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SHOULD YOUR SMALL BUSINESS
BE A LIMITED LIABILITY COMPANY?

"To Incorporate... or not to Incorporate...?"
(That WAS the Question)


EXECUTIVE SUMMARY AND INTRODUCTION: Until just a few years ago, the only choices of legal entity for a business were generally: "To incorporate, or not to incorporate." However, in recent years, all 50 states and the District of Columbia have adopted limited liability company (LLC) laws, offering a very attractive new alternative that every small business, including the smallest home-based business, should now consider, since an LLC can provide the liability protection of a corporation but offers the pass-through tax treatment of a partnership or sole proprietorship, under the federal income tax laws and under the tax laws of most states. LLCs can also generally be operated in a less formal manner than a corporation, although separate accounting records and bank accounts must be maintained.

In addition to LLCs, every state has also created a somewhat similar but often even simpler new type of business entity, the limited liability partnership, or LLP, which can provide partners of a general partnership with liability protection by simply electing under state law to be an LLP. Several states now also allow a limited partnership to make an LLP election, becoming a limited liability limited partnership, or LLLP, which operates much like a traditional limited partnership, but offers liability protection to the general partners as well as to the limited partners.

This web page, excerpted from the authoritative books, Starting and Operating a Business in California, Starting and Operating a Business in Texas, and other state editions in our Kindle e-book series, by Michael D. Jenkins, Esq., will guide you through the pros and cons and ground rules for operating your business in the form of an LLC or LLP, including some of the specifics of various state laws dealing with LLCs and LLPs. This web site provides a small sample of the comprehensive tax, legal, and practical business advice found in the Small Business Advisor program and the included "Starting and Operating a Business in ..." e-books, all of which are written for non-lawyers in plain English.


EVERYTHING YOU EVER WANTED TO KNOW (AND PROBABLY MORE) ABOUT LIMITED LIABILITY COMPANIES AND LIMITED LIABILITY PARTNERSHIPS

By: Michael D. Jenkins, Esq., J.D., CPA (Inactive). Mr. Jenkins is a graduate of the Harvard Law School, and has practiced as a tax attorney with the firm of Cooley, Godward, et al, in San Francisco, as a CPA and Tax Supervisor with Peat, Marwick in Los Angeles, and as a tax partner in a large regional CPA firm in the San Francisco Bay Area. From 1980 to 1999, he was the author and principal editor of the million-selling state-specific book series, "Starting and Operating a Business in.... (state)" (which he revised and re-published in 2000 as a single national edition, "Starting and Operating a Business in the U.S.," with a CD-ROM included that contained state chapters for all 50 states and the District of Columbia.)

All of the print versions of those books are now out of print -- However, new, updated versions of these books for most states and D.C. are now published in electronic book format by the author, each of which is updated regularly. Editions for over 30 states and D.C. are available -- see the Kindle ordering page, to order the e-book edition for your state.

In, in 2011, we converted all 51 of the state and D.C. editions to the Kindle format, listing them for sale at the Amazon.com "Kindle Store," such as our Florida edition. However, only 32 editions are still being updated and available for sale, at prices from $5.99 to $9.99, since Amazon.com decided 19 of our books were too "similar." (?? No, we don't understand that logic, either, since the laws in every state that we have researched and explained, with footnotes, vastly differ from state to state.)


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LIMITED LIABILITY COMPANIES -- A RELATIVELY NEW TYPE OF LEGAL ENTITY:

The age-old choice of entity in starting a business has long been a threefold one: sole proprietorship, partnership, or corporation (plus such oddities as the "Massachusetts business trust," an entity which the state of Massachusetts recently did away with). But now, not only do most states allow you to change your partnership into a "limited liability partnership," but there is also a relatively new kind of business entity which has arrived on the scene and finally accepted and "blessed" by the IRS: the "limited liability company."

What, you may wonder, is this LLC entity?

  • Is it a corporation? No, not exactly.
  • Is it a partnership? Yes, sort of.
  • Is it a sole proprietorship? No, not quite. (Though it is sometimes treated as one for tax purposes.)
  • Is it recognized in all states? Yes, since Hawaii's
    law went into effect on April 1, 1997.

