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HOW TO INCORPORATE

Limited-Liability Companies: How Do They Work?
 

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For many years, many small-business people have been torn between operating as a sole proprietor (or if several people are involved, a partnership) or incorporating. On the one hand, many owners were attracted to the tax reporting simplicity of being a sole proprietor or partner. On the other, they desired the personal-liability protection offered by incorporation. Traditionally, it was possible to achieve these dual goals only by forming a corporation at the state level and then complying with a number of technical rules to gain S-corp status from the IRS. Then a few years ago a new legal entity, the limited liability company (LLC) was introduced. LLCs, which are recognized by all states, can have many of the most popular attributes of partnerships (pass-through tax status) and corporations (limited personal liability for the owners). As of October 1998, in California, the District of Columbia, Massachusetts, New Jersey and Tennessee, an LLC must have at least two owners, meaning they are not suitable for sole proprietors except where a spouse is included as a co-owner. You can establish an LLC by filing a document called Articles of Organization with your state's corporate filing office (often the Secretary of State or Commissioner of Corporations).

Here are the main features of the LLC, which make it so attractive to many small business owners:

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  • Limited liability. Until the LLC came along, business owners were personally on the hook for all the business debts, including liability from most lawsuits, unless they incorporated. But LLC owners are not personally liable for business debts such as court judgments or legal settlements obtained against the business. They risk losing only the amount they paid into the business to get it started. (If however, you personally co-sign a loan, you are personally liable, no matter how the business is set up.)
  • Flexible management. The owners of an LLC are called members. Small LLCs are normally member-managed--after all, most small-business owners want and need to have an active hand in running the business. Members can, however, elect a management group, which may include nonmembers. This flexibility can't be found in a standard corporation, where owners must split up decisions among directors and shareholders. Even if the same people fill all positions, corporate rules require the owners to don both director and shareholder hats when approving major decisions. A limited partnership is less formalistic, but has its own built-in restrictions: generally, limited partners are not allowed to manage the business without losing their limited liability.
  • One level of taxation. The LLC, like a partnership, is normally recognized by the IRS as a " pass through" tax entity. (You can also elect to have it taxed like a corporation, which for some business owners can result in lower overall taxation; LLCs can even elect S-corporation tax status, but this is a complicated tax strategy that puts LLCs in a quasi-partnership type of tax treatment.) Unless you choose corporate tax treatment, the profits or losses of the LLC are not reported and taxed at a separate business level, as are corporate profits. Instead, they pass through the business and are reflected and taxed on the individual tax returns of the owners. (Sole proprietorships and corporations that have elected Chapter S status with the IRS (S corps) are also pass through entities.)
  • Flexible distribution of profits and losses. When a business is co-owned, the owners may or may not wish to split profits and losses of the business proportionately to capital contributions. Different business forms have different rules about how business profits, losses and assets can or cannot be split up. The corporate form is generally the most rigid, and partnerships the most flexible; S-corporation tax status falls somewhere in between. The LLC is treated like a partnership for tax purposes, and this applies to the division of profits and losses of the LLC.

But LLCs are not for everyone. Although LLCs are probably the best choice for the majority of new business owners who wish to limit their personal liability for business debts and claims, some would be better off forming a corporation. For example, a business that would benefit from a formal separation of management from financial interests--as is found in the separation of the corporate board of directors from its shareholders, with each group subject to separate legal rules, responsibilities and decision making power--or a business that looks forward to issuing stock incentives to employees or selling its shares to the public should consider incorporating instead of forming an LLC.

A few states, including Texas and California, impose annual fees or taxes on LLCs.

Copyright © 1999 Nolo.com, Inc.

Last updated: Oct 21, 1999




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