Limited liability companies, often referred to as "LLCs," have been around since 1977, but their popularity among small-business owners is a relatively recent phenomenon.
An LLC is a hybrid entity, bringing together some of the best features of partnerships and corporations. "An LLC is a much better entity for tax purposes than any other entity," says Ralph Anderson, a CPA and small-business tax specialist with accounting firm M. R. Weiser. LLCs were created to provide business owners with the liability protection that corporations enjoy without the double taxation. Earnings and losses pass through to the owners and are included on their personal tax returns.
Sound similar to an S corporation? It is, except an LLC offers small-business owners even more attractions than an S corporation. For example, there's no limitation on the number of shareholders an LLC can have, unlike an S corporation, which has a limit of 75. In addition, any member or owner of the LLC is allowed a full participatory role in the business's operation; in a limited partnership, on the other hand, limited partners aren't permitted any say in the operation. To set up an LLC, you must file articles of organization with the secretary of state in the state where you intend to do business. Some states also require you to file an operating agreement, which is similar to a partnership agreement.
Like partnerships, LLCs do not have perpetual life. Some state statutes stipulate that the company must dissolve after 30 or 40 years. Technically, the company dissolves when a member dies, quits or retires.
Despite the attractions, LLCs also have their disadvantages. Since an LLC is relatively new, its tax treatment varies by state. If you plan to operate in several states, you must determine how a state will treat an LLC formed in another state. If you decide on an LLC structure, be sure to use the services of an experienced accountant who is familiar with the various rules and regulations of LLCs.
Even after you settle on a business structure, remember that the circumstances that make one type of business organization favorable are always subject to changes in the laws. It makes sense to reassess your form of business from time to time to make sure you're using the one that provides the most benefits.
- Limited liability. Your only risk is capital paid into the business. Business debts and other liabilities can't be squeezed out of your personal assets. Caution: If you personally guarantee a debt, you've forfeited your "limited liability."
- Tax simplicity. Profits and losses are reported and taxed on owners' individual returns. There's no separate business tax return, unless you have more than one member and choose to be taxed as a partnership, in which case you file Form 1065. And there's no corporate "double taxation," in which both the business and the shareholders are taxed.
- Flexible management. A "member" (shareholder equivalent) can be a person, partnership or corporation. Members get a percentage of ownership. If your idea people can't manage their way out of a paper bag, you can hire management help. Smaller LLCs are usually member-managed, but not always.
- Flexible distribution. Profits and losses don't have to be distributed in proportion to the money each person puts in. A regular C corporation can't allocate profits and losses. And in a subchapter S corporation (taxed as a partnership), profits and losses are in proportion to shares held.
And now for the downsides:
- No stock. LLCs are tough if you have several investors or raise public money, since you don't have shares or stock certificates to offer. If you give a percentage of ownership to outside investors, you must decide whether they'll be managing members. Seidel cautions entrepreneurs: "Ask yourself if you need more flexibility in terms of corporate stock ownership, financing options, etc. If so, the LLC is probably not a good idea-try a C corporation."
- Two's a crowd. LLCs in most states require only one member: you. But if you live in Massachusetts or the District of Columbia, you must have two members, and that could be a deal-buster.
- Fewer incentives. LLCs aren't ideal if you want to give fringe benefits to yourself or employees. Unlike with a C corporation, you can't deduct the cost of benefits with an LLC. And since there's no stock, you can't use stock options as incentives for your employees.
- Paperwork. LLCs file articles of organization with the State Corporation Commission or Secretary of State and must draft an operating agreement listing members' rights and responsibilities. Some paperwork that must be filed, like an application for employer ID number (IRS Form SS-4) and choice of tax status (IRS Form 8832), are one-shot; others (annual report, quarterly withholding and tax deposit coupons, and business bank account) are ongoing. While it's not an impossible burden, there's more paperwork than if you're a sole proprietor.
- Taxes. LLC members pay self-employment taxes, the Medicare/Social Security tax paid by entrepreneurs; it's calculated on 15.3 percent of profits. Contrast this with an S corporation: Self-employment tax is due on salary only, not your entire profits. You're caught in the self-employment tax net if: 1) you participate in the business for more than 500 hours during the LLC tax year; 2) you work in a professional services LLC (health, law, engineering); or 3) you can sign contracts on behalf of the LLC.
Ultimately, the LLC decision is one you won't want to make alone. "Get advice from a specialist about the ideal corporate form to take," advises Seidel. "It can make a huge difference later on." In business, as in life, one size rarely fits all.