BACKGROUND OF LLCs:

Starting with the pioneering state of Wyoming in 1977, and ending with the action of the Hawaii legislature in 1996, every state has, during those twenty years, passed laws creating a new type of legal entity called a "limited liability company" (or LLC). These entities, which resemble (and are usually taxed as) partnerships, offer the advantages of limited liability, like corporations. While it has long been possible for partnerships to offer limited liability to their LIMITED partners, a limited partnership always had to have at least one GENERAL partner, who was fully liable for the debts of the business. That is no longer the case, with LLCs.

The new limited liability company entities have, in effect, done away with the need to have unlimited liability for ANY of the owners of what is, in essence, a partnership form of business organization.


LIMITED LIABILITY PARTNERSHIPS:

In addition, all 50 states and D.C. have now adopted a similar type of entity, the limited liability partnership (LLP) or registered limited liability partnership (RLLP). The LLP (or an RLLP) is simply a garden variety partnership that registers with the state and pays a specified fee, in order to become an LLP or RLLP and to have limited liability conferred upon the partnership, which is generally quite similar to an LLC, except that it may be operated like a regular partnership, for the most part.

However, LLPs are mostly used for professional firms, and in some states (New York and California and, until recently, Nevada) only professional firms may set up LLPs. For those professionals, the LLP offers only somewhat limited protection from liability, in that a professional who is a partner in an LLP remains personally liable for his or her own malpractice or gross negligence, or such misdeeds committed by employees of the LLP who operate under that partner's direction. (The same is generally true of professional corporations or professional LLCs.) But in most states, other, non-professional businesses may also operate as LLPs, and generally obtain more liability protection than professional LLPs. For more on limited liability partnerships, see our LLP BASICS WEB PAGE.


I.R.S. CHECK-THE-BOX-REGULATIONS OPENED THE DOOR WIDE FOR LIMITED LIABILITY COMPANIES:

It was not until 1988 that the Internal Revenue Service finally ruled that LLCs created under the LLC law of Wyoming could qualify for tax treatment as a partnership, rather than as a corporation, even though they offered limited liability protection to the owners, much like a corporation. However, the IRS initially laid down a strict set of highly technical rules that LLCs had to follow, if they were to avoid being subject to corporate income taxes, such as requiring LLCs to have a limited term of existence, such as 20 years.

This tended to discourage the use of LLCs by all but the most adventuresome businesses, for a number of years. Because of the complex tax requirements of the IRS rules, many lawyers, other than a few tax lawyers, were reluctant to attempt to set up LLCs for their small business clients. In addition, the IRS took the position that a one-owner LLC would be taxed as a corporation in all instances.

However, in 1997, the IRS opened the floodgates when it issued a new set of regulations that basically allowed any LLC to choose whether it wished to be taxed as a partnership or a corporation, simply by filing an IRS form and "checking the box" as to what kind of taxable entity it wanted to be. The new "check-the-box" tax regulations also allowed one-owner LLCs, for the first time, to escape corporate tax treatment and instead could be ignored as separate taxable entities for tax purposes, the same as a sole proprietorship.

The tax regulations provide that any newly formed "eligible entity" (which excludes corporations and, in most cases, banks) will be treated by default as a partnership, unless the owners or members of the eligible entity elect corporate tax treatment, by filing Form 8832. A noncorporate entity with only one owner, such as a one-person LLC, will be treated as not being an entity that is separate from its owner -- that is, its existence will be ignored -- unless the owner elects corporate tax treatment. Thus, a sole proprietorship that becomes an LLC will continue to be treated as a sole proprietorship (for most purposes) by the IRS, and an LLC set up by a corporation will be treated as just another branch or division of the corporation, and not treated as a separate legal entity.

The IRS will also continue to honor the noncorporate tax status of any entity that was reporting as a noncorporate entity (such as an LLC reporting as a partnership) before 1997, generally.

An existing eligible entity, if previously treated as a corporation before 1997, is now able to elect noncorporate status by simply filing Form 8832 with the appropriate IRS service center, specifying the date the election is to become effective, provided the date is not more than 75 days after, or 12 months prior to, the date of filing. If no date is specified on the form, the election becomes effective on the date filed. A copy of this form must be attached to the tax return of the person or entity filing the form for the first year in which the election is in effect.

