LLOYD MARTIN PLC

Flexible Starting Date 

Under the Virginia Limited Liability Company Act, an LLC is formed by filing articles of organization with the Virginia State Corporation Commission (SCC).  Virginia Code Section 13.1-1010, permits one or more persons to file the articles of organization but does not require that these persons be members of the LLC after it is formed. Many attorneys who organize LLCs sign the articles of organization themselves. The Act does not require a Virginia LLC to have any members at the time of formation, so a Virginia LLC can be organized and kept “on the shelf” before beginning operations. While there is no express statutory provision in the Act providing for a “shelf” LLC, this conclusion is based on the absence from the Act of the requirement for members when forming an LLC; from the Act's definition; from the Act's dissolution provisions; and, the inclusion in the Act of a number of provisions addressing how action is taken in an LLC that has no members.

Qualifications of Members 

The Act does not impose any qualifications on becoming a member of an LLC. Under the Act, an individual, estate, corporation, unincorporated association, business trust, partnership, other trust, or governmental entity may become an LLC member. Section 13.1-1002 of the Virginia Code contains the definition of a “member” and a “person” for purposes of the Act. The LLC in this respect contrasts with another popular entity that enjoys pass-through treatment for income tax purposes, the Subchapter S corporation. Corporations (other than 100-percent S corporation parents), partnerships, other entities, most trusts, and nonresident aliens cannot be shareholders of an S corporation.  See IRC Section 1361.  Because it allows ownership by business and other entities, the LLC is often used in joint ventures among businesses, as well as by investment entities such as private equity and hedge funds.

Contributions and Interests 

The Limited Liability Company Act has very flexible rules about contributions by members in exchange for their membership interests. Contributions may be in cash, property, or services rendered. In addition, a promissory note or any other binding obligation to contribute cash or property or to perform services is recognized as a valid contribution. A contribution can be conditioned on the happening of a future event. For example, a required capital contribution could be conditional on the LLC obtaining a commitment for bank financing or identifying an acquisition target.

An LLC may admit a person as a member and issue a membership interest to that person without that person either making a contribution or being obligated to do so. The Act also does not prohibit an LLC from establishing through its articles of organization or operating agreement one or more classes of membership interests with different economic rights, such as distribution rights and rights to net assets on liquidation of the LLC. For example, venture capital and “angel” investors often require they be issued “preferred” membership interests with distribution and liquidation rights to the founders' “common” membership interests.

Corporations

As a general proposition corporations come in many forms, stock and non-stock, profit and nonprofit, public and private, to name a few.  For the purposes of starting a business, the basis decision which you will face is a tax question, that is, whether to use the small business form of corporation, commonly referred to as an "S" corporation, or the regular corporation, commonly referred to as a "C" corporation.

Small businesses typically begin as S corporations, and often later change to C corporations. Both forms offer liability protection.   The primary distinctions in the two are tax-based.

The S corporation is essentially a pass-through entity for income tax purposes, that is, all profits and losses "pass-through" the corporation and are reported on the individual tax returns of the shareholders.  Like partners and sole proprietors, however, more-than 2% S corporation shareholders are ineligible for some tax-favored fringe benefits.  There are also limitations on the number and kind of permissible shareholders for S corporations.  These restrictions tend to limit an S corporation's growth potential and access to capital.  C corporations do not have the shareholder restrictions that apply to S corporations, but they are subject to a double system of taxation.  That is, their profits are subject to income tax at the corporate level, and are also taxed to the shareholders if distributed as dividends.

But if profits are to be plowed back into the business to foster the company's growth, the tax bite is usually lower than with an S corporation.  And there are many situations in which the double tax can be substantially minimized.

An additional, and often very important, advantage of using a C corporation is that shareholder-employees are entitled to greater tax-advantaged corporate-type fringe benefits, such as medical coverage, disability insurance, group-term life and medical/dental reimbursement plans.

Characteristics of S Corporations

Most new small businesses begin as S corporations.  The reasons that the S corporation is the preferred entity become evident when reviewing the relative advantages and disadvantages of the S corporation form.  Some of these advantages/disadvantages will be more important than others, depending upon the particular circumstances of the business owner.

You must be aware, however, that S corporation reform measures are almost constantly being considered by Congress, any of which could make the S corporation more or less attractive and eliminate, lessen, or even add to, some of the listed disadvantages.

