Is it time for your ISP business to consider a LLC or LLP operating structure? Learn why current tax laws that limit liability could build tangible tax benefits for your ISP.

by Mark E. Battersby [March 28, 2001]

You've heard about limited liability companies (LLCs) for years, but you decided to go with a corporation, partnership or sole proprietorship for your Internet service business. Maybe you didn't know what a LLC was—maybe it wasn't even allowed in your state until recently. But now that this form of doing business is experiencing increasing and widespread acceptance, it may be time to take a closer look at operating your ISP as a LLC.

The limited liability company is a hybrid operation that is structured like an incorporated ISP business and an ISP operating as a limited partnership. It is an entity created under state law. For federal tax purposes, a LLC is treated as a partnership and usually must file a Form 1065, U.S. Partnership Return of Income. An exception to this rule applies to single-owner LLCs, which are treated identically to sole proprietorships and whose owners must file a Schedule C with their Form 1040.

Under state laws, LLC owners are given protection from liability that was previously afforded only to corporate stockholders. Although the LLC is a relatively new business form, all 50 states have enacted legislation providing for limited liability companies.

While a LLC can be taxed as a partnership for federal income tax purposes, its members, like corporate shareholders, are not personally liable for he entity's debts and liabilities. In fact, unlike limited partners, LLC members may participate in management without risking personal liability.

The basics
LLCs were created to provide business owners with the same level of liability protection that corporations enjoy—without double taxation penalties, whereby profits already taxed at the corporate level are passed through as dividends to the shareholders who pay taxes at individual rates as well. With a LLC, earnings and losses pass-through to the owners and are included on their personal tax return—with no entity or corporate level taxation.

Although similar to an incorporated ISP that has elected or chosen to be treated as a partnership (S corporation), a LLC offers ISP operators even more benefits than an S corp. For example, there is no limit on the number of shareholders that a LLC can have, unlike an S corporation, which as a limit of 75 shareholders. What's more, any member or owner of the LLC is allowed a full role in the business's operation. On the other hand, in a limited partnership, partners are not permitted any say in the ISPs day-to-day operations.

At its most basic layer, a LLC is nothing more than an organization formed at the state level, that may be treated as a partnership for federal tax purposes, and which offers limited liability protection for the owners. However, the business entity may be subject to state franchise taxes as a corporation.

Some states, however, also recognize limited liability partnerships (LLPs), in which the individual partners are protected from the liabilities of the other partners. These entities are considered partnerships for both federal and state tax purposes.

For the record, like partnerships, LLCs do not have perpetual life. Some state statutes stipulate that the operation must dissolve after 30 or 40 years. Technically, a LLC dissolves when a member dies, quits or retires.

Checkout check-the-box
Most entities that qualify for partnership treatment also qualify for electing out of partnership treatment under the Internal Revenue Service's check-the-box regulations. Under these rules, most entities that are not corporations may choose how they are to be taxed without specifically qualifying as one form of entity or another under local laws.

An entity with two or more members can be classified, at least for federal tax purposes, as either a partnership or as an association taxed as a corporation. An entity with only one member can be classified as an association or can be designated as an entity separate from its owner. Under these check-the-box rules, a LLC would elect partnership status to avoid taxation at the entity level as an association taxed as a corporation.

Pratfall to pitfall
Despite the many appealing tax features of operating your ISP as a LLC, there is also a downside. Since the LLC entity is relatively new, its tax treatment varies from state to state. Anyone operating—or planning to operate in several states must determine how each state will treat a LLC, which has been formed in another state. Fortunately, the majority of ISPs usually operate their business with a physical presence in only one state—that in which they are headquartered.

No one knows how the courts will rule in any case involving a LLC because legal precedent is scant. However, the flexible operating structure offered by LLC status means that it is often the entity of choice for new ISP businesses. If you currently do not operate your ISP business as a LLC, contact your accountant to see if LLC or LLP status bears consideration for your ISP.

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