WARNING:
Such a change from corporate to noncorporate status would be the equivalent of a corporate liquidation, with potential capital gains or other taxable income resulting at both the corporate and owner level at the time of such changeover. Don't make such a change without first consulting a competent tax advisor, as the tax consequences can be very severe in certain situations!

This new set of IRS regulations was a truly revolutionary change in the very old and long-established ground rules for choosing a legal entity.

Under the "check-the-box" regulations, there is very little reason for any business with more than one owner to operate in "naked" form, without limited liability, as a partnership. Also, since the 1997 "check-the-box" IRS regulations went into effect, the states which still required an LLC to have at least two members have all since amended their LLC laws to permit formation of one-member LLCs.

(You may disregard statements in both major professional all-state tax services that say that Massachusetts still requires an LLC to have more than one member. That requirement ended on January 1, 2003, and in 2008 tax legislation Massachusetts made it clear that it will follow the federal classification of legal entities, including "disregarded entities" -- i.e. single-member LLCs. The major publishers' state tax publications are still badly out of date in this regard in 2013.)


THE INS AND OUTS OF OPERATING YOUR BUSINESS AS AN LLC:

Now that all of the states allow one-member LLCs, it makes good business sense for almost any sole proprietor to become an LLC, since the IRS will ignore the existence of the LLC and continue to treat its income as being earned by a sole proprietorship. In short, you will gain the benefits of limited liability for your sole proprietorship without any increase in your federal tax compliance chores or any changes in your tax liability, except that, starting in 2009, federal tax regulations require all disregarded entities to be employers for purposes of federal payroll taxes. This means that you will need to apply for a separate tax identification number for a single-member LLC if the business has any employees and file payroll tax returns under the name and taxpayer I.D. of the LLC.

In contrast, if you incorporate your business to gain limited liability, you become subject to a whole host of federal and state income and franchise tax burdens, plus much more complicated tax compliance requirements. Of course, there are still situations when certain corporate tax advantages may outweigh such disadvantages. For example, S corporation status is often preferable to an being an LLC for professional firms, since profits not paid out by an S corporation as salary will not be subject to self-employment tax. Furthermore, not all states allow professionals to operate in LLC form, but all states allow professional corporations.

It is also becoming standard practice for any form of business, including sole proprietorships, partnerships or corporations, to create separate LLCs for any new business ventures, such as new stores for a retail chain, so that the failure of such a new store or other venture will not devastate the entire company. This could be accomplished in the past by setting up multiple corporations for each such business segment, but the heavy accounting, legal, and tax return compliance costs of setting up and maintaining multiple corporations has generally made that strategy prohibitively expensive for all but quite large businesses.

Under the new set of ground rules, the main business entity can now set up a series of subsidiary LLCs that create "fire walls" between different segments of the business, but which can be totally ignored for federal tax filing purposes -- the main business will still file one partnership or corporate tax return (or file one Form 1040 with one or more Schedule C's, in the case of an individual owner), combining the results of all the separate "sole proprietorship" LLCs on the single tax return. No multiple tax returns, no horrendously complex consolidated corporate tax returns and intercompany accounting will be required for such arrangements -- a very clean, very simple, and very effective way to reduce your liability exposure to creditors!

However, be aware that it will still be necessary to keep separate accounting records and bank accounts for these LLCs, as each will be a separate legal entity. Otherwise, creditors might be able to "pierce the veil" of limited liability if the LLC's assets are commingled with yours or with assets of another entity, or if you do not otherwise consistently treat the LLC as a separate business entity. Also, most states require some kind of annual report to be filed, along with filing fees, by all LLCs doing business in the state, so that each LLC will require some additional paperwork, besides keeping separate accounting records and bank accounts.

Note, however, that some state laws have recently provided for "series LLCs," which allow you to set up a single LLC and create separate "divisions" (or "series"), each of which is a separate legal entity, in terms of liability exposure, as discussed below.

Some states, such as Tennessee, do subject LLCs to their corporate income taxes, and some states with only a franchise tax (on capital or gross receipts), such as Texas or Wyoming, impose the franchise tax on LLCs as well as on corporations. Others, like New Hampshire and the District of Columbia, impose an income or franchise tax on the taxable income of all businesses, including unincorporated ones. California imposes an "LLC fee" each year on LLCs, based on their gross receipts, if California gross receipts exceed $250,000, plus an $800 minimum franchise tax, which is imposed regardless of size.


