Limited Liability Company

Definition: A form of business organization with the liability-shield advantages of a corporation and the flexibility and tax pass-through advantages of a partnership

Many states allow a business form called the limited liability company (LLC). The LLC arose from business owners' desire to adopt a business structure permitting them to operate like a traditional partnership. Their goal was to distribute income to the partners (who reported it on their individual income tax returns) but also to protect themselves from personal liability for the business's debts, as with the corporate business form. In general, unless the business owner establishes a separate corporation, the owner and partners (if any) assume complete liability for all debts of the business. Under the LLC rules, however, an individual isn't responsible for the firm's debt, provided he or she didn't secure them personally, as with a second mortgage, a personal credit card or by putting personal assets on the line.

The LLC offers a number of advantages over subchapter S corporations. For example, while S corporations can issue only one class of the company stock, LLCs can offer several different classes with different rights. In addition, S corporations are limited to a maximum of 75 individual shareholders (who must be U.S. residents), whereas an unlimited number of individuals, corporations, and partnerships may participate in an LLC.

The LLC also carries significant tax advantages over the limited partnership. For instance, unless the partner in a limited partnership assumes an active role, his or her losses are considered passive losses and cannot be used as tax deductions to offset active income. But if the partner takes an active role in the firm's management, he or she becomes liable for the firm's debt. It's a catch-22 situation. The owners of an LLC, on the other hand, do not assume liability for the business' debt, and any losses the LLC incurs can be used as tax deductions against active income.

However, in exchange for these two considerable benefits, the owners of LLCs must meet the "transferability restriction test," which means the ownership interests in the LLC are not transferable without restriction. This restriction makes the LLC structure unworkable for major corporations. For corporations to attract large sums of capital, their corporate stock must be easily transferable in the stock exchanges. However, this restriction isn't as problematic for smaller companies, where stock ownership transfers take place relatively infrequently.

Since the LLC is a relatively new legal form for businesses, federal and state governments are still looking at ways to tighten regulations concerning them. Unfortunately, some investment promoters use LLCs to evade securities laws. That's why it's imperative to consult with your attorney and CPA before deciding which corporate structure makes sense for your business.

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