Thinking 'Limited Liability
Company Formation'? Is an LLC for you and how do you form a Limited Liability
Company?
To incorporate or not to incorporate - that is the question
Is the Limited Liability Company the Right
Entity for Your Business? by:
Germaine A Hoston
Should you operate your business as a
corporation? Or is there another, simpler alternative? You've probably noticed
that in the past decade there are more and more businesses with their names
followed by the letters "LLC" instead of "Inc.". "LLC" stands for Limited
Liability Company, is the newest type of legal entity that exists in the United
States, and for many entrepreneurs it is the ideal marriage between the tax
advantages of the limited partnership and the limited liability feature of the
corporation. Now available in all 50 states---even to non-U.S. citizens--most
likely the LLC should have a key place in your business structure.
When it comes to legal entities for conducting business, limited liability
companies are the newest kid on the block in the United States. The state of
Wyoming was the first to pass legislation, in 1977, to establish this new
entity. By 1999 all fifty states in the United States had enacted legislation to
allow the formation of this exciting new legal entity.
But why is the LLC so attractive, so irresistible to legislators? And why have
so many entrepreneurs opted for the LLC instead of a "C" corporation, or even an
"S" corporation? And most important, how do you decide if it's right for you?
Perhaps the most important reason is for the popularity of the LLC that the it
satisfies the demands of both accountants and attorneys. Accountants tend to
prefer the Limited Partnership ("LP") because they are concerned about the
dangers of "double taxation" if their clients use a corporation: If your
corporation pays dividends, the corporation pays taxes on its profits, and its
shareholders pay taxes again on those same profits when they are taxed on the
dividends they receive. By contrast, attorneys usually prefer the greater asset
protection offered by the limited liability that the corporation has to offer to
all its owners.
Let's begin with an understanding of what the limited liability company is.
Basically it is a partnership among its owners, who are called "members". The
LLC is like a limited partnership (and an S-corporation), because it is a
"pass-through entity"--each partner's or member's share of the net gain or loss
for the year "flows through" to the individual tax-payer's 1040 individual tax
return. There is no separate tax to which the LLC itself is subject. On the
other hand, the LLC is also like a corporation, because unlike the limited
partnership--which requires a general partner, who is responsible for all
results of all decisions and actions of the partners--all its owners benefit
from limited liability.
People choose to form LLCs basically for the same reasons that they would elect
to set up an S-corporation or a limited partnership. The LLC, like the
S-corporation, is attractive if you have earned income that puts you in a high
tax bracket, and you would like to be able to offset that income with the losses
that you can normally expect to incur in your first years in a business. When I
formed my first business entity twenty years ago, my husband and I selected the
S-corporation. We both had salary income that placed us in a high tax bracket,
and we knew that our new consulting business would incur significant capital
expenses in the first few years. After all, we would have to purchase new
equipment such as a fax machine, a laser printer, personal computers, and the
replaceable supplies to operate them. We were also aware that it would take some
time to build a clientele, so our income from the business would take a few
years to take off. The S-corporation allowed us to carry the losses we incurred
onto our individual 1040 tax returns. The losses were deducted from our gross
personal salary income, and we paid dramatically lower taxes.
If you can get this advantage from an S-corporation, why would you bother with
an LLC? The LLC has a number of advantages over the S-corporation:
- First, the LLC does not have the limitations
that the S-corporation has on who can be a member of the LLC. Only
individuals, estates, some trusts, and other S-corporations can be members of
an S-corporation. Individuals (shareholders) must be either U.S. citizens or
residents. By contrast, the LLC is not subject to these limitations. Thus, it
is an ideal entity that you can combine with other entities in your business
structure. For example, you can have a corporation or other legal entity be a
member of an LLC.
- The LLC has much greater flexibility for
allocation of rights, profits, and assets than the S-corporation. The
S-corporation can have only one class of stock: In other words each share of
stock has the same rights as every other share. This means that the allocation
of profits and assets is extremely rigid. If Parties A and B are equal
shareholders in a corporation, and the corporation decides to distribute its
profits of $10,000, then A and B must each receive $5,000. This might not
necessarily be equitable if one partner was much more active and produced a
much greater share of the profits than the other. The LLC allows for A to
receive, say, $8,000 if its business activities generated 80% of the profit,
leaving B with the remaining 20%, or $2,000. This can be very attractive in a
partnership in which there is a significant difference in the amount of
capital and ongoing business activity that the partners are contributing to
the business.