NOTE RE SINGLE-MEMBER LLCs:

Not all state tax laws initially conformed to the IRS "check-the-box" regulations, so it was possible that a one-owner LLC could be treated as a corporation under such states' income tax laws, until conforming legislation was enacted. Also, a few states' LLC laws did not recognize, or permit the formation of, single-owner LLCs, at the time the IRS regulations were promulgated.

Now, however, all 50 states and D.C. permit one-owner LLCs, though some states still tax LLCs like corporations.


UPDATE NOTE:
Note that in 2008, the IRS issued several Private Letter Rulings (200816002, 200816003, and 200816004) to the effect that an S corporation will not lose its "S" status if it has a shareholder that is a single-member LLC, provided that the LLC is a "disregarded entity" for tax purposes (meaning that it has not elected corporate tax treatment) and is owned by an individual.

The upshot of these major law changes has not been to make S corporations, sole proprietorships, and general partnerships "endangered species." However, almost every small business is now able to gain some measure of limited liability protection by adopting either LLC or LLP formats, without need of incorporating or paying corporate-level federal income taxes.

While single-member LLCs generally are accorded very favorable and flexible tax treatment, it was not always entirely clear whether an LLC is a "single-member LLC" LLC or not, in a community property state like California, where the "single owner" is a married person, which means the owner's spouse may also have an ownership interest, as community property, in the LLC. Fortunately, the federal Internal Revenue Service has taken a very lenient position in Rev. Proc. 2002-69, stating that the IRS will accept whatever choice the couple make, either to disregard the LLC as an entity (treating it as a "single-member LLC") or to treat it as a partnership between the husband and wife. Presumably, the couple's choice of federal tax treatment will also generally apply for state tax purposes, since most states with income taxes follow the federal tax treatment of LLCs, generally. (The nine community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and, since 1986, Wisconsin.)

However, where the LLC is owned by a husband and wife as joint tenants, or tenants in common, or as tenants by the entirety, it is unclear whether the IRS treatment would be as lenient as for community property owners, since the IRS has not yet issued any published rulings on whether an LLC can be a disregarded entity if held in one of the various forms of tenancy by a married couple, rather than being held as community property. Thus, it is also unclear, where an LLC is owned by a husband and wife as co-tenants, whether a state would treat the LLC as a single-member LLC or as a partnership. (Where a husband and wife directly own a business, a new federal law now allows them to elect to either treat it as a partnership or as a "Qualified Joint Venture" where each reports his / her share of the business earnings on separate Schedule C's on Form 1040.)

Since your lawyer no longer needs to be a rocket scientist or a tax genius to properly set up an LLC that qualifies for noncorporate tax treatment, the legal costs of forming an LLC have come down quite a bit in recent years, due to the explosive growth in the number of businesses or professional practices operating as LLCs. For example, there are several organizations (not law firms), such as Northwest Registered Agent LLC, that will set up an LLC (or corporation) for you in any state for as little as $100. Or, contact this California firm, CenterPoint Corporate Services, which can also set up an LLC for you for less than most law firms charge. (Not all states allow professional LLCs, and California prohibits most businesses that require a state license of any kind from operating as an LLC, so not every kind of business in every state can be operated in the form of an LLC.)

Note that in Rev. Rul. 95-37, the IRS has ruled favorably that an existing partnership may generally be converted, tax-free, to an LLC (if the LLC qualifies for partnership tax treatment). In fact, such a conversion can be done without terminating the partnership's taxable year (the LLC is simply treated as a continuation partnership) and without need to obtain a new Federal Employer Identification Number. In many states, a simpler approach may be to merely register the partnership as an LLP, where state law permits, and where the liability protection that is offered by an LLP is comparable to that of an LLC. (In our state editions of the "Starting and Operating a Business in ... (state)" e-books, we analyze the liability protection offered by the LLP laws in the state. Some states offer much less protection to partners in an LLP than for members of an LLC.)

