LLC - Limited Liability Company
A limited liability company, or LLC, is a form of business organization that allows for limited liability for the owner(s). It allows for an unlimited number of members and gives them the liability shield that they might not have otherwise enjoyed had they formed as a simple partnership, but all the while maintaining most of the taxation benefits afforded by a partnership.
Because of these dual benefits, the shareholders, or “Members” as they are known if part of an LLC, basically enjoy the same types of limited liability protection that a corporation offers, with very few exceptions, and at the same time, also enjoy certain tax advantages, including, but not limited to, pass-through taxation and partnership treatment by the IRS. These advantages make LLC’s very desirable for certain business dealings and ventures.
After limiting individual member liability and thus providing for the protection of member assets, the advantage of “pass through taxation” can be one of the key benefits offered by an LLC. The profits or losses of the business, whether or not there is an actual distribution, pass directly through to the Member's personal income tax return (IRS Form 1040) and by-pass the typical “business profit” tax at the company level. The LLC files a Form 1065, then lists each member's taxable profit on IRS Form K-1. This pass through taxation is one of the hallmarks of the tax advantages available to an LLC. Because of this tax treatment, the LLC is not subject to the double taxation pitfall that befalls standard corporations (where income is taxed at the corporate or company level as profit, then again at the individual shareholder level as earned income). The net profit of the LLC is not considered to be income earned by the Members, though portions distributed to the Managing Member (if the LLC is thusly structured) can be treated as such via the “fringe benefit” treatment called for by the IRS.
Advantages of the LLC form of business organization
- An LLC allows members, like shareholders in a corporation, to enjoy limited liability. The LLC is a separate, legal entity and thus its assets are considered separate and apart from Member’s assets save for the amount invested by the member in the LLC.
- An LLC, if properly organized, enjoys the advantage of pass-through taxation, whereby business profit is treated as having “passed through” the entity and onto the individual members, via the 1065 form filed by the LLC, and thus avoiding tax a the corporate level, and again at the member level (“double taxation”).
- Corporations are allowed as members of an LLC. This further level of tiered ownership increases the limited liability aspect of an LLC, and makes for greater features and benefit options for the owner.
- Less strict organizational rules and an absence of the “corporate formalities.” Depending on how it is structured, an LLC can be completely driven (managed) by the operating agreement, with no special need for annual meetings or special notations or record keeping.
- Unlike an S Corporation, there is no limit to the number of members allowed by an LLC.
Some of the minor disadvantages of an LLC might be
- Because of the pass-through profit designation via the 1065 form, all income “distributed” to the individual members’ K1s is treated as member income, irrespective of any actual distributions. This highlights a situation potentially controlled by the managing member, and is one of the “powers” that may need to be addressed via the operating agreement.
- When a corporation is a member of an LLC, the owner of the corporation can be subject to taxation from the LLC's income.
The process of forming an LLC is very similar to that of incorporating, with the notable exception that the documents filed with the state are known as the Articles of Organization and the company owners are known as LLC members (versus “shareholders”). The rules are a bit different state by state, of course, but the formation is basically the same.
The formation begins with the filing of the appropriate documents with the appropriate state agency. Once your LLC is filed, you should create and then adopt an operating agreement (we provide assistance with this--Companies Incorporated delivers a comprehensive LLC operating agreement with each formation package) that is used to govern your company. The operating agreement is a legal document wherein the management type, ownership and interest, allocation of power and many other forms of company operations are described in legal detail. The operating agreement is not generally filed or recorded with any state or federal office, but it is a best practices, due-diligence requirement for any well-organized LLC. Most states accept single member LLC's, though some specify at least two members. Please note that there can be tax consequences associated with a single member LLC, and thus it may be more prudent to form as a corporation instead in some instances. That is definitely an option that should be considered.
Some LLC’s are managed by its members, or in the alternative, you may elect to assign managers to the LLC, similar in nature to corporate officers. When an LLC is run by managers, their power and control should be, and most often times is, managed explicitly by provisions outlined in the operating agreement. Other important things that should be properly and thoroughly outlined in the operating agreement include voting rights, distribution of interest, distribution of profits, etc. The management structure can be arranged so that the manager has 100% control and little to no ownership. This may be an ideal arrangement to maximize asset protection.
There are other benefits to forming as an LLC rather than a corporation. For example, while a an S corporation may allow for many of the same liability protections and asset distribution benefits of an LLC, it is limited to between 75 and 100 shareholders, and none of these shareholders can be in the form of a Corporation or IRA’s (in direct contrast to an LLC which does permit corporations as member). These rules limit the subchapter “S” option to smaller organizations or forcing the buyback or buyout of stockholders for those organizations wishing to convert to an S corporation. Additionally, there are ventures of limited duration, such as movie production, or the collaboration on a limited real estate venture, where the perpetuity of a corporation is neither necessary, nor prudent, and where the ability to outline a duration or “end” of an LLC agreement makes the most business sense.