Are You Down With LLC? This hybrid entity combines the best of partnerships and corporations, but is it the right choice for your biz?

Probably the single greatest disadvantage of the corporate formis the burdensome range of formalities that corporate managers mustobserve. A modern corporation's heavy administrative burden isa remnant of the more traditional and formal legal system underwhich corporate law was cultivated. The LLC changed all that.

Limited liability companies (LLCs) have been around since 1977,but their popularity among small-business owners is a relativelyrecent phenomenon. The LLC offers the liability protection benefitsof the corporation without the corporation's burdensomeformalities. This simplicity has made the LLC an instantly popularbusiness form for smaller companies.

LLCs are the favorite choice for small businesses with one tothree owners working who don't plan to grow the businesssignificantly and don't expect to raise significant amounts ofcash. But as the number of owners grows, the corporation oftenbecomes a more attractive choice as a business form.

An LLC is a hybrid entity, bringing together some of the bestfeatures of partnerships and corporations. LLCs were created toprovide business owners with the liability protection thatcorporations enjoy without the double taxation. Earnings and lossespass through to the owners and are included on their personal taxreturns.

Sound similar to an S corporation? It is, except an LLC offerssmall-business owners even more attractions than an S corporation.For example, there is no limitation on the number of shareholdersan 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 fullparticipatory role in the business's operation; in a limitedpartnership, on the other hand, partners are not permitted any sayin the operation.

Unlike corporations (and like partnerships), LLCs do not haveperpetual life. Some state statutes stipulate that the company mustdissolve after 30 or 40 years. Technically, the company dissolveswhen a member dies, quits or retires.

More Pros and Cons

Here are more advantages of the LLC form of businessorganization:

• An LLC allows for an unlimited number of members; however, ifthe LLC has just one owner, it will be taxed as a soleproprietorship.

• The LLC allows for the "special allocation" ofprofits--the disproportionate splitting of member profits andlosses (in different percentages than their respective percentagesof ownership). This means that members can enjoy the benefits ofreceiving profits (and writing off losses) in excess of theirindividual ownership percentage.

• The members enjoy limited liability, which means they arepersonally protected from any liability of the LLC and successfuljudgments, as well as from the LLC itself.

• Managing members' share of bottom-line profit is consideredearned income because the managing member is considered to be anactive owner--therefore qualifying the managing member for special"fringe benefit" treatment.

• The members' share of the bottom-line profit of an LLC isnot considered earned income, and therefore is not subject toself-employment tax.

• Members are compensated using either distributions of profit orguaranteed payments. A distribution of profit allows each member topay themselves by merely writing checks--whenever they need themoney (provided the business has the available cash). Guaranteedpayments represent earned income to the members, thereby qualifyingthem to enjoy the benefits of tax-favored fringe benefits.

• The managing member of an LLC can deduct 100 percent of thehealth insurance premiums he or she pays--up to the extent of theirpro-rata share of the LLC's net profit, because the profit isconsidered earned income. Note: If a member has earned income, heor she will also qualify.

• A corporation can be a member of an LLC. This allows you tocreate an additional level of ownership, which is designed tocreate an entity that can offer such traditional fringe benefits asretirement plans and an additional level of protection fromliability.

• As a member, you can contribute capital or other assets to theLLC, or loan the LLC money to put dollars or value into thebusiness. You can take dollars out by taking a repayment of yourloan (plus interest), a distribution of profit or a guaranteedpayment. If any of the members die, the LLC can continue toexist--subject to the unanimous positive vote on the part of allremaining members.

Some of the disadvantages of an LLC include:

• Each member's pro-rata share of profits represents taxableincome--whether or not a member's share of profits isdistributed to him or her.

• The managing member's share of the bottom-line profit ofthe LLC is considered earned income, and therefore is subject toself-employment tax.

• The members' share of bottom-line profit is not consideredearned income because the members are considered to be inactiveowners; therefore, the members do not qualify for specialtax-favored "fringe benefit" treatment.

• As a member of an LLC, you are not allowed to pay yourselfwages.

• Some states do not allow the organization of LLCs for certainprofessional vocations.
• For companies that wish to pursue venture capital, accumulate alarge number of shareholders, and/or eventually pursue an initialpublic offering, the LLC is not an appropriate alternative to acorporation.

Setting It Up

To set up an LLC, you must file articles of organization withthe secretary of state in the state where you intend to dobusiness. Some states also require you to file an operatingagreement, which is similar to a partnership agreement.

Before deciding upon an LLC, remember to check with your lawyeror accountant about the advantages of the LLC in your particularstate. Ask up front what it would cost to form a corporation versusthe cost of forming an LLC. You may be surprised to learn that insome states an LLC could be established by filing a simple,one-page document, which lays out the Articles of Organization ofyour LLC, with the secretary of state.

You can form an LLC for any lawful business as long as thenature of the business is not banking, insurance, and certainprofessional service operations, such as doctor, lawyers oraccountants. By simply filing articles of organization with therespective state agency, an LLC takes on a separate identity.Similar to a corporation, but without the tax problems of thecorporation, it will be taxed like a partnership.

Also, you'll need two people (members) to meet the staterequirement in many states and to meet the basic federal tax lawrequirements to obtain the flow-through tax provisions that are oneof the advantages of an LLC.

The cost of setting up an LLC is roughly equivalent to settingup a corporation. The secretary of state's fees for filingarticles of organization and for filing annual reports are oftenthe same for both LLCs and corporations. Entrepreneurs who wish toseek help in organizing an LLC through an LLC formation service orthrough an attorney will find the fees to be roughly the same.

Even after you settle on a business structure, remember that thecircumstances that make one type of business organization favorableare always subject to changes in the laws. It makes sense toreassess your form of business from time to time to make sure youare using the one that provides the most benefits.

Outgrowing Your Business Structure

What should the owners of an LLC do if their company grows insize such that an LLC is no longer the appropriate business form?The answer is simple: it is possible to convert an LLC into acorporation. Thus, some small companies begin life as LLCs, outgrowthe LLC form, and then the LLC's owners transfer the assets ofthe LLC to a newly formed corporation with the same owners as theLLC.

As one might imagine, it is also possible to convert acorporation into an LLC, or nearly any business form into anyother. It is also possible to reorganize a business in anotherstate by transferring the assets of a business into a newlychartered entity. Converting business forms does require somesophisticated legal and tax analysis and should not be attemptedwithout the services of a qualified attorney and accountant.

This article was excerpted from the books Start Your OwnBusiness and Entrepreneur Magazine's Ultimate Book onForming Corporations, LLC's, Sole Proprietorships andPartnerships, and the article "Pros and Cons of the LLCModel" by David Meier.