Limited Liability Companies
One of the Best Ways to Organize A Small Business
For many years, business owners have had to choose between operating as a sole proprietor (or if several people are involved, as a partnership) or incorporating. On the one hand, many owners were attracted to the tax reporting simplicity of being a sole proprietor or partner.
On the other, they desired the personal liability protection offered by incorporation. Traditionally, it was possible to achieve these dual goals only by forming a corporation and then applying for S corporation status from the IRS. Then a few years ago a new legal entity, the limited liability company (LLC) was introduced. LLC’s, which are recognized by all states can have many of the most popular attributes of partnerships (pass through tax status) and corporations (limited personal liability for the owners). Most states allow a one person LLC but some states require an LLC to have at least two owners, meaning they are not suitable for sole proprietors except where a spouse is included as a co-owner.
LLC’s, like corporations, are formed by filing Articles of Organization with your state's corporate filing office, usually the Secretary. Then the parties prepare and adopt an Operating Agreement which is similar to a Partnership Agreement which sets forth the rights and responsibilities of the parties involved.
Here are the main features of the LLC, which make it attractive to many small business owners :
Limited liability . Until the LLC came along, business owners were personally on the hook for all the business debts, including liability from most lawsuits, unless they incorporated. But LLC owners are not personally liable for business debts, such as court judgments or legal settlements obtained against the business. They risk losing only the amount they paid into the business to get it started. (If however, you personally co-sign a loan, you are personally liable, no matter how the business is set up.)
Flexible management . The owners of an LLC are called members. Small LLCs are normally member-managed, since most small business owners want and need to have an active hand in running the business. Members can, however, elect a management group, which may include nonmembers.
One-level of taxation . The LLC, like a partnership, is normally recognized by the IRS as a "pass-through" tax entity (you can also elect to have it taxed like a corporation which for some business owners can result in lower overall taxation); LLC’s can even elect S corporation tax status, but this is a complicated tax strategy that puts LLC’s in a quasi-partnership type of tax treatment). Unless you choose corporate tax treatment, the profits or losses of the LLC are not reported and taxed at a separate business level, as are corporate profits. Instead, they pass through the business and are reflected and taxed on the individual tax returns of the owners. (Sole proprietorships and corporations that have elected S corporation status with the IRS are also pass-through entities with similar tax status.)
Flexible distribution of profits and losses . When a business is co-owned, the owners may or may not wish to split profits and losses of the business proportionately to capital contributions. Different business forms have different rules about how business profits, losses and assets can or cannot be split up. The corporate form is generally the most rigid, and partnerships the most flexible; S corporation tax status falls somewhere in between. The LLC is treated like a partnership for tax purposes, and this applies to the division of profits and losses of the LLC.
However, LLC’s may not be for everyone . Although LLC’s may be the best choice for some business owners who wish to limit their personal liability for business debts and claims, some would be better off forming a corporation. For example, a business that would benefit from a formal separation of management from financial interests--as is found in the separation of the corporate board of directors from its shareholders, with each group subject to separate legal rules, responsibilities and decision making power--or a business that looks forward to issuing stock incentives to employees or selling its shares to the public should consider incorporating instead of forming an LLC.
Practical Suggestions
Many accountants I work with are still recommending the S corporation for operating a small business which offers a service or sells a product. For people who need an entity for buying, selling or holding real estate or for holding other assets, the LLC may be the best choice. Both entities provide similar limited liability protection. The only difference is that S corporations have been around for so many years that there are a lot of legal decisions determining various issues of liability which make them more predictable. LLC’s are relatively new and their treatment by the courts is less predictable.
With respect to taxes, many accountants suggest you can save some money in the area of FICA taxes (the 15.3% Social Security and Medicare Taxes) in an S corporation where the same treatment is generally not available in an LLC. Some accountants suggest using an LLC that elects S corporation tax status. This is certainly a possible way to get the best of both worlds but is a fairly new strategy and not familiar to some accountants or tax practitioners.
To help you decide if an LLC is best for your business, please feel free to call us toll free at 1-888-527-6207.
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