Choosing the Best Legal Structure (Part 2)

Your Startup — What Legal Structure Is Best?
Part 2 of a Four-Part Tutorial

Limited Liability Companies

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The most common way for small business startups to separate the liability of the business from the liability of the owner is to form an LLC. These initials stand for "limited liability company." LLCs blend many freedoms enjoyed by sole proprietorships with the greater liability protection enjoyed by corporations.

LLCs versus Corporations

LLCs can embark on any kind of investment that is open to corporations. LLCs can have ownership positions in other LLCs or enter into partnerships with them. They can also partner with individuals, corporations, or non-profits. And they can hold stock — even controlling interest — in a corporation, with but one exception. Like corporations, LLCs are precluded from being shareholders in an S-Corp.

The most common way to protect a business owner from personal liability for the company is to form a Limited Liability CompanyOwners of LLCs have tremendous freedom in terms of operating their LLC. When compared to the rules governing corporations, record-keeping requirements for LLCs are rather minimal. In this regard LLCs have much in common with sole proprietorships.

But in contrast to a sole proprietorship, an LLC is an entirely separate legal entity from its owner. This separation is what cloaks the owner with limited liability. When your company is an LLC, any court or legal action against the company can only lay claim to the assets of the LLC itself, not to your own personal assets.

Indeed, LLCs provide the same liability protection as a corporation. Yet they differ from corporations in some fundamental ways. In contrast to corporations, LLCs do not sell stock and do not have shareholders. Instead, owners are known as "members."

Most jurisdictions allow you to form an LLC with only a single member. But theoretically you can have any number of members. Quite often a family business which operates as an LLC will have two members, the husband and wife.

Operating Agreements

Once established, the LLC creates an Operating Agreement. This agreement is roughly equivalent to the by-laws of a corporation. It lays out the policies and guidelines that will govern the way that the LLC conducts its affairs. Even if you organize an LLC in a state that has no statutory requirement for an Operating Agreement, it is sound practice to create one.

  • A written Operating Agreement strengthens your claim of limited liability by demonstrating that the LLC is indeed a legal identity separate from the identity of its owners.
  • In multi-member LLCs the Operating Agreement sets the ground rules for what members may and may not do in their capacity as members.
  • It also spells out when distributions of profits will be made, how they will be made, and how the distributions will be prorated.
  • Banks, creditors, institutions, and others with whom you may partner will often request a copy of your Operating Agreement as a condition of doing business with you.

This Operating Agreement is no mere formality. In any challenge before a court or in a tax audit your Operating Agreement is open to review. If your actions have been substantially inconsistent with it, you may be denied the limited liability that you would have otherwise enjoyed. So you not only want to have an Operating Agreement in place. You also want to modify and amend it should any of its provisions become outdated or outmoded.

Even if you organize an LLC in a state that does not require an Operating Agreement, it is sound practice to create one.

Beyond this Operating Agreement, the primary record-keeping requirement for an LLC is to maintain adequate financial records to properly report local, state, and Federal taxes. You can normally do this adequately with inexpensive bookkeeping software and a good filing system for receipts.

Taxes and the Many Faces of an LLC

Because they were designed to provide maximum flexibility to their owners, LLCs have a certain chameleon-like quality about them, particularly with regard to taxes. The IRS treats single-member LLCs as though they were sole proprietorships. The income (or loss) from the LLC is reported on Schedule C of the member's 1040 tax return.

A limited liability company can be taxed as a sole proprietorship, a partnership, or a corporation, depending on its structure and owner preferencesIf the sole member of a single-member LLC is a corporation, the income or loss from the LLC is reported as part of the corporation's income tax.

Multi-member LLCs receive a different tax treatment. Even though they are not partnerships from a legal standpoint, they are generally taxed under the same rules that govern partnerships. Accordingly, the members report their income from the LLC on their respective 1040s, but on Schedule E rather than Schedule C.

There are two situations in which this partnership treatment may not apply. The first is when a husband and wife are the only two members of an LLC and they live in a community property state. In this instance the husband and wife can elect to report their LLC income on Schedule C, the same as single-member LLCs. But they are not required to do so. (For more on this option, see our tutorial on husband-wife joint ventures.)

Second, LLCs have the option of being taxed as corporations. They can choose be taxed under the rules for C-Corps or for S-Corps. They do not become a corporation by making this choice. But they file their taxes as though they were indeed a corporate entity.

