San Francisco Examiner – March 7, 1995
Best features of partnership, corporation – “Limited Liability Company”
Bob, Ted and Carol decide to manufacture biodegradable baby diapers. Bob and Ted will invest $50,000 and $25,000, respectively; Carol will invest $1,000 and run their business.
All three will have equal ownership. They all have substantial personal assets and want to protect themselves from personal liability. Also, Bob and Ted will be repaid before Carol receives her share of the profits.
How should this trio proceed to organize?:
- Form a corporation to limit their personal liability with special repayment provisions (but this could cause double taxation)?
- Form a general partnership (a “flow-through” entity in which the partners are directly taxed on their share of the income) — an arrangement noted for its simplicity and flexibility and which permits the repayment to Bob and Ted, but will not limit their personal liability?
- Or form a small business corporation (S corporation), which limits their liability, is a flow-through entity for tax purposes, but does not permit repayment to Bob or Ted?
For years, these have been the main options available to new small businesses or partnerships. But now there’s another, often better choice. Late last year, the legislature made good on one of its “pro-business” promises by enacting the Limited Liability Company Act.
This law now permits a new legal entity: the Limited Liability Company (LLC), which allows the flexibility of a general partnership plus the legal protection of a corporation. Because of its dual benefits of partnership tax treatment and corporation protection (but without the paperwork and expense of a corporation!), LLC’s could replace general partnerships, limited partnerships and S corporations as California’s business entity of choice.
The Basics
Forming an LLC is easy: You file a simple form with the Secretary of State, and, once approved, it becomes registered in California. Your LLC needs at least two “members,” who may be U.S. or foreign citizens or other entities, such as partnerships, trusts, corporations, estates or even other LLC’s. However, professionals (lawyers, accountants and doctors) are prohibited from forming an LLC.
An LLC uses an “operation agreement” (like a partnership agreement) to control business, financial and tax provisions. The operating agreement may be oral, although it may save future problems if it is written and signed by all the LLC members.
This statement is not filed with the Secretary of State; therefore, changes to the agreement can be made in an informal setting, say over a pizza, and it’s a done deal! An LLC’s management rests either with its members or with certain designated “managers.” Managers do not have to be members of the LLC, and even corporations may serve as managers.
An LLC decides to be taxed as a partnership or corporation. In general, most LLCs choose to be taxed as a partnership; as a flow-through entity, income and losses will be reported by its members on their tax returns. In contrast, if an LLC chooses corporate tax treatment, the LLC (and not the members) will pay taxes at the federal and California corporate tax rates.
LLC’s pay an annual minimum franchise tax of $800 to the Franchise Tax Board, the same amount charged for corporations and limited partnerships. LLC’s pay additional taxes if annual gross receipts exceed $250,000.
The Advantages
LLC members are shielded from personal liability to the same extent as corporate shareholders, without the nuisance of annual elections or maintaining corporate minutes. They also enjoy the financial agility of a partnership, and have greater flexibility than either a corporation or partnership when delegating management responsibilities. In general, the LLC will be treated as a partnership for tax purposes; it will be a flow-through entity in which income and losses are reported directly by its members. In our case, if Bob, Ted or Carol decide to shift management roles, it simply takes their agreement.
Unlike an S corporation, an LLC permits special allocations of income, expenses, deductions and losses can be made among its members, and membership is not restricted to U.S. individuals. Unlike a partnership, management can be vested in nonmembers. Unlike a limited partnership, members may be actively involved in the LLC’s management, without risk of personal liability, as can occur to a limited partner.
Further, an LLC member may deduct losses that exceed his or her direct investment, which can occur when the LLC borrows funds. Hence, an LLC is an ideal substitute for an S corporation whenever foreign citizens or entities, corporations, partnerships, other LLC’s or trusts are members, or when money is loaned to the LLC. The LLC provides estate planning opportunities since trusts and estates are eligible shareholders.
LLC’s also might pay a substantially lower California income tax than an S corporation. For instance, an entity with a profit rate of 10 percent and gross receipts of $1.5 million will pay $1,800 in state tax as an LLC, compared with $2,250 as an S corporation.
An LLC can provide that Bob and Ted will be repaid in full before profits are equally split among the three. Carol can manage their venture without participation or interference from Ted or Bob. An LLC permits transfer of a membership interest to a corporation or revocable living trust, and — of paramount importance — none of the members is personally liable for any debts or claims against the business.
The LLC also provides estate planning opportunities since trusts and estates, including revocable living trusts, may own a membership interest. This makes an LLC an excellent investment vehicle for unmarried couples, families or friends who invest together, since they decide how to share their income and losses. And by using revocable living trusts, probate will be avoided upon an individual’s death.
The Disadvantages
As a new entity, an LLC offers little legal precedent. Also, Congress has not passed any tax legislation establishing LLC as a partnership for tax purposes. Thus far, the IRS has ruled that the LLC qualifies as a partnership for tax purposes, but there is nothing in the Internal Revenue Code that permits such treatment. In cases where you could be satisfied with S corporation benefits, use it because it is an established business and tax entity.
Conclusion
Forming an LLC with two or more people or entities could be ideal because it offers distinct advantages over both general and limited partnerships structures. It is similar to an S corporation, but without its restrictions. LLC’s, however, cannot be used by professionals, or in situations when a regular “C” corporation would take advantage of the corporate reorganization tax provisions or the ability to have separate classes of stock.
An LLC is particularly well suited for real estate ventures containing corporations, trusts or foreign investors or new business ventures involving existing corporations. Also, an LLC is excellent as an estate planning vehicle for investments between an individual and his or her family corporation, trust or partnership.
In fact, the LLC may eventually replace both general and limited partnerships since it offers the same tax treatment and management opportunities, plus the advantage of limited liability to all members. LLC’s might also pay a substantially lower California income tax than an S corporation.