Limited Liability Companies
A limited liability company (LLC) is a partnership or a sole proprietorship that limits the liability of the business to the business, not the partners or proprietor. Unlike working in a general partnership, the partners of an LLC can operate the business without exposing themselves to personal liability for the debt or torts of others.
Like a sole proprietorship or a partnership, gains and losses pass through to the owners of the business. Owners are called members and must report and pay taxes on the LLC income on their individual tax returns and they must pay estimated taxes quarterly. LLC's do not pay federal income taxes, although they may pay state taxes. Active members, but not passive investors, also pay self-employment taxes.
A limited liability company combines the corporate benefit of limited liability for the owners and the benefits of partnership taxation, with a single level of tax at the owner level and possible special allocations of income, losses, and cash flows. However, LLC's can elect to be taxed as a C corporation. Most states require annual tax reporting by LLC's.
Single-member LLC's file Schedule C, Profit or Loss from Business, single-member farming LLC's file Schedule F, Profit or Loss from Farming, and multimember LLC's file Form 1065, U.S. Return Of Partnership Income.
Only the business assets are subject to creditors' claims, not the personal assets belonging to members, even if the LLC only has a single member. However, the IRS and state tax authorities can collect LLC payroll taxes directly from members. Of course, even key employees of C corporations can be held liable for payroll taxes.
The advantages of the LLC over a corporate entity includes the following:
- an LLC is cheaper to operate;
- an LLC can allocate income and expenses to the members that differs from their ownership interest, while corporations must allocate income and expenses according to the shareholders' percentage of ownership;
- an LLC can have an unlimited number of owners, including foreign owners, while an S corporation is limited to 100 shareholders, none of whom can be nonresident aliens.
LLC's are much like limited partnerships except they do not require a general partner that assumes full personal liability for all business debts. Furthermore, unlike LLC members, limited partners can lose their limited liability if they participate actively in the business.
Since LLC's are pass-through entities, there is no double taxation of profits as there is with a C corporation. Furthermore, a liquidation of the C corporation may result in corporate and shareholder taxes, while a liquidation of an LLC usually only has tax consequences to the members. However, any profit left in an LLC at the end of the tax year is taxable income to the members, whether they withdraw the money or not. Hence, they do not benefit from the lower corporate tax rate on C corporations.
Many states also allow the formation of limited liability partnerships (LLPs), which is an LLC for specified professionals — usually state licensed occupations, such as doctors, accountants, lawyers, or architects. The LLP designation, or RLLP for Registered Limited Liability Partnership, must be part of the business's name in all legal transactions and in public advertising. Unlike a general partnership, the partners of an LLP do not have liability for malpractice by the partners; they only have liability for their own actions.
Forming an LLC
LLC's are regulated under state law and while the laws vary among the different states, there are some common elements. To form an LLC, members must contribute money, property, labor, or skill, to carry on a trade or business. Members can include individuals, other LLC's, corporations, and foreign entities. The members must provide written articles of organization (aka certificate of formation, certificate of organization) that is filed with the Secretary of State. Filing fees generally range from $50 or more, and some states require the payment of an annual franchise tax.
Some businesses cannot be LLC's, such as banks, insurance companies, and nonprofit organizations.
Unless the LLC has only a single member who can use his Social Security number, it must obtain a federal identification number (FEIN), especially if the LLC will have employees. There may be other requirements such as the publication of the business name in a local newspaper, a local business or occupational license, or a sales tax permit.
An operating agreement governs LLC members and their operation of the LLC, including voting rights, who has check signing authority, profit-sharing, rules for ownership transfers, responsibilities of the individual members, and other essentials. There are generally no documenting requirements as there is with corporations, such as keeping minutes, passing resolutions, or recording annual meetings, although it may be wise to document important decisions.
The operating agreement for a multimember LLC must specify the percentage of income or loss allocated to each member. LLCs also allow special allocations of separately stated items, as do partnerships, but they must satisfy specific tax code requirements and must be specified in the LLC operating agreement. The purpose of special allocations cannot only be tax avoidance.
Although there are generally no obstacles to converting another business entity to a limited liability company, it may have tax consequences, especially if the previous business entity was a corporation. In such a case, the C corporation would have to be liquidated, which under tax law, the assets of the corporation will be treated as being sold to the shareholders, resulting in income or losses for both the corporation and the shareholders.