Be aware that, if an LLC is treated as a partnership, the members may be subject to self-employment tax on their earnings from the partnership. However, proposed IRS 1997 tax regulations (which have never been finally adopted) would have generally treated members of an LLC like limited partners in a limited partnership, so that certain members of an LLC would not be subject to self-employment tax on their distributive share of earnings from the LLC. However, under those proposed, but never adopted, regulations, a member of an LLC that elected to be taxed as a partnership (or a partner in a limited partnership) would be treated as earning self-employment income if any of the three following conditions applied to the member:

  • He or she has personal liability as a partner of the partnership for debts or claims against it (this would generally only apply to a general partner in a limited partnership, not an LLC);
  • The member has authority to contract on the LLC or partnership's behalf under the law of the state in which the LLC or partnership is organized; or
  • The member participates in the entity's trade or business for more than 500 hours during the tax year. [Prop. Regs. Sec. 1.1402(a)-2(h)(2), proposed in 1997 but never adopted or revised since]

Even if a member of an LLC participates more than 500 hours a year in the LLC's business, his or her distributive share of the profits may not be subject to self-employment tax, although any "guaranteed payments" received from the LLC for services would be. Thus, part of a member's income from an LLC could be subject to self-employment tax, while part is not, under the (never finalized) Proposed Regulations.

However, in service partnerships engaged in activities such as legal or medical services, accounting, architecture, engineering, actuarial or consulting services, anyone who provides more than a minimal amount of such services would not qualify for treatment as a "limited partner" for purposes of the above exemption from self-employment tax on his or her income from a limited partnership or LLC.

Unfortunately, the status of the tax law regarding the application of the self-employment tax to members of an LLC is still very much up in the air, since the IRS came under heavy criticism for the Proposed Regulations, which Congress ordered the IRS not to finalize or implement before July, 1, 1998. The IRS has not to this date set forth any new Proposed Regulations or other pronouncements on this controversial subject, and has never implemented the Proposed Regulations.

As a general rule, many tax practitioners today believe that an LLC member is not subject to self-employment tax on his or her income if the member is not a manager of the LLC and that, generally, 10% or less owners of an LLC are not subject to self-employment tax unless they receive a guaranteed payment (like a salary) from the LLC for services rendered, and not just a percentage share of the LLC's profits. However, there is no clear answer to this question at present, and the IRS may not necessarily agree if you treat your share of income from an LLC as exempt from self-employment tax.

One court case in 2000 that considered whether some LLC members could be treated like general partners, despite the fact that all members of an LLC have limited liability, concluded that members who actively participate in the business were similar to general partners, and thus their income or loss from the LLC was not "passive income or loss" under the passive activity tax rules. Steven A. Gregg, et ux. v. United States, 87 AFTR 2d Par. 2001-311, U.S. District Court, District of Oregon (November 29, 2000). The IRS had argued in this case that all the members were similar to limited partners, due to their limited liability, and that their losses were thus "passive losses" that could not be deducted against other income.

While the IRS lost the Gregg case, regarding passive activity tax losses, they might now try to use that court decision to argue that some or all LLC members are also like general partners for purposes of the self-employment tax. In one recent federal District Court case in New Mexico, Riether v. United States, 919 F Supp. 2d 1140 (D. N.M. 2012), members of an LLC had issued themselves W-2s for much of their income, treating themselves as employees of the LLC, and treating the rest of their income (reported on a K-1) as "unearned income," not subject to self-employment tax.

The court held that they were not employees and that ALL of their income from the LLC was subject to self-employment tax. The District Court opinion noted that members of an LLC are not automatically treated as limited partners (who would be exempt from self-employment tax). The District Court rendered a summary judgment in favor of the IRS, stating that "Plaintiffs are not members of a limited partnership, nor do they resemble limited partners, which are those who 'lack management powers but enjoy immunity for debts of the partnership,'" citing the U.S. Tax Court decision in Renkemeyer, 136 T.C. 137 (2011).

CAUTION:
It is probably safe to assume that, in the case of an LLC which is not a service business in one of the professions, performing arts, or consulting, and which has a management agreement that creates two classes of members -- managers and passive investors -- the managing members will be subject to self-employment tax and the passive members will very likely not be subject to self-employment tax on their share of the LLC's profits.

Otherwise, in most cases, the courts seem to be leaning recently in the direction of treating all LLC members as general partners, so there may not be many other situations where members will be able to escape self-employment tax any longer on their share of LLC profits.

