If you are in business as a sole proprietorship, and looking to change the face of your company to limit your personal liability without the tax ramifications of a corporation, you should consider forming a limited liability company, or LLc. Why an LLc instead of a limited partnership, an S corporation, or a traditional corporation? LLcs have become popular with consultants in a variety of businesses, from real estate brokerages and investment companies to the single person operating a computer repair shop, because this form of business entity offers the owner the best of both worlds, combining features of both a corporation and of a limited partnership.
The Limited Liability Company is a relatively new form of business ownership, created to provide greater flexibility than found under S corporation provisions, giving business owners who have put there personal assets into a company protection from personal liability similar to a corporation; and granting the owner management flexibility not found in any form of corporation but common in limited partnerships.
The ability to form a limited liability company has been created by state law in every state. These state statutes vary somewhat from state to state, but are fairly uniform. LLcs are treated as partnerships by federal tax code, meaning a direct pass-through of profits or losses for from the business for tax purposes. This removes your business venture from receiving a one-two tax punch, first on corporate profits, then on your personal income derived from the company. When you form a limited liability company under the laws of your state, you need to file a Form 1065 with the Internal Revenue Service, “U.S. Partnership Return of Income.”
What forming a LLc does is remove your personal assets from financial risk for any debts incurred by the LLc, as long as you do not sign a personal guarantee of the debt, but instead only pledge the assets of the LLc as security. You still receive the tax write-off the cost of the debt, passing through the LLc. This is similar to owning shares in a corporation, in which the only asset at risk is what you have paid for the shares. In a sole proprietorship, proving that the expense of the debt was a company expense, and deductible, versus a personal expense, and not deductible, can be troublesome.
An LLc is a hybrid of a limited partnership and an S corporation, with your personal liability limited to that of a corporate officer. In that regard, a LLc and an S corporation are similar. However; with an S corporation, you are required to pass through all income and expenses to the shareholders, and each shareholder must have an equal ownership of the corporation. You are also limited in the number of shareholders in an S corporation to 25 individuals who are all U.S. citizens.
The means of operating an S corporation requires annual meetings of the shareholders, a charter as specified by the state, and restrictive rules on management. With a LLc, the operation of the business is specified in a private agreement between the owners, who can be any sort of entity, corporation, individual, partnership, etc. and there is no restriction on the number or citizenship of the owners. Because the business operation of a limited liability company is governed by the private agreement between the individuals, the principal owner can retain full control of the company’s operations.
With a limited liability company, the company may be allowed to retain a portion of its net income of the LLc for future expansion and growth without penalty. Some states limit the number of investors in an LLc to as few as two, while other states allow multiple investors in the company. Investors in an LLc do not necessarily have equal rights in management decisions – with a limited liability company, the head of the business can retain virtually all say in day-to-day management and long-range business strategy.
If the agreement forming the limited liability company calls for it, a portion of profits may be invested in other business ventures, with the LLc holding ownership. It is not unusual, especially in real estate investment companies, for one LLc to hold ownership of several other limited liability companies, each of the LLc’s the “master” LLc owns holding title to a single property as its only asset.
With any form of corporation, quarterly tax statements must be filed with the Internal Revenue Service, along with estimated tax payments. With an LLc, the owners file personal tax returns, once a year, using the 1040 form, along with either a Schedule C if they are the sole owner, or a 1065 Partnership Return if there are multiple owners. The owners only pay taxes once a year with their personal return.
You also need to analyze where you are in your estate planning when considering whether or not a LLc is your right option. Corporations can exist indefinitely, while some state laws require that a limited liability company have a specified lifetime of a set number of years, or a specific date. at which time the LLc is disbanded. The death of a single owner can trigger the dissolution of the LLc in some states. The complexity of the rules that govern limited liability companies varies from state to state, and as yet there is little case law on how they are to be interpreted.
As with any complex legal transaction, you should seek the advice of an attorney who is familiar and competent with the laws governing the formation of the business venture. You may want to form your LLc under the laws of a different state from the one in which you reside, since that state’s laws may have more favorable terms than where you live; however, you could also create additional taxation risk by doing so. But you can clearly see that it is in your personal interest to consider an LLc for your small business or sole proprietorship, over either a partnership, corporation or a limited partnership.
