partnership interest. By retaining his 2 percent general partnership interest, Jim could control the entities until the day he died. While he was hopeful his boys would straighten out, the limited partnership format