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| An LLC generally can be viewed as a hybrid entity combining the characteristics and, more importantly, the benefits of a corporation and a partnership.
With limited liability for its members, an LLC resembles a corporation.
The owners of an LLC, like shareholders of a corporation, are generally not responsible for the debts and obligations of the LLC beyond their contributions to the LLC.
Members of an LLC can directly participate in the company's management or can elect managers to manage the business.
Property with "debt and excess of basis" may be contributed and the contribution structured to avoid gain recognition.
A person who contributes appreciated assets to the LLC in exchange for a membership interest is not required to recognize gain on the exchange.
Receipt of an interest in an LLC for a profit interest is generally not taxable (although services for stock would be).
Liquidating and non-liquidating distributions of appreciated property from an LLC are generally received without gain.
In short, the LLC offers significant tax benefits to its members, which are not available to a stockholder in a C corporation.
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 What are Limited Liability Companies?
If you're a business owner considering your formation options, The Coddan is a valuable online resource for information to help you decided whether to form a Delaware LLC or another type of corporation. There are pros and cons to each, but no matter what type of corporation you opt for, the corporate designation confers an image of stability, longevity, and competence.
Entrepreneurs trust us to incorporate in Delaware and form Delaware LLCs the same day. Two business days after forming your company, on average, we deliver it to you by priority mail. Incorporating protects your personal assets from business liabilities. Referrals and repeat customers generate most of our business. We are more than just a filing service; we develop relationships with clients to help make them successful and keep them returning.
The Coddan makes forming your Delaware LLC fast and easy. Most states answer formation submissions within 2-3 business days, so your Delaware LLC can be up and running quickly.
A Limited Liability Company, also referred to as an "LLC", is a new class of business operating entity with legal status in certain states (see below) - a hybrid between an S corporation and a partnership. It combines the tax advantage of a partnership (avoidance of corporate income tax) with the legal safeguard of a corporation - namely the fact that owners' personal assets are not normally at risk in business-related lawsuits. As of December 1997, all states, plus the District of Columbia, have passed laws governing the administration and operation of LLCs within their jurisdictions.
Simplicity and Flexibility of Operation. An LLC is formed by filing a form called Articles of Organization with the Secretary of State, which are similar to Articles of Incorporation for a corporation. Some states, including California, require an annual