- The LLC is not subject to the same corporate
formalities that are required of the S or C corporation. While the LLC must
still maintain appropriate LLC records and bookkeeping, it is not required to
be managed by a board of directors and maintain minutes of regular board of
directors meetings.
- Unlike the S-corporation, liquidation of an
LLC is generally not a taxable event. As your personal and business financial
situation change over time, you may determine that it is no longer in your
interest to maintain a "pass through" entity for your business. Once your
business begins to turn a regular profit after the relatively high costs of
the first year or two, you may decide that a C-corporation that is taxed at a
maximum of 25% (unless it is a personal service corporation) would be more
advantageous to you. If you have been operating as an S-corporation and you
liquidate it by selling the liquidated assets to the shareholder(s) at their
fair market value, the liquidation will be a taxable event. This does not
apply to the LLC. This is one of the factors that makes the LLC particularly
attractive for holding real estate.
- The concept of the charging order makes the
LLC especially effective for asset protection. This makes it a particularly
attractive entity for holding real estate. The corporation should not be used
to hold real estate, because if the corporation is sued, the court might award
shares in the corporation in the judgment. Control of the corporation
translates into control of the property, and you effectively lose control over
your real estate holdings. By contrast, the charging order, used with Limited
Liability Companies as with Limited Partnerships, gives the plaintiff only the
right to receive income distributions from the interest of the party or
parties against whom the suit was brought. The charging order grants no voting
rights or management powers. Thus, the existing managers or members could vote
simply not to distribute income, thus leaving the plaintiff with no recourse;
yet the plaintiff will have to pay taxes on the income allocated to her, even
though the funds were not distributed(!). This offers a strong incentive for
the plaintiff to negotiate for a settlement.
Clearly, the LLC is a powerful tool for
protecting your assets against financial predators. If you use it for real
estate holdings, you can maximize this protection by holding each piece of real
estate in a separate LLC. Thus, if one LLC comes under attack from financial
predators, the operations affecting only a single property will be affected.
Disadvantages of the Limited Liability Company
Needless to say, there are some disadvantages with the LLC--otherwise there
would not be remain so many other attractive options for structuring your
business. Why might the LLC not be the best option for you?
- Increased taxes for LLC members in high tax
brackets. Once your LLC is making a profit, its income passes through the
individual members, who are taxed directly on that income, whether it is
actually taken out of the LLC or not. Thus, members who are in a high tax
bracket might pay higher taxes than they would if they used a C-corporation,
which is subject to lower marginal tax rates. Proper planning of disbursements
for expenses and other aspects of the business could overcome this
disadvantage.
- Higher initial filing fees for LLCs in some
states. Some states may levy heavier tax obligations on LLCs in their initial
years. Our home state of California requires that an LLC pay a minimum $800
tax in its first year, while corporations are exempt in their first
year--whether the business has any earnings or not! It can still be worthwhile
for you to start an LLC: If you have high start up costs, tax savings in the
thousands of dollars will outweigh these higher filing fees.
- Unlike corporations, LLCs do not have
continuity of life, that is they are limited usually to a specific period of
time (say, 50 years) depending on the state.
If an LLC member dies, the remaining members may vote to continue the LLC
business. LLC interests can be gifted to other family members; and the LLC can
have a trust or family limited partnership as a member, thus providing for
effective estate planning.
- The LLC is a relatively untested entity.
There is the large body of case law on corporations but on LLCs. We may also
expect to see changes in the laws governing LLCs as the implications of this
new entity become more apparent to legislators.
Space does not permit coverage of all the
advantages and disadvantages of LLCs, but clearly the LLC can be a powerful tool
for operating your business, protecting your assets, and planning your estate.
It is easy and inexpensive to set up on your own, if you use one or more of the
items on our
Wealth
Structuring Resources page.
Copyright 2006 Azur Pacific Associates
About the author
Germaine A. Hoston, Ph.D. is President
and Treasurer of Azur Pacific Associates, a consulting and translation firm
and distributor of the Secret Millionaire Asset Security System and Eventis
wealth-building courses. Get a free gift when you sign up for her free
wealth structuring eNewsletter for Women Entrepreneurs at:
http://www.womenswealthlive.com.
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