This means that an LLC which chooses to be taxed as a C-Corp must pay corporate income tax on its profits. Then, at its own discretion, the LLC can pass after-tax profits to its members in the form of disbursements. From a tax standpoint these disbursements are treated the same way as dividends from a C-Corp. That is, the members of the LLC report the disbursements on their personal 1040 using Schedule E. And the disbursements are taxed at the dividend rate.

In some situations it may make financial sense for an LLC to be taxed as an S-Corp. Since an S-Corp is a "pass-through" entity like an LLC, this gives the LLC access to certain tax advantages enjoyed only by corporations, but without subjecting itself to the double-taxation of a C-Corp. On the other hand, it is rarely financially wise for an LLC to be taxed as a C-Corp, again because of the double-taxation issue.

Unless it does choose to be taxed as a C-Corp, an LLC never files Federal income taxes. Income from the LLC flows directly to the members and is apportioned among them in keeping with the Operating Agreement. Profits from the LLC are therefore taxed at personal income tax rates.

Incidentally, IRS regulations allow even single-member LLCs to be taxed as corporations. The considerations for making this choice are the same for both single-member and multi-member LLCs. But you should never elect to have any LLC treated as a corporation without first obtaining professional counsel from a CPA or tax attorney. You want to understand all of the long-term consequences of this election, because for the most part they are irreversible.

LLCs and Partnerships

While a multi-member LLC is usually treated as a partnership for tax purposes, it is legally quite distinct from a partnership. For one thing, there is no partnership agreement governing the LLC. The Operating Agreement sets the ground rules for the LLC.

Unlike corporations and partnerships, limited liability companies are free to apportion profits among its members however it wishesFor another, the LLC is free to apportion profits among its members in a way that is precluded to partnerships.

In a partnership, profits can only be divided among the partners based on their percentage of ownership. LLCs are not bound by this rule. The Operating Agreement can set a formula for disbursing profits that disregards how much the respective members have invested in the company.

To cite an example, consider two people who start an LLC with one putting up 60% of the investment capital, the other putting up 40%. However, because the 40% party will play a larger role in the day-to-day management of the company, they agree to split the profits 50-50. This is perfectly allowable in an LLC so long as there is a defensible reason for a disproportionate division of profits. Only an LLC allows this kind of flexibility.

Pros and Cons of LLCs

Here, then, are some of the distinct advantages to an LLC structure for your business.

  • LLCs are easy to set up and have rather minimal record-keeping requirements.
  • The owners maintain exceptional freedom over how they manage the affairs of the company.
  • Profits from the company can be distributed in an arbitrary manner among the members.
  • Income from the LLC is taxed at the personal income rate, not the (usually) higher corporate rate.
  • LLCs can easily spin off other companies which they control, whether LLCs or corporations.

On the other hand, there are some disadvantages to LLCs, especially those which need to accumulate working capital in their early years of existence. Members of an LLC are taxed on the income that the company earns, not the income actually disbursed to them as members. Thus, if an LLC needs to reinvest some of its earnings for future operations, the members pay income tax on these reinvested earnings, even though the member never received the money that is reinvested.

All "pass-through" entities have this same disadvantage. Shareholders in C-Corps, on the other hand, are not personally taxed on earnings which are retained in the company. For that reason, one of the few cases in which an LLC might wisely choose to be taxed as a C-Corp (or even organize itself as a C-Corp from the outset) is when it needs to build up sizable retained earnings over several years to underwrite growth and expansion.

There is also another case in which a corporate structure may be preferable to an LLC, namely, if the company envisions overseas expansion. LLCs are a rather recent type of legal structure in the U.S, and corporate laws in other parts of the world do not always provide convenient avenues for American LLCs to conduct business.

We have experienced this within our own family of companies. A few years ago one of our LLCs decided to open a subsidiary in an emerging nation in Africa. But that country’s laws anticipated that foreign-owned subsidiaries would be owned by a traditional corporation. They had no provision for a subsidiary owned by an American LLC. Nor did they have a provision for assumed names, which our LLC used extensively.

After weeks of frustration with the registration process, we ended up forming a corporation in the U.S., transferring the LLCs assets to the corporation, and then using the corporation as the parent company of the subsidiary.

Overall, however, most small startups — and even larger ones — opt for an LLC as the best way to organize their business and provide limited liability for the owner. Later, if circumstances dictate, the LLC can be converted to a corporation with the unique advantages (and disadvantages) of a corporate business structure.