Preface: Setting up a good legal structure for your business will minimize future risks, and can position you for the best legal protection and tax savings.
Why You Should Consider Converting Your Business to an LLC
By Nevin Beiler, Attorney
A large part of my law practice consists of forming and restructuring business entities for business owners. People often ask me what would be the best form of entity for their business. Although there are exceptions, in the vast majority of cases the answer to that question is a Limited Liability Company (“LLC”). If you have a business that is located in Pennsylvania and is structured as something other than an LLC, you may want to at least consider restructuring it. This is especially true if your business is a sole proprietorship or a general partnership.
In this article I will explain the main benefits of being structured as an LLC. But first, a quick story about some clients I assisted in restructuring their business from a general partnership to an LLC. As always, I have changed the names and some details in order to protect the confidentiality of my clients.
A father and his three sons came to my office one day to discuss restructuring their construction business. For the past 15 years they had been operating as a general partnership. At the time of the meeting, the father owned 90% of the business, his three sons owned 2% each, and two other workers owned 2% each.
In the past, the sons and two other workers had been listed as partners mainly to avoid payroll taxes. The father wanted to increase his son’s percentage of ownership and give them more management responsibilities. He was also considering putting the other two workers on payroll because he had heard that the strategy of having workers be low-percentage partners to avoid payroll taxes was causing some partnerships to incur fines and penalties in Pennsylvania Unemployment Tax audits (he was right about that).
The father had also heard somewhere that he should consider changing from being a general partnership to an LLC partnership, but he wasn’t totally sure why. I explained that one reason he should convert to an LLC partnership was to limit the personal liability of the partners for lawsuits against the business. He seemed to have a “lightbulb moment” when I said that, and said, “do you mean that if the business is sued all the money in my sons’ personal bank accounts would be at risk”? When I answered “yes” and also said that the personal assets of his other workers were also at risk, he become very concerned. His sons had worked hard for the business since their teen years, and had each developed sizable savings accounts. He was also uncomfortable with the thought that his workers, who functioned essentially like employees, were sharing in the risk of the business due to the fact that they were 2% general partners.
The realization that the way his business was structured was putting his sons’ savings and his employees at risk provided a substantial motivation for the father to change the general partnership to an LLC partnership. As part of that change, he put the other workers on payroll and increased his son’s percentages of ownership in the business. He also increased the liability insurance of the business. The good news for them was that converting a general partnership to an LLC partnership is fairly simply in Pennsylvania. The bad news was that the conversion and the limited liability it brought would only apply to the future. Any potential lawsuits for activities prior to the date of the conversion to an LLC would still put the partner’s personal assets at risk.
The Benefits of a Limited Liability Company
The above story illustrates one of the main benefits that an LLC has over sole proprietorships, general partnerships, and general partners in limited partnerships, which is that partners in an LLC (typically called “members”) do not have personal liability for lawsuits against the LLC. The members of an LLC also generally do not have personal liability for the debts or other liabilities of an LLC, unless they sign a personal guarantee for the liability. They are at risk of losing the value of their share of the business if an accident or lawsuit is not covered by the business’s insurance policy, but their personal assets would be protected.
On the other hand, the personal assets of all the partners in a general partnership (including a 1% partner) can be fully at risk for the liabilities of the partnership (including loans, audits assessments, lawsuits, etc.), regardless of which general partner of the partnership incurred the liability or caused the lawsuit. The same is true of sole proprietors, who are generally fully responsible for both their own actions, and the actions of their employees during the workday. Most businesses should and do carry liability insurance that will cover unexpected accidents and lawsuits. However, not everything can be covered by insurance, and sometimes insurance coverage limits are lower than a lawsuit amount, so having the extra protection of the LLC structure can be a big help in protecting the owners of the business when things go majorly wrong.
