THE LIMITED LIABILITY COMPANY

RELATED MATERIAL REGARDING LIMITED LIABILITY COMPANIES

Organizing A Limited Liability Company In Massachusetts. An overview of the processes and considerations involved in starting and operating a limited liability company in the Commonwealth of Massachusetts.

Choice of Entity Considerations. Unsure whether to form a corporation or limited liability company? Read about corporation and limited liability choice of entity considerations.

Choice of Entity Taxation Considerations. Read about choice of entity considerations related to Federal income taxation.

What is a limited liability company (LLC)?

A LLC is neither a corporation nor is it a partnership or sole proprietorship; it is a unique form of legal entity. The limited liability company (LLC) is a relatively new type of organization through which one or more individuals can join together and conduct business. An LLC is created pursuant to state law by completing a filing with the Secretary of State. In a LLC one sees a blending of certain of the beneficial characteristics of a corporation and certain of those of a partnership. Along with a corporation’s limited liability for all protections, comes “flow through” taxation consistent with the treatment of a partnership under the Internal Revenue Code of 1986, as amended (Code). Federal income taxation under Sub-chapter K of the Code offers the members of a LLC a great deal more flexibility than is accessible to shareholders of a corporation taxed under Sub-Chapter S of the Code. A LLC is also afforded with freedom from certain rigid rules of corporate operation and far fewer constraints in structuring ownership. The LLC quickly gained popularity among entrepreneurs, attorneys, accountants and venture capitalists. It must be noted however that despite the benefits offered by advent of the LLC, there are certain situations that will require a person starting his or her own business to elect to operate their venture as either a corporation or limited partnership.

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Is a LLC the right type of entity for a new business venture?

Protecting Personal Assets from Business Liabilities. When a person starts a new business they need to understand that proper business planning at the outset can avoid many problems down the road. People are increasingly “sue happy,” and too many owners of small businesses (operating as a sole proprietorship or general partnership) find themselves defending law suits and facing judgments that threaten a business owner’s personal assets. Unless members of a LLC agree to be personally liable for the debts of a LLC, their personal assets are shielded from judgments against the LLC. Protection of personal assets is one of the primary reasons persons starting their own businesses form a LLC. The organization of a corporation will also accomplish this goal.

Federal Income Taxation. A LLC is not a taxpaying entity as it almost always qualifies for partnership taxation status. By operating a business as a LLC, an entrepreneur will likely avoid the two levels of taxation encountered by many owners of shares of a corporation. In addition to flow through taxation, Sub-chapter K of the Code provides members of a LLC more flexibility with respect to allocations of profits and losses. As such, tax planners and accountants are quite often able to save LLC members tax dollars. A person starting his own business who is concerned with the tax consequences of his business activities should consider a LLC as his or her entity of choice.

Flexibility in Business Governance. Unlike the statutes governing the organization and existence of corporation, most state LLC statutes do not require the keeping of minutes and resolutions to maintain compliance with the law. There is no statutory requirement to keep extensive minute books, hold shareholder and board of directors’ meetings, or adopt resolutions. A LLC operating agreement can be drafted to its members desires and eliminate the pitfalls associated with corporate maintenance. It is imperative, however, that an LLC operating agreement be drafted properly from the outset to ensure that the LLC is taxed as a partnership rather than a corporation and that there exists in the operating agreement no unnecessary governance provisions that can be inadvertently violated.

Adding Co-Owners and Investors. As a business grows, additional owners whose talents compliment those of the current ownership may be required, or the venture may need to bring in one or more “money men” (angel investors or venture capital groups) to increase capital and grow the business. A LLC provides simplicity in adding these new owners and/or investors. Statutes typically do not require the authorization of additional interests and the IRS does not limit the number of members that a LLC may have. In contrast, the addition of shareholders, especially in “S corporations,” can be cumbersome, expensive and, in certain cases, impossible. All types of individuals, corporations, trusts and other entities are permitted to be members of a LLC.

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Why not wait to create a LLC until the business is up and running?

If a business is not organized at “start-up,” a host of problems are likely to occur. Once business activities commence, there will be little time to dedicate to organizational issues, as the operators of the business will be consumed with ensuring the venture’s success. In addition, when two or more persons start a business each has different expectations (whether they believe so or not). If these expectations are not documented and agreed to in advance, confusion and disagreements will inevitably ensue regardless of any previously existing personal relationships. For example, who may withdraw funds from company bank accounts? How will expenses be shared amongst the owners? How will the owners be compensated for their labors? What happens in the event of the death, incapacity or divorce of an owner? These are just a few of the issues that can arise in the operation of a business without advance planning and agreement. With proper planning; disagreements, lengthy legal battles and hard feelings can be easily avoided – everything is documented. By entering into a LLC operating agreement prior to opening up for business, owners can decide in large part how much paper work the business will be required to generate internally, how company expenses will be shared, who will be charged with maintaining company funds, what will happen to the business in the event one of the owners wants to sell, and so on. A LLC operating agreement can be drafted as a simple document taking into account just the basics or it can be a complex and comprehensive document which takes into account all facets of business operation and all contingencies. In addition, by properly forming a LLC prior to beginning business operation, the owners will be shielded from personal liability from day one. Once a liability has been created, the window has closed on forming a LLC to protect personal assets from that particular liability.