Whether or not income from an LLC should be reported as self-employment income is a decision that should only be made after consultation with a competent tax professional, as this is a highly technical tax question and an area where experts (and the IRS) can and do disagree as to what the proper tax treatment should be. This issue is likely to continue to be litigated until, if ever, Congress decides to resolve the controversy.

Also, beware of much of the information on this question you will find on the Internet, much of which assumes that the IRS Proposed Regulations (of which Congress disapproved, but did not order the IRS to rescind, in the 1997 tax act) are the law. Sophisticated tax practitioners would beg to differ.


SOME STATES NOW ALLOW "SERIES" LLCs

Individual entrepreneurs, corporations, or other entities have learned to utilize multiple LLCs, by putting separate business ventures in separate LLCs, which allows the owner to isolate the risks of each venture to the capital invested in that LLC. However, in many states, such as California, using multiple LLCs means incurring multiple taxes or other fees or administrative costs, particularly where the various LLCs have somewhat different members. The following example is how multiple LLCs are being used to insulate separate businesses from liability, in most states (not utilizing a "series LLC"):

EXAMPLE:
ABC Restaurants, a restaurant chain, typically might set up a number of LLCs, one for each restaurant, perhaps with local partners in each city who own part of the LLC that operates the ABC Restaurant in that city. The bankruptcy of one of the LLCs will not affect the parent company or other owners of any of the other restaurants. This may work well to limit liability from the failure of any one or more restaurants, but will result in multiple annual fees and costs of annual reporting for each of the LLCs, which may be substantial if there are a large number of restaurants, each operated as a separate LLC.

Now, some states, notably Delaware, [Delaware Code, Title 6, Subtitle II, Sec. 18-215] have amended their LLC laws to allow "series LLCs." Several other states have enacted similar LLC provisions, including Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, and Utah, as well as the District of Columbia.

A series LLC is a single LLC that divides itself into a "series" of separate divisions, each of which must keep a separate set of books, but with each such division or series operating a separate business, with its own separate limited liability, so that if the business of one series goes bankrupt, the other series or divisions of the LLC are not liable for its losses. In effect, each such "series" of an LLC is like a separate legal entity, with regard to legal liability, but only one LLC exists, thus creating only one set of taxes, tax filings, etc.

Each "series" can even have different members, managers, and ownership percentages and can make distributions to its members while other members of the LLC receive none. Thus, in the restaurant chain example above, in a state that allows "series LLCs," a single "series" LLC could be substituted for a large number of separate LLCs, with each restaurant segregated into a separate unit ("series") or subdivision of the single large series LLC. Doing so would provide the same liability protections, but filing fees and tax returns would only be required for the one LLC entity, resulting in considerable cost savings.

However, legal experts are divided, so far, as to whether other states will respect such series LLCs established under the laws of, for instance, Delaware. Also, it is not yet clear whether the IRS will allow such an LLC to file a single partnership tax return, or will treat each separate series as a separate partnership, with tax returns required for each. California has already decided that Delaware "series" LLCs that do business in California will be treated as multiple LLCs, so that each will be subject to the California $800 minimum franchise tax. (Ouch!)

Thus, while this new legal development offers significant potential benefits, you may take significant risks if you are one of the pioneers who sets up a series LLC before the tax and legal treatment of such entities has been sorted out by the courts, IRS, and state legislatures.


PROS AND CONS OF LIMITED LIABILITY COMPANIES:

Major benefits of LLCs over the traditional business entities that were available up till now (corporations, partnerships and sole proprietorships) include the following:

  • Unlike partners in a general partnership or the general partners in a limited partnership, the owners of an LLC have limited liability; and, unlike limited partners in a limited partnership, they do not lose their limited liability if they actively participate in management.
  • Under the IRS "check-the-box" regulations, a business that is currently a sole proprietorship is also able to change to LLC form and thus obtain limited liability, with no tax consequences or added tax compliance requirements of any kind (except, on or after January 1, 2009, to get a separate tax I.D. number for payroll tax reporting), as the IRS will now, in effect, ignore the existence of the one-owner LLC for income tax purposes. Most, but not all, states follow the federal treatment of such "disregarded entities."
  • Like a regular corporation (a C corporation), an LLC provides limited liability to its owners, but taxable income or losses of the business will generally pass through to the owners (but any such losses may not always necessarily be deductible, due to the "at-risk" and "passive loss" limitations of the tax law).
  • An LLC is more like an S corporation, in that it provides for a pass-through of taxable income or losses, as well as limited liability, but can qualify in many situations where an S corporation cannot, since an S corporation cannot:
    • have more than 100 shareholders;
    • have nonresident alien shareholders;
    • have corporations or partnerships as shareholders;
    • be a financial institution, insurance company, or a special corporation such as a DISC or a "possessions corporation" (however, LLCs generally cannot be one of those types of entities, either);
    • have more than one class of stock (or otherwise have disproportionate distributions); or
    • have too much of certain kinds of "net passive income" (under certain circumstances).
  • Also, LLC owners may be able to claim tax losses in excess of their "at-risk" investment, such as on certain leveraged real estate investments, which would not ordinarily be possible in the case of an S corporation or even a limited partnership.
  • LLCs are (generally) simpler entities to maintain than corporations. An LLC is required to file its "articles of organization," which are similar to articles of incorporation, but the operational similarities tend to end there. It is also a good idea for an LLC to have a written operating agreement, which spells out how the company is to be operated, much like a partnership agreement. However, from that point on, the LLC is governed by its operating agreement, and there is generally no need for any of the tedious corporate formalities such as minutes of meetings, resolutions and annual meetings of the shareholders ("members" in the case of an LLC). This operating flexibility, in addition to freedom from corporate level income tax (except in the few states that impose state income taxes on them) makes the LLC a highly advantageous form of doing business for the closely-held or family-owned business.

However, the federal tax treatment of LLCs is not uniformly favorable. Perhaps unintentionally, a partnership tax law provision that was added in the Revenue Reconciliation Act of 1993 may adversely impact professional service firms that are organized as LLCs, rather than as true partnerships. Under the 1993 tax law amendments, certain payments made by partnerships to outgoing partners (for "goodwill" or "unrealized receivables") are not deductible to the partnership, except when made to a general partner in a service partnership, such as a law or medical partnership.

Since LLCs with multiple owners, if properly organized, are treated as partnerships for income tax purposes, this 1993 law applies equally to professional service firms that are either LLCs or partnerships.... With one important Catch-22: Since an LLC has NO general partners (all of its partners have limited liability, like limited partners), then NO payments (for goodwill, etc.) by an LLC to buy out one of its members can qualify as deductible under the 1993 tax law change. This can be a serious tax disadvantage for a professional service firm that operates as an LLC, rather than as a partnership. (Furthermore, some states do not allow professional service firms to operate in the LLC form.)

Professional firms will often find it preferable to operate in the form of professional corporations, and S corporation status, rather than as LLCs, since all the earnings of a professional LLC will generally be subject to self-employment tax. If operating as an S corporation, only the salaries paid will be subject to FICA taxes (at the same rate as self-employment tax), and any remaining profit that is earned by the S corporation will be subject only to income tax, not to self-employment or FICA taxes, provided that the amount of salaries paid is not unreasonably low and subject to treatment as tax avoidance by the IRS.

Another disadvantage of an LLC is that an LLC may need to file with the IRS as a tax shelter if it has members who are treated as limited partners or “limited entrepreneurs” (persons who are not limited partners but who do not actively participate in the LLC's management).

In addition, some states, which have corporate income taxes or franchise taxes based on income, treat LLCs as corporations for state income tax purposes. This can result in double state taxation of income in New Hampshire (although only in special cases after 2010), if you distribute income, since the distributions may be treated as taxable dividends to the recipients, after being taxed once already at the LLC level; or, in states like Texas, or Tennessee, which have no general personal income tax, can result in at least one layer of state tax on income, which would not otherwise be incurred with either a regular general partnership or a sole proprietorship.

Also, some states impose other income-based taxes at the entity level on LLCs, just as for corporations, such as the Michigan Business Tax (prior to 2012) or the Illinois Personal Property Replacement Tax. Other business entity gross income or net income taxes such as in Washington, D.C., New York City, New Hampshire, Texas, Kentucky, Ohio, and Washington (state), apply equally to LLCs and to some or all other unincorporated businesses, as well as to corporations. (However, the Texas franchise tax and Kentucky Limited Liability Entity tax both mostly exempt small businesses with under $600,000 or $3 million of gross receipts, respectively.) New Mexico and Hawaii also impose gross receipts taxes that are in place of sales taxes and those taxes apply to all types of business entities.