Another benefit of the LLC structure is its administrative and structural simplicity and flexibility. Unlike corporations (which were more common before LLCs became available), LLCs do not require many formalities like annual meetings, electing directors, director meetings, etc. An LLC can require certain formalities in its Operating Agreement, but very few formalities are required by law for LLCs.
Similar to a general partnership, an LLC can be structured as “member managed” (meaning it is managed by all its members) or “manager managed” (meaning the members elect one or more managers from among or outside the membership to manage the LLC). The provisions regarding voting, compensation, profit sharing, buy/sell agreements, etc., are all very flexible in an LLC and can be customized in the LLC’s Operating Agreement to suit the needs of the members.
LLC’s are also very flexible when it comes to how they are taxed. A single member LLC is normally taxed as a disregarded entity, meaning that the income and expenses of the LLC are reported on the appropriate schedule of the owner’s Form 1040 (e.g. on Schedule C). However, a single member LLC can elect to be taxed as an S Corp or C Corp if that would be advantageous to its owners (not common for those exempt from FICA taxes).
A partnership LLC (an LLC with more than one member), like a general partnership, is normally taxed as a pass-through entity, meaning that the partnership entity files an information tax return but all income taxes are paid by the individual members. However, the members can choose to have the partnership be taxed as an S Corp or C Corp if that would be advantageous to the members. The flexibility to choose between the full range of tax elections could become an advantage over corporations, which are limited to C Corp and S Corp tax options. With the Qualified Business Income Deduction (new for the 2018 tax year), more small corporations may want to consider whether changing their structure to an LLC would be advantageous. Doing so would allow them to be taxed as a disregarded entity (one owner) or partnership (multiple owners) and potentially maximize the QBI Deduction.
Another advantage, though perhaps smaller than the ones discussed above, is that registering a business as an LLC provides more protection for the registered business name than filing a fictitious name registration (as is required for sole proprietorships and general partnerships). Many business owners are surprised when I tell them this, but the reality is that filing a fictitious name registration does not result in exclusive use of that name in Pennsylvania (and probably many other states). If only a fictitious name registration is filed in Pennsylvania, another business owner could come along and register the same name as an LLC or Corporation (or other registered entity). But once a name is registered as an LLC (or other registered entity) in Pennsylvania, nobody can come along and register a business under that same name in Pennsylvania. (Businesses that want exclusive use of a name in multiple states may want to consider registering a Trademark for their name.)
Starting an LLC or Converting to an LLC
Starting an LLC in Pennsylvania is fairly simply. New LLCs in Pennsylvania do not require legal advertising (which is required for fictitious names and new corporations), so that helps to keep the cost down. Also, Pennsylvania has a conversion process by which a general partnership can convert to an LLC partnership without re-titling assets or getting a new EIN number. This greatly simplifies the administrative hassle of these conversions.
An existing sole proprietorship business will generally need a new EIN in order to change to a single member LLC. This means a little more administrative burden (usually involving a new bank account, new payroll accounts if there are employees, new PA Dept. of Revenue accounts, and transferring business assets to the new LLC), but it is very manageable for most businesses.
When starting a new business or changing your business structure, you should seek good legal advice and tax advice. Setting up a good structure for your business will minimize complications down the road, and can position you for the best legal protection and tax savings.
Nevin Beiler is an attorney licensed to practice law in Pennsylvania (no other states). He practices primarily in the areas of wills & trusts, settling estates, and business formations & agreements. Nevin and his wife Nancy are part of the conservative Mennonite community, and Nevin previously served as the in-house accountant for Anabaptist Financial before leaving to become an attorney. Nevin’s office is located at 105 S Hoover Ave, New Holland, PA 17557, and he can be contacted by email at firstname.lastname@example.org or by phone at 717-287-1688. More information can be found at www.beilerlegalservices.com.
Disclaimer: This article is general in nature and is not intended to provide specific legal or tax advice. Please contact Nevin or another attorney licensed in your state to discuss your specific legal questions. This article was initially published in the PCBE.