The 4 Tax Benefits of Operating Through an LLC  Instead of a Corporation

By Barry Klingman

1)  Not getting taxed twice.  
A limited liability com­pany can sell its assets and operations and li­quidate without triggering a double tax – meaning both an entity-level tax and a shareholder-lev­el tax.

Purchasers strongly prefer to purchase assets, rather than equity in­terests, because an as­set sale gen­erally results in a “step-up” in the tax basis of the acquired as­sets from the seller’s cost (net of depreciation) to the purchaser’s cost.  This step-up en­titles the purchaser to greater de­­preciation deductions and/or less gain when the acquired as­sets ulti­mately are sold.  Purchasers are acutely aware of the tax ben­efits associated with a bas­is step-up and typically dis­count the pur­chase price signifi­cantly where corporate shareholders insist on a stock sale in order to avoid the double tax that would result from an asset sale.

2) An equity com­pen­sa­tion program that is treated more favorably than a corporate equity com­pen­sation pro­gram.
If a limited liability company grants a key employee a “profits interests” (whether restrict­ed or vested), the employee will not recognize income or gain at the time he receives the profits in­ter­est (or, if the interest, is restricted, at the time it vests), but only when the company ulti­mate­­ly is acquired or goes public.  On the other hand, regular corporate stock options trig­ger ordinary in­­come when exercised, qualified corporate stock op­tions trig­ger alternative minimum tax when exercised and grants of vested corporate stock require the recipient either to pay fair value for the stock or recognize ordinary in­come on the difference between fair value and purchase price.

3) Losses generally can pass through directly to its owners as cur­rent de­duc­tions and can offset the income they earn from their “day jobs.” This especially is helpful in the beginning stages of a new company.  Of course, this loses sig­nificance once the company turns a profit.  In a corp­or­a­tion, however, this would fall under operating losses and not offer the same benefit.

This enables a limited liability company to make “tax distributions” to its members on a tax-free b­a­sis, thereby providing its members with cash with which to pay any tax liability associated with their ownership of the company. (While most loan agreements prohibit borrowers from making distributions to their owners, lenders typically make exceptions for tax distributions in the case of limited liability companies.)

4) Limited Liability Companies are Easier to Restructure.
Since an overwhelming majority of start-ups are financed entirely by friends and family or a com­bi­na­tion of friends and family and angels and then are ac­quired or go public without
ven­ture capital funding, selecting a business structure for the purpose of at­tracting venture   capital funding is putting the cart before the horse.  This is particularly so if and when a lim­ited liability com­­pany reaches a stage in its de­vel­opment where it wishes to attract such funding; it can in­­corporate at that time without incurring any tax liabili­ty. On the other hand, there is typically a sig­nificant tax cost associated with the conversion of a corporation into a limited liability com­pa­ny.

Barry Klingman is a Partner at Warshaw Burstein, LLP in New York.  He has more than 40 years of experience in all areas of taxation, with a particular emphasis on structuring commercial transactions.