Why an LLC
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Why an LLC? In the world of business there are 4 common entities: sole proprietorships, partnerships, limited liability corporations (LLC), and corporations, C and S corps. Due to its nature of a single person forming a sole proprietorship is out of the question. Because partnerships do not provide personal liability protection they don’t make a good option either. That leaves LLCs and corporations (C and S types). The following discussion will provide the reasoning for our selection of the LLC as the best corporate entity. The LLC is the newest form of business organization. It was designed by state legislatures to overcome limitations of each of the other business forms – sole proprietorship, partnership, and corporations. Essentially, the LLC is a business ownership structure that allows owners to pay business taxes on their individual income tax returns like partners, but that also gives the owners the legal protection of personal limited liability for business debts and judgments as if they had formed a corporation. So, an LLC provides both pass-through taxation of business profits and limited personal liability for business debts. Number of owners - The number of owners can be from one to dozens. LLC members need not be residents of the state where they form their LLC (or even the U.S.), and other business entities, such as a corporation or another LLC, can be LLC members. For a corporation there are many more restrictions on who may become owners. Limited Liability – The owners of an LLC are not personally liable for its debts and other liabilities. The personal legal liability protection is the same as that offered to shareholders of a corporation. Pass-Through Taxation – Federal and state tax laws treat an LLC as a partnership. The LLC owners report LLC income, losses, credits and deductions on their individual income tax returns. The LLC itself does not pay income tax. Because an LLC is taxed as a partnership, it files standard partnership tax returns (IRS Form 1065 and Schedules K) with the IRS and the state, and the LLC owners pay taxes on their share of LLC profits on their individual income tax returns. Each owner gets a Schedule K-1 from the LLC which shows the owner’s share of the LLC profits and deductions. The owner attaches the K-1 to his/her individual income tax return. Income taxes are paid whether an LLC’s profits are distributed or not. In other words, if an LLC wants to retain a years worth of profits for further investment the owners would have to pay income taxes on that year’s income. The retained profits are referred to as “allocated” and those paid to the owners are referred to as “distributed”. Our Hearth CPA prepares the Form 1065 and K-1. We then send them to each LLC owner. A C corporation is faced with double taxation on all profits or dividends paid to its shareholders. The corporation pays income tax on all income and then the owners pay tax on their salaries and/or dividends. An S corporation is taxed like a partnership. This is its only advantage over a C corporation. There are specific times when it is more advantageous to be organized as a corporation for tax purposes but we do not foresee that happening with our investments. One more reason, it is highly recommended that if you hold real estate or buy other types of property that are likely to increase in value, an LLC is the right corporate structure. Again, corporations are faced with double taxation on the sale of appreciated assets. The profits are taxed through the business and then through the owners when the profits are distributed. There are even more tax advantages of an LLC, but we don’t anticipate using them for our investments. Management- With each LLC that is formed for each project, Hearth Investments LLC is set as the manager partner. It is our intent to negotiate a “seat at the table” with the developer for each and every project. By designating Hearth as the managing partner it enhances the authority we have with the developer representing our LLC owners. Formation Requirements- This is another area where an LLC has a significant advantage over a corporation. While this process can be done by an individual we use our attorney for several reasons. However, the main reason is in forming the operating agreement which is an integral part of the LLC. The operating agreement spells out how the LLC will be owned, how the profits and losses will be shared, how departing members will be bought out, the management structure, and other essential ownership details. Due to the individual nature of each of our projects the operating agreement for each LLC is slightly different. To form a corporation is a much more formal process. The paperwork involved and governance requirements are very time consuming. This includes corporate officers and a board of directors. In addition, there are several fees to be paid. Conclusion - After extensive research and consultations with our attorney and CPA we believe the LLC is the best corporate structure for our investments. Because of the corporate protections and tax advantages each of us has formed a family LLC. Our family LLC’s make up our ownership in Hearth Investments LLC. P.S. – Owners of an LLC that incurs losses can use them to offset earnings or investment income from other sources, such as a regular salaried day job or investment income from a stock or mutual fund portfolio.