Limited liability company

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A limited liability company (LLC) is a relatively new business structure allowed by state statute. LLCs are popular because, similar to a corporation, owners have limited personal liability for the debts and actions of the LLC. Also, an LLC is more like a partnership, providing management flexibility and the benefit of pass-through taxation. Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities. There is no limit to the number of members. Most states also permit a “single member” LLC. One which has only one owner.

What type of businesses can form a LLC?

Most businesses can form a LLC. The exception is banks and insurance companies.

How do you form an LLC?

A LLC is formed by filing a form, usually called Articles of Organization, with the Secretary of State office in the state where most of the business activity is expected to occur. Most secretary of state offices have corporation divisions which handle LLCs. The majority of the states require an annual report be filed. The LLC is not a tax paying entity; therefore, any profits or losses pass on directly through to the individual members and they are reported on the individual members tax returns.

To learn how to set up a LLC, here is one of many websites that can be of help. http://entrepreneurs.about.com/od/businessstructure/ht/llcsetup.htm

Management Structure

The members of the company either manage the business affairs themselves or appoint a manager to operate the company for them.

Advantages of the LLC

The main advantages of the LLC are the protection of personal assets from business debt and the liability of members is limited to the amount of their investments, which are benefits of a corporation. In addition, profits and losses pass through to personal income tax returns of the members (or owners), which is a benefit of a partnership. This is called pass-through taxation. [1] As you can see, the LLC is a hybrid of a corporation and a partnership, receiving the benefits of both business entities.

Another advantage of the LLC is no double taxation [2]. The earnings of the LLC are only taxed one time unlike the earnings of a corporation where they pay taxes on their earnings and likewise the shareholders are taxed on those same earnings when they receive dividends.

Finally, no group of individuals, such a board of directors, stand between the members and the managers and there is a great deal of flexibility in determining management structure and organization of the business. The members can adopt a structure best suited to the particular needs of the company.

Disadvantages of the LLC

The main disadvantage is the potential existence of disagreement and deadlock amongst the members because each member has managing rights of the company. Members are individuals who have their own opinions. Also if the members allow personal differences to get in the way, the company could suffer.

Another disadvantage for the LLC is difficulty of receiving a loan to expand its business unless the individual members or the company has excellent credit.

The next disadvantage is the fact that there is a lack of uniformity among state statutes concerning LLCs because of case law dealing with LLCs. This effects those LLCs who operate in more in than one state. The LLC has to abide by the statutes in state where they do business.

Lastly, LLCs often have a limited life (not to exceed 30 years in many states) and LLCs are not corporations so they do not benefit from stock ownership and sales. Therefore, it is difficult for the LLC to go public and offer ownership through the sale of stocks.

Comparison of the LLC and Other Business Organizations

Corporation vs. LLC

The two most common corporation types are the C Corporation and the S Corporation. The C Corporation is a general corporation that provides the shareholders (owners) protection from the creditors of the business. The S Corporation is the same as a C Corporation with the exception of its tax designation. The S Corporation was designed for smaller corporations to help avoid double taxation. A business must file an election with IRS and meet specific requirements.

Every corporation is governed by a board of directors. A director occupies a position of responsibility unlike that of other corporate personnel. Sometimes directors are characterized as agents because they act on behalf of the corporation, however, no individual director can act as an agent to bind the corporation. Directors are responsible for authorizing major corporate decisions, appointing supervising, and removing corporate officers and other managerial employees, determining employees' compensation, making financial decisions necessary to the management of corporate affairs, and issuing authorized shares and bonds. Directors and officers are exposed to liability on many fronts. Corporate directors and officers may be held liable for the crimes and torts committed by themselves or by corporate employees and under their supervision. Directors also have a loyalty to the corporation. The duty of loyalty requires directors and officers to subordinate their personal interests to the welfare of the corporation.

Below is a list of differences between the C Corporation, the S Corporation, and the LLC.

C Corporation S Corporation Limited Liability Company
Operation Board of directors hires officers; set corporate policies; officers run day to day operations Same as C Corporation No board of directors; member managed or manager hired; operating agreement not required, but recommended
Taxation Double taxation on corporate profits Profits and losses are allocated down to shareholders Same as a partnership - profits and/or losses flow down to partners
Personal Liability Limited to the amount of the shareholder's investment Same as the C Corporation Members (not shareholders) are given a shield from debts and obligations of business
Transferring stock Easy; no permission Same as C Corporation Lack the benefits of stock ownership and sales
Types of Owners Unlimited number of shareholders; foreign investors allowed Maximum number of 100 shareholders; foreign investors not allowed Unlimited number of members; foreign investors allowed

Partnership vs. LLC

A partnership arises from an agreement, express or implied, between two or more persons to carry on a business for a profit. A partnership is based on a voluntary contract between two or more competent persons who agree to place some or all of their funds or other assets, labor, and skills in a business with the understanding that profits and losses will be shared. The contrary for the LLC is the filing it must submit to the state where it plans mainly to do business.

