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ENTREPRENEUR RESOURCE CENTER
Business Legal Structure: Limited Liability Corporation
In most states, almost any type of business may form a Limited Liability Corporation, or LLC. These are businesses formed to engage in banking or insurance, businesses comprised of licensed professionals, such as doctors, lawyers or accountants. Also, you will need two people (members) to meet the state requirement in many states and to meet the basic federal tax law requirements to obtain the flow-through tax provisions that are one of the advantages of an LLC.
There are four main advantages of an LLC:
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Personal protection from business debts and claims (limited liability). Your only risk is capital paid into the business. Business debts and other liabilities can not be squeezed out of your personal assets. Caution: If you personally guarantee a debt, you have forfeited your limited liability. |
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Flow-through tax advantages of a partnership — that is, profits or losses that flow through directly to the members. Profits and losses are reported and taxed on the 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 (Form 1065). And there is no corporate double taxation, in which both the business and the shareholders are taxed. |
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Flexible Management. Simplicity of operation without the statutory necessity to keep minutes, hold meetings or create resolutions as with a corporation. A member (shareholder equivalent) can be a person, partnership or corporation. Members get a percentage of ownership. If your idea people can not manage their way out of a paper bag, you can hire management help. Smaller LLCs are usually member-managed, but not always. |
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Flexible distribution of profits and losses. Profits and losses do not have to be distributed in proportion to the money each person puts in. A regular C-corporation can not allocate profits and losses. In a subchapter S-corporation (taxed as a partnership), profits and losses are in proportion to shares held. |
The disadvantages of an LLC:
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No Stocks. LLCs are tough if you have several investors or raise public money, since you do not have shares or stock certificates to offer. If you give a percentage of ownership to outside investors, you must decide whether they are managing members. |
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Number of members in LLC. LLCs in most states require only one member. However, in some states, including Massachusetts and the District of Columbia, you must have two members, and that could be a deal-buster. There is also a restriction in transfer of ownership associated LLC. |
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Fewer incentives. LLCs are not ideal if you want to give fringe benefits to yourself or employees. Unlike with a C-corporation, you can not deduct the cost of benefits with an LLC. Since there is no stock, you can not use stock options as incentives for your employees. |
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Paperwork. LLCs file articles of organization with the State Corporation Commission or Secretary of State and draft an operating agreement listing members' rights and responsibilities. Some, like an application for employer ID number (IRS Form SS-4 - ftp.fedworld.gov/pub/irs-pdf/fss4.pdf) and choice of tax status (IRS Form 8832 - ftp.fedworld.gov/pub/irs-pdf/f8832.pdf), are one-shot; others (annual report, quarterly withholding and tax deposit coupons, and business bank account) are ongoing. While it is not an impossible burden, there's more paperwork than if you are a sole proprietor. Different states may also need different requirements, which makes it difficult to do an expansion outside the original state. |
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Number of 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 are caught in the self-employment tax net if:
- you participate in the business for more than 500 hours during the LLC tax year.
- you work in a professional services LLC (health, law, engineering).
- if you can sign contracts on behalf of the LLC.
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Forming an LLC is similar to forming a corporation. Members file articles of organization with the secretary of state in their state capital and, in some states, a newspaper notice. Additionally, LLCs should create a written operating agreement that spells out the rights and responsibilities of LLC members and/or managers.
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