When someone starts a business, one of the important decisions that he must make is to determine what type of business organization it will be. The three main choices have been, until recently, sole proprietorship, partnership, and corporation. This decision is crucial in terms of the tax consequences, the authority given to individuals associated with the company, and potential liability (that is, the financial responsibility) for each person connected with the business.

In 1977 Wyoming was the first state to enact a law authorizing a new type of business organization, the limited-liability company (LLC). By 1997, all 50 states had passed legislation authorizing the establishment of limited-liability companies, although each state's laws differ slightly from one another.

There are some restrictions on the types of business that you can set up as a limited-liability company. For example, in Wyoming and Florida, a bank cannot be organized as an LLC; also, in Wyoming an insurance company cannot be an LLC.

Limited-liability companies share some of the advantages of both corporations and partnerships without the disadvantages of these two traditional forms of business.

Corporations

One of the advantages of a corporation is that stockholders and officers in the business are not personally responsible for its debts. The law recognizes the corporation as a separate legal entity and any claims that are made against the corporation can only be paid from corporate assets. Furthermore, a stockholder can sell his interest in the company without first getting the approval of other stockholders. Another major advantage is that a corporation can continue indefinitely even when investors or owners quit, die, or declare bankruptcy.

The rate at which corporations are taxed by the federal government is a major drawback to this type of business, however. The federal tax code requires a corporation to pay taxes on its income before any distribution is made to owners. These individual owners must then pay tax on the income they receive from the corporation. Thus, in essence, corporate income is taxed twice. The maximum tax rate for a corporation is higher than the rate paid by individuals.

Partnerships

Forming a partnership also has its benefits and disadvantages. A partnership is less complicated to set up than a corporation, and this form of business avoids the double taxation to which the higher-taxed corporations are subject.

A major risk inherent in a partnership arrangement, however, is that each partner can be held personally responsible for the debts of the partnership. Another problem is that most state partnership laws provide that when one of the partners dies, quits, or declares bankruptcy, the partnership is then dissolved, jeopardizing the continuity of the business.

Features of LLCs

Although the LLC acts adopted by the states contain different provisions, they do have some common features. Each LLC law establishes that individual members will not be personally liable for debts or other obligations of the company. Like a corporation, an LLC is a separate legal entity that can sue and be sued, and it can own property. An LLC must file its articles of organization with the state's secretary of state and must designate a registered agent who is located within the state. At least two members must initially be involved in forming the LLC (note that a "member" may be either an individual or a corporation).

An LLC cannot be in operation more than 30 years. During that time, however, the death, withdrawal, expulsion, or bankruptcy of one member does not necessarily represent the end of the LLC. If all of the remaining members agree, the LLC can continue. And in Florida and Kansas, the business can continue without the consent of all of the remaining members. If a member wants to sell or transfer his or her interest in an LLC, the other members must agree.

Source: Reader's Digest's Legal Problem Solver: A Quick-and-Easy Action Guide to the Law, 1994, updated 1998

Copyright 1999 Reader's Digest