Management and control responsibilities are divided among the partners equally. With an LLC, the members can choose to draw up an operating agreement that establishes structure for the business such as ownership percentage, allocation of profits or losses, responsibilities of each member and what happens to business if a member wants out.[3] On the other hand, the partnership automatically dissolves upon the retirement, death, or incapacity of any partner.

Personal liability is the main disadvantage for the partnership. Each partner is an agent of every other partner and acts as both a principal and an agent in any business transaction within the scope of the partnership agreement. In addition, all partners are personally liable for the debts and lawsuits incurred by the entity, including individual debts and lawsuits incurred by the other partner(s). The liability is essentially unlimited because the acts of one partner in the ordinary course of business subject the other partners to personal liability. Alternatively, the members of the LLC are given a shield from debts and obligations of the entity.

Partnership Limited Liability Company
Creation No filing required; minimal cost; oral or written agreement between two or more persons Filing required; must meet regulations in the state where filed; 1 or more members except for DC & MA (2 or more)
Operation According to written agreement; partners have equal control of business and property Member managed or manager hired; operating agreement not required but recommended
Taxation No business tax; profits or losses flow down to partners individual tax returns Same as Partnership
Personal Liability All partners are personally responsible for all debts and obligations incurred by entity, including personal debts and lawsuits developed by the other partner(s) Members are given a shield from debts and obligations of entity (benefit of corporation)

Sole Proprietorship vs. LLC

The simplest form of business is a sole proprietorship. The owner is the business; thus, anyone who does business without creating a separate business organization has a sole proprietorship. A major advantage of the sole proprietorship is that the proprietor receives all of the profits. The sole proprietor is free to make any decision he or she wishes concerning the business whom to hire, when to take a vacation, what kind of business to pursue, and so on. A sole proprietor pays only personal income taxes on the business' profits, which are reported as personal income on the proprietor's personal income tax return. The major disadvantage of the sole proprietorship is that as a sole owner, the proprietor alone bears the burden of any losses or liabilities incurred by the business enterprise. The proprietor has unlimited liability, or legal responsibility, for all obligations that arise in doing business. Below is a comparison chart for the sole proprietorship and limited liability company.

Sole Proprietorship Limited Liability Company
Creation Simple; no filing required; minimal cost Filing required; must meet regulations in the state where filed; 1 or more members except for DC & MA (2 or more)
Operation Owner has complete control Member managed or manager hired; operating agreement not required but recommended
Taxation No business tax; profits or losses are filed with owner's individual tax return Same as Partnership
Personal Liability Owner is personally responsible for all debts and obligations incurred Members are given a shield from debts and obligations of entity (benefit of corporation)

Taxation Issues for the LLC

As mentioned above, the LLC enjoys pass-through taxation and avoids the "double taxation" that general, or "C," corporations experience. The Internal Revenue Service (IRS) does not assess taxes on the entity itself, but does ultimately decide how the LLC will be taxed based on certain criteria. If the LLC is too much like a corporation, it will be treated like one.[4]

LLCs have an additional tax advantage over a corporation because of the flexibility to allocate earnings among owners. Furthermore, the profits and losses of the LLC can be distributed in disproportion to the share of ownership. Just because "Eddie Entrepreneur" owns 55% of the LLC and "Mary Member" owns 45% of the LLC, their LLC operating agreement can state the allocation of the company's profits and losses conversely to their share of ownership.

Single-Member LLCs are automatically classified by the IRS as a sole proprietor unless the owner of the company specifically elects to do otherwise.

When does the LLC dissolve?

A LLC does not have an infinite life. There are three ways that would cause a LLC to dissolve. It could dissolve with the death of one of the members or the single member, a bankruptcy of an individual member or single member, or if an individual member decides not to continue with the business anymore. However, if the LLC has an operating agreement that addresses how the LLC can be dissolved, it would forgo the previously mentioned reasons.[5]

Single-Member Limited Liability Company (SMLLC)

Although most states, except the District of Columbia and Massachusetts, permit Single-Member LLCs, a traditional LLC is designed to be used by two or more members. This is because the Single-Member LLC has not been fully tested before the IRS. The IRS is uncertain as to how they will ultimately be treated in various situations. By definition, one person cannot be a partnership. Therefore, an individual organized as a LLC might lose the protection of this type of business organization.

History of Limited Liability Companies in U.S.

In 1977, Wyoming became the first state to pass legislation authorizing the creation of a LLC. Although LLCs emerged in the United States only in 1977, they have been existing for over a century in other areas, including European and South American nations. History of a LLC actually dates back to the German law of 1892. [6]

Conclusion

The business entity you choose can greatly affect your personal liability. When shareholders or owners of a business are not personally liable for any business debts or obligations, they enjoy "limited liability." The last thing you want to do is create a business where the negligence of a partner, or even an employee, puts your personal assets at risk.

References