Starting a Limited Liability Company

A limited liability company (LLC) is a hybrid entity that combines the tax flow-through aspects of a partnership with the liability protection of a corporation or a limited partnership. However, unlike limited partners in a limited partnership, who lose their limited liability status if they attempt to manage the business, a member of an LLC is not prohibited from managing the business.

Warning Although the limited liability company form generally results in limited liability for its members, lenders usually require some or all members of a limited liability company to personally guarantee corporate loans.

The LLC is a relatively new type of entity that has only recently become available in all 50 states. Since it is so new, the laws among the various states differ somewhat in their treatment of an LLC. As a result, transactions outside the state of formation by the LLC may be treated differently from transactions within the state of formation.

Prior to 1997, an LLC was treated as either a partnership or an association taxable as a corporation for federal tax purposes depending on whether the LLC possessed more than two of the four corporate characteristics that define a corporation. The four corporate characteristics are:

• continuity of life
• centralization of management
• limited liability
• free transferability of interests

If the LLC had more than two of the corporate characteristics, it would be treated as an association taxable as a corporation. Consequently, most LLCs formed before 1997 wrote their operating agreements to avoid at least two of the corporate characteristics.

Beginning in 1997, federal regulations assume that a new unincorporated business with more than one owner is treated as a partnership, regardless of how many corporate characteristics it has. Businesses can elect to be treated as a corporation by filing Form 8832, Entity Classification Election. Older LLCs will be presumed to continue the federal tax status they had on January 1, 1997.

Forming an LLC. To form an LLC, articles of organization must be filed with the secretary of state's office. The articles of organization contain information about the LLC, such as its name, address, purpose, who organized it, who the registered agent is, etc. The operating agreement is similar to a partnership agreement. Its purpose is to guide the conduct of the business. If the operating agreement is not required to be filed with the articles of organization, it can generally be in written or oral form. As a precautionary measure, the operating agreement should be written to limit future conflicts.

In addition, you must consider whether the company will conduct business across state lines. If so, you may consider forming the LLC out-of-state. You also have option of qualifying the LLC as a foreign entity with state authorities, registering it to do business within that state's borders. The foreign qualification process requires the filing of some forms and paying some initial and annual state fees and taxes.

Advantages of a limited liability company:

• Limited liability. Members are shielded from being personally liable for acts of the LLC and its members.
• Flexible membership. Members can be individuals, partnerships, trusts, or corporations, and there is no limit on the number of members.
• Management. Members can manage the LLC or elect a management group to do so.
• Flow-through treatment. Income, losses, deductions, and tax credits flow through the LLC to the individual members.

Disadvantages of a limited liability company:

• One member LLCs. Many jurisdictions do not allow LLCs to have only one member, although the number of jurisdictions that do allow them is growing. Under federal law, a single-member LLC is treated as a sole proprietorship.
• Free transferability of interest. In older LLCs, transferability of interests was usually restricted to enable the LLC to be treated as a partnership.
• Nontraditional entity. An LLC is a new entity type for which there is little precedent available.
• Cost. An LLC usually costs more to form and maintain than a sole proprietorship or a general partnership. States may also charge an initial formation fee and an annual fee; check with your state's secretary of state's office.

Limited liability partnerships. Limited liability partnerships are similar to limited liability companies in terms of the tax advantages, but they differ in that limited liability partnerships are normally available only to select professions, such as doctors or lawyers. They're also recognized in fewer states than are limited liability companies, with only about 40 states now recognizing them. For more information on LLPs, see limited liability companies/partnerships.

Tax issues. An LLC is generally treated as a partnership for federal tax purposes. Since the individual members are treated as partners, they may be subject to self-employment taxes. If the business hires employees, a Federal Employer Identification Number will need to be obtained and payroll taxes will have to be paid. The Federal Employer Identification Number can be obtained by filing a Form SS-4, Application for Employer Identification Number.

Among the Business Tools is Form SS-4. It is in Adobe Portable Document Format (.pdf), and you will need the free Acrobat Reader to view and print the file.