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Limiting Liability
The limited liability company (LLC) is one of the best forms of doing business in the United States. The LLC combines the limited liability of a corporation with the pass-through taxation of a partnership. LLCs are great tools for small operating businesses. While LLC’s don’t provide some of the fringe benefits available with a C-corporation, the flexibility and simplicity of ownership make it the ideal tool for a small company looking for liability protection.
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Ownership
LLCs are made up of members who act in a similar capacity to shareholders in a corporation. Corporations can even be a member or manager of an LLC. This allows greater flexibility than an S-corporation which places restrictions on the number of shareholders and who can be a shareholder. An LLC is considered a separate and distinct legal entity from its members. The members buy interest in the LLC with cash, property, services or the promise of payment. There can be different designations of members based on active decision makers or passive investors. If the LLC is managed by its members than it is considered “member managed”. If the LLC chooses to hire an outside manager or designate the position to a member then the LLC is considered “manager managed”.
Managing Your LLC
How the LLC is going to be managed usually depends on the long-term outlook for the company. If there are only a few active members in the LLC then you might want to have the LLC “member managed”. If you are operating multiple ventures out of one company with active and passive members then you might be better off hiring a professional manager or electing an active member to be the manager to avoid any unnecessary conflict when it comes to decisions made by the LLC. Some people will choose to have a corporation act in the capacity of the manager for the LLC. This allows income to be split between the LLC and the corporation, usually causing a favorable tax outcome.
Tax Treatment
LLCs offer flexibility in the way they are taxed. LLCs can choose to be taxed as a partnership or as a corporation. When an LLC doesn’t make an election the IRS will automatically tax the entity as a partnership, which means all the profits and losses will pass through to the member’s personal income tax return.
Flexibility in Distributions
Another benefit to having an LLC is the flexibility in distributing profits and losses to the members. Distributions of the LLC can be based on the total amount of membership interest each member has, it can be based on the amount of work the members put into the company, or a number of other flexible distribution formulas. For example, if you started a computer programming business with a partner and you contributed all the capital and your partner was the brains behind the programming but didn’t have any money, you might decide to allocate a greater percentage of the distribution to you for a few years until you receive some of your investment back and then reevaluate the situation.
Why You Would Use an LLC
Let’s say you want to buy some rental property but you know how risky it is to have tenants. So you decide to form an LLC and have the LLC buy the property. This prevents you from being held personally liable if the LLC were ever sued. For another example, a small group of family, friends or business associates decide to start a small consultation firm. Instead of forming a partnership which adds risk to everyone involved they decide to form an LLC. This provides limited liability to everyone. In addition some people are buying ownership with cash while others are going to be providing their services. Since you can adjust the distribution in the operating agreement, the people who contribute cash are going to get a higher percentage of distributions than the people who are providing services. Suppose you already own a corporation but you want to buy some property personally that the company might be using in the future. So you form an LLC and have the LLC purchase the property. In a few months the corporation decides it needs that property to expand, so the corporation leases the property from the LLC. This allows you to sell the property in the future without having to pay the additional tax generated by selling a piece of property in a corporation. You can convert a sole proprietorship or a partnership to an LLC. In many cases it’s simply a matter of forming the LLC and transferring assets in exchange for a membership interest which is not a taxable event.