Advantages of S Corporations:

• Your personal assets will not be at risk because of the activities or liabilities of the S corporation (unless, of course, you pledge assets or personally guarantee the corporation's debt).
• Your S corporation generally will not have to pay corporate level income tax.  Instead, the corporation's gains, losses, deductions, and credits are passed through to you and any other shareholders, and are claimed on your individual returns.  The fact that losses can be claimed on the shareholders' individual returns (subject to what are known as the passive loss limits) can be a big advantage over regular corporations.  Liquidating distributions generally also are subject to only one level of tax.
• The S corporation also has no corporate alternative minimum tax (AMT) liability (however, corporate items passed through to you may affect your individual AMT liability).
• Social Security and Medicare taxes are not owed on the regular business earnings of the corporation, only on salaries paid to employees.  This is a potential advantage over sole proprietorships, partnerships, and limited liability companies.
• The S corporation is not subject to the so-called accumulated earnings tax that applies to regular corporations that do not distribute their earnings and have no plan for their use by the corporation.

Disadvantages of S Corporations:

• S corporations cannot have more than 35 shareholders (with husband and wife being considered as only one shareholder).
• Corporations, nonresident aliens, and most estates and trusts cannot be S corporation shareholders.
• S corporations may not own subsidiaries, which can make expansion difficult.
• S corporations can have only one class of stock (although differences in voting rights are permitted).  This severely limits how income and losses of the corporation can be allocated to shareholders.
• A shareholder's basis in the corporation does not include any of the corporation's debt, even if the shareholder has personally guaranteed it.  This has the effect of limiting the amount of losses that can be passed through.  It is a disadvantage compared to partnerships and limited liability companies, and is one of the main reasons that those forms are usually used for real estate ventures and other highly-leveraged enterprises.
• S corporation shareholder-employees with more than a 2-percent ownership interest are not entitled to most tax-favored fringe benefits that are available to employees or regular corporations.
• S corporations generally must operate on a calendar year.

Maximize Benefits of Start-up Costs

Planning to get the most out of any new business venture begins with making sure you get the greatest possible tax advantages for your investigation costs, start-up expenses, and other organization costs.  These include costs such as advertising, salaries and wages of employees-in-training, travel and other expenses of lining up customers, suppliers, and distributors, and fees paid for consultants and professional services.

You may assume that all of these start-up expenses are deductible as business expenses in the year you pay them, but that's not the case!

Such expenses are not considered to be business expenses because they are not incurred in a going business.  Instead they must be capitalized unless you make a proper election to amortize them ratably over the appropriate period.  The costs of organizing a corporation can also be amortized, if the corporation properly elects to do so.  Another complication with start-up expenses is that they may be amortizable only by the person who incurs them.

If your new business is going to be a sole proprietorship, that won't be a problem.  However, if the venture is to be a corporation, you can't personally deduct the costs you incur before incorporation.  Those costs are part of your investment in the corporation's stock--you may want to contribute the funds to the corporation and let the corporation incur the expenses so that it can amortize them.

It's also important to know that some expenses are treated more favorably than the regular start-up costs we have been talking about, and some less favorably.

Start-up expenses for interest, taxes, and research costs usually can be deducted in the year paid.  The cost of tangible and intangible property purchased for use in the business can be recovered by way of depreciation deductions (or expensed) over various periods, depending upon the type of asset.

Finally, You want to be sure that you get whatever tax benefit you can from all of these expenses.  To do so, you need to coordinate the expenses with the business's starting date, and properly make the necessary elections.  

If you are expanding an existing business, rather than starting a new one, you may be able to deduct the expansion costs currently.  You should explore these possibilities further with your accountant to be sure that you avoid any costly pitfalls.

Our Pledge of Quality Service

We pride ourselves on the quality and excellence of our service to our customers and clients.  However, we are not perfect, so if we do not give you the service you expect, in both a timely and cost-effective manner, tell us.  We also believe that our competitive prices always give you value for your dollar.  Please tell us if you disagree!

LLOYD MARTIN PLC, is a Virginia professional limited liability company. Our law practice emphasizes real estate closings, real estate law and related matters; legal services to clients in the areas of wills, trusts and estates; and, legal services to small businesses.   We bring to our clients and prospective clients over two decades of real estate experience in Northern Virginia.  We have also served the legal needs of our trust and estate and small business clients in the City of Alexandria and Arlington, Fairfax and Prince William
Counties and surrounding areas since 1984.

The information contained herein is furnished by LLOYD MARTIN PLC for clients and prospective clients.  Readers should not attempt to solve legal problems based on information contained herein, it being of general interest only.