If a limited liability company sounds like a foreign concept, that's because it is.
For years, Germans, South Americans and the French were allowed to have small companies or groups of individuals who enjoyed limited personal liability while operating under partnership types of rules.
It wasn't until 1977 that Wyoming became the first U.S. state to enact LLC legislation. In 1982, Florida followed suit. Now, all states have made it legal, and it's the most popular structure, by far, for a small business. "It is simple, has management flexibility with no board of directors, limits the owner's liability and passes the taxes through like a partnership," says Douglas Bayer, a Wilton, Conn., attorney who has served as one of my resources in putting together this series.
Two weeks ago, I began a three-part look at legal structures for small businesses with a
discussion of C corporations and S corporations. Last week, I
examined general and limited partnerships and sole proprietorships. Today, I'll finish up with an in-depth look at LLCs.
When LLCs finally hit these shores, the big question was whether the
Internal Revenue Service
was going to tax them as corporations or partnerships. The fuzzy picture came into focus in 1988 when the IRS agreed that an LLC formed under the Wyoming statute was eligible for partnership status. In 1997 the IRS eliminated a complicated series of regulations relating to LLCs. The IRS also gave LLC owners the option of electing corporate-tax treatment. These actions paved the way for more small businesses to elect to do business as LLCs. Most states also allow a sole proprietor to form an LLC.
There are four reasons behind the popularity of LLCs:
- Limited liability. The LLC is the only entity (other than a corporation) that has limited liability. Owners are exempt from personal liability for business debts and other legal issues, such as court judgments.
Pass-through taxation. Profits and losses pass through the business and are taxed on the owners' individual tax returns.
Management flexibility. Owners are referred to as members. A member/owner can be an individual, a partnership or a corporation. Each investor/owner has a percentage interest in the LLC. This helps to determine how to split up profits and losses and divide voting rights.
Profit and loss distribution. LLC owners can decide how to distribute profits and losses among themselves. They are not required to divide profits so that they are proportional to capital contributions. They can be split in any manner.
What businesses benefit the most from an LLC structure?
Here are some ideas:
- Businesses that are active and have between one and 35 owners. With more than 35 owners, things begin to get a little cumbersome, and perhaps a C corporation or S corporation would be a better structure.
New businesses with start-up losses. The owners can use the losses to reduce other taxable income.
People considering an S corporation. The requirements of an S corporation are more rigid, complex and limiting than those of an LLC.
Existing partnerships that want to limit liability for the general partner. In a limited partnership, limited liability applies only to limited partners, not to the general partner. With an LLC, all owners have limited liability.
Businesses that hold appreciating assets like real estate. For instance, in a C corporation, the profits are taxed twice, once at the corporate level and again at the personal level. LLCs avoid this because of the direct "passthrough" to the owners.
To help you determine the most beneficial form for your business, here are some comparisons:
Thanks for your comments. And just a word of caution: Always coordinate with your accountant and/or attorney. The extra bucks you spend will pay off. It costs a lot more to correct a misjudgment on this than to do it right in the first place.
See you next week.
Vern Hayden is a certified financial planner in Westport, Conn. He is a financial consultant and advisory associate of Financial Network Investment Corp. He also is an owner of Hayden Financial Group. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While he cannot provide investment advice or recommendations, Hayden welcomes your feedback at