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How much does it cost to organize and maintain a LLC?

The cost of filing the proper documentation with the Secretary of State ranges from approximately $100 to $500 depending on the state of organization. In addition, there is a similar fee on an annual basis to maintain the existence of the LLC under state law. There is also the attorney’s fee for preparation and filing of the formation document. Much of the cost involved in creating a LLC is incurred in the drafting and negotiation of the LLC operating agreement.

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How much does it cost to organize and maintain a corporation?

The cost of filing the proper documentation with the Secretary of State differs from jurisdiction to jurisdiction and depends on the number of shares authorized for issuance to shareholders. There is an additional fee on an annual basis to maintain the existence of the corporation under state corporate law. There is also the attorney’s fee for preparation and filing of the formation document. Much of the cost involved in creating a corporation is incurred in the preparation of by-laws, shareholder and board of director resolutions, and agreements among the shareholders. Standard documents can be prepared in just a few hours, while highly complex shareholder agreements can witness over forty hours of attorneys’ time prior to execution.

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Which is the better choice: Subchapter S Corporation or the LLC?

As is almost always the case with the law, the answer to this question lies in the particular situation at hand. A corporation comes with liability protection identical to that of a LLC. “S corporations” avoid the corporate level tax by electing to be taxed under Subchapter S of the Internal Revenue Code; however, there are many rules that these corporations must follow to maintain the election. A LLC does not have to live up to these requirements. For this reason alone, entrepreneurs will often choose to organize a LLC. A LLC also provides flexibility in profit sharing and business operation. Corporations must maintain certain records and jump through statutorily mandated hoops to conduct business. A LLC need not operate under such a stringent regime. A LLC may be the best choice for persons who want to conduct business in a world inhabited by fewer legislative and regulatory mandates and requirements.

Despite these benefits of forming an LLC, circumstances continue to exist where an “S corporation” is a more appropriate entity choice for an aspiring entrepreneur. Some states do not permit certain types of businesses to be operated as a LLC (for example, California presently does not permit professionals to conduct business as an LLC). In addition, some investors (both angels and venture capitalists) have their own business and financial reasons for wishing to elect a corporation and sometimes a “S corporation” as the entity through which to operate the business venture. The facts and circumstances of each situation will dictate whether a LLC or a “S corporation” is the best entity choice upon starting one’s own business.

See also, Choice of Entity Considerations

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Is a LLC better that a general partnership or limited partnership?

A general partnership is created when two or more people agree (even verbally) to go into business together. The downside to operating as a general partnership is that each partner is fully liable for the acts and misdeeds of his or her partners as well as his own. The general partnership provides no limited liability protections to its partners. For this reason, it is often not advisable to operate a business as a general partnership.

A limited partnership is created by completing a filing with the Secretary of State. The limited partners in a limited partnership receive limited liability protection and only their investment in the entity is at risk. However, the general partner who is charged with operating the business has unlimited liability for the debts and obligations of the limited partnership. In addition, if the limited partners become involved in the management and operation of the business of the limited partnership, they lose limited liability protection. The LLC provides much greater limited liability protection to its owners. Certain venture funds continue to operate as limited partnerships as certain countries (such as Canada) have traditionally taxed a LLC as a corporation, relieving the LLC of its tax advantages. These venture funds typically choose to have a LLC serve as the general partner of the partnership.

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Can the members of a LLC participate in management without losing their limited liability protections?

One of the major benefits of the LLC that distinguishes it from a limited partnership is the fact that all members can participate in the management and operation of the business of the LLC without losing limited liability protections.

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Why not operate as a sole proprietor?

While a sole proprietor may avoid state filings and attorneys’ fees, there is no limited liability protection between individual and business assets. Planning, at the “get-go”, will save the entrepreneur money on an ongoing basis and protect the assets he or she is working so hard to accumulate.

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Can one person form a LLC?

Most states permit a single member LLC. The IRS typically disregards single member non-corporate entities for Federal income tax purposes. Persons considering forming a single member LLC should contact their tax advisor to determine whether the state in which they reside or operate their business views a single member LLC in the same light as the IRS.

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Does a LLC pay federal income tax?

Unless it elects to be taxed as a corporation, a LLC is a “flow through” entity. As such it does not pay any income tax. Instead profits and losses flow through to the tax returns of the individual members. Some states charge a franchise tax on the continued existence of a LLC; other states require the payment of a fee for the filing of an annual report with the Secretary of State.

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