Limited liability company
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 not 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. Any profits or losses pass on directly through to the individual members and they are reported on the individual members tax returns.
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. As you can see, the LLC is a hybrid of a corporation and a partnership.
Another advantage of the LLC is no double taxation[1]. 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.
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.
Taxation Issues for the LLC
Like a sole proprietorship or partnership, an LLC enjoys pass-through taxation. This means that owners (also known as "members") report their share of profits or losses in the company on their individual tax returns. The Internal Revenue Service (IRS) does not assess taxes on the company itself. This avoids the "double taxation" that general, or "C," corporations experience, where profits are taxed once at the corporate level and dividends are taxed again at the shareholder level.
LLCs can offer an additional tax advantage over a corporation because the allocation of earnings among owners is flexible. Profits and losses in an LLC do not necessarily need to be distributed in proportion to ownership. The owners of an LLC can agree to allocate the company's profits and losses among themselves however they see fit and not necessarily based on the percentage of the company each owner controls. Single-Owner LLCs - Unless the owner of the company specifically elects to do otherwise, the IRS will automatically classify a single-owner LLC as a sole proprietor. The owner of the LLC reports the company's profits or losses on Schedule C of their personal tax return (usually Form 1040).
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
Partnerships are governed both by common law concepts and by statutory law. 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.
Management and control responsibilities will be divided among the partners. The rights of partners in a partnership relate to the following areas:
- management
- interest in the partnership
- compensation
- inspection of books
- accounting
- property
Events that will dissolve the partnership are the retirement, death, or incapacity of any partner.
The duties and liabilities of partners that we examine here are basically derived from agency law. 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. One disadvantage of the partnership is that partners are personally liable for the debts of the partnership. The liability is essentially unlimited because the acts of one partner in the ordinary course of business subject the other partners to personal liability.
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.
When does a 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.
Single Member Limited Liability Company (SMLLC)
Although most states, except DC 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 an 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.
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
[1]http://www.wisegeek.com/what-is-double-taxation.htm
Links
http://www.llcweb.com/index.html
http://www.morebusiness.com/getting_started/incorporating/d934832501.brc
http://www.nolo.com/resource.cfm/catID/BAAE1B67-F54A-41B4-91943A51F56C3F79/111/182/245/
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