Even with the above drawbacks, LLCs seem to have many advantages that almost guarantee a continued boom in their popularity in coming years.

IMPORTANT NOTE RE LLC FORMATION:
If you want to set up an LLC in any state, or need Registered Agent services in any state where your LLC does or will do business,
Northwest Registered Agent LLC will handle the entire process of creating an LLC (or corporation) for you for a flat fee of $100, which seems to be the minimum price charged by any of the various companies that specialize in setting up LLCs. (Of course, you will also have to pay the state any fees or taxes that are required when forming an LLC -- but this particular firm does not "mark up" those costs that they pay on your behalf, unlike some of the other incorporation/LLC firms.)

Northwest Registered Agent LLC has a simple one-page online sign-up page for creating your LLC. Just click here to fill out their form, and for $100 plus applicable state fees or taxes, you can have an LLC up and running in a few days.

State laws generally require an LLC to have a "registered agent" in states in which the LLC does business. This company will also serve as your registered agent in any state for (a very reasonable) $125 a year. For information on the nature of the registered agent services that you will need if doing business outside your home state and that Northwest Registered Agent LLC provides, click here.

STATE NOTES ON LLC LAWS:

As noted above, every state in the U.S., has now adopted a limited liability company (LLC) law, in some form. Thus, in addition to the traditional choices of a sole proprietorship, partnership, or corporation, a business may also choose, in most states, to operate in the form of an LLC. In most states, LLCs are very attractive entities for many small businesses, in that they offer the same protection as a corporation from creditors for debts of the business, while offering much of the flexibility plus the flow-through tax treatment of a partnership for federal tax purposes.

However, some states limit the types of businesses that may operate as LLCs, or impose significant income taxes, capital taxes, or fees on LLCs. For example, California severely limits the types of businesses that may operate in the form of an LLC, and imposes "LLC fees" on LLCs, based on gross receipts of the business, as well as a $800 annual minimum tax. Other states, such as Tennessee, tax the income of an LLC in the same manner as a corporation, so that there is no state tax advantage of using the LLC form in those states. The states of New York and New Jersey impose hefty annual fees on most LLCs, based on the number of members (owners) of the LLC in New Jersey or on gross receipts in New York, up to a maximum fee of $4,500 in New York or $250,000 in New Jersey. Ohio has phased out its corporate franchise tax in 2009 and replaced it with a "Commercial Activities Tax," a gross receipts tax that applies equally to all types of legal entities.

Similarly, Kentucky now imposes a "limited liability entity" tax on LLCs and all other limited liability business entities, based on gross receipts or gross profits, but small businesses with less that $3 million of gross receipts pay only a flat $175 tax. The Texas franchise tax (sort of a modified gross receipts tax) applies to LLCs and other unincorporated limited liability entities (LLPs and limited partnerships) as well as to corporations, although it exempts small businesses with under $600,000 of gross receipts.

Still other states, such as New Hampshire, plus the District of Columbia and New York City, tax the income of all business entities in more or less the same manner, regardless of the legal form of the business, so that the LLC form provides no state tax advantages in those jurisdictions.

The following links are to pages on this site that provide general information on LLC organizational requirements, filing fees, and, in some cases, state taxation, in several of the various states.

OTHER STATES' LLC LAWS (NOT COVERED HERE):

The state-by-state summary of key provisions of LLC and LLP laws for all 50 states and D.C., which was previously found on this web page, has partly been removed from this web site. The LLC and LLP laws of over 30 states and D.C. (as well as other business laws and taxes) are now covered in our book series, Starting and Operating a Business in the U.S., (by Michael D. Jenkins, Esq.), now published in Kindle e-book format, in place of the former print editions.

UPDATE NOTE:
Since May, 2011, Kindle editions ($5.99 to $9.99 each) have been available for most states. See our ordering page for the Kindle edition for your state, which not only can be read on Kindle devices, but on PC's, iPads, iPhones and other smart phones, and on numerous other devices, using the free Kindle "apps" that you can download from Amazon.com.




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Click on the above image for information on the new, updated electronic book/software versions, of the "Starting and Operating a Business in the U.S." electronic book series for most states and the District of Columbia.




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Last modified: August 4, 2014