Limited Liability Companies
A limited liability company (LLC) is a hybrid entity that
combines the tax flow-through aspects of a partnership with the
liability protection of a corporation or a limited partnership.
However, unlike limited partners in a limited partnership, who
lose their limited liability status if they attempt to manage
the business, a member of an LLC is not prohibited from managing
Although the limited liability company form
generally results in limited liability for its
members, lenders usually require some or all
members of a limited liability company to
personally guarantee corporate loans.
The LLC is a relatively new type of entity that has only
recently become available in all 50 states. Since it is so new,
the laws among the various states differ somewhat in their
treatment of an LLC. As a result, transactions outside the state
of formation by the LLC may be treated differently from
transactions within the state of formation.
Prior to 1997, an LLC was treated as either a partnership or
an association taxable as a corporation for federal tax purposes
depending on whether the LLC possessed more than two of the four
corporate characteristics that generally pertain to
corporations. The four corporate characteristics are: continuity
of life, centralization
of management, limited
liability, and free
transferability of interests. If the LLC had more than two
of the corporate characteristics, it would be treated as an
association taxable as a corporation. Consequently, most LLCs
formed before 1997 wrote their operating agreements to avoid at
least two of the corporate characteristics.
Beginning in 1997, federal regulations assume that a new
unincorporated business with more than one owner is treated as a
partnership, regardless of how many corporate characteristics it
has. Businesses can elect to be treated as a corporation by
filing Form 8832, Entity Classification Election. Older
LLCs will be presumed to continue the federal tax status they
had on January 1, 1997.
Forming an LLC. To form an LLC, articles of
organization must be filed with the secretary of state's office.
Some jurisdictions also require that an operating agreement be
filed in addition to the articles of organization. The articles
of organization contain information about the LLC, such as its
name, address, purpose, who organized it, who the registered
agent is, etc. The operating agreement is similar to a
partnership agreement. Its purpose is to guide the conduct of
the business. If the operating agreement is not required to be
filed with the articles of organization, it can generally be in
written or oral form. As a precautionary measure, the operating
agreement should be written to limit future conflicts.
Advantages of a limited liability company:
- Limited liability. Members are shielded from being
personally liable for acts of the LLC and its members.
- Flexible membership. Members can be individuals,
partnerships, trusts, or corporations, and there is no limit
on the number of members.
- Management. Members can manage the LLC or elect a
management group to do so.
- Flow-through treatment. Income, losses, deductions,
and tax credits flow through the LLC to the individual
Disadvantages of a limited liability company:
- One member LLCs. Many jurisdictions do not allow
LLCs to have only one member, although the number of
jurisdictions that do allow them is growing. Under federal
law, a single-member LLC is treated as a sole
- Free transferability of interest. In older LLCs,
transferability of interests was usually restricted to
enable the LLC to be treated as a partnership.
- Nontraditional entity. An LLC is a new entity type
for which there is little precedent available.
- Cost. An LLC usually costs more to form and
maintain than a sole proprietorship or a general
partnership. States may also charge an initial formation fee
and an annual fee; check with your state's secretary of
Limited liability partnerships. Limited liability
partnerships are similar to limited liability companies in terms
of the tax advantages, but they differ in that limited liability
partnerships are normally available only to select professions,
such as doctors or lawyers. They're also recognized in fewer
states than are limited liability companies, with only about 40
states now recognizing them. For more information on LLPs, see limited
Tax issues. An LLC is generally treated as a
partnership for federal
tax purposes. Since the individual members are treated as
partners, they may be subject to self-employment taxes. If the
business hires employees, a Federal Employer Identification
Number will need to be obtained and payroll
taxes will have to be paid. The Federal Employer
Identification Number can be obtained by filing a Form SS-4, Application
for Employer Identification Number.
Among the Business Tools is Form
SS-4. It is in Adobe Acrobat .pdf format,
and you will need Acrobat Reader 4.0 to view the
file and print it. A free version of Acrobat 4.0
is available in the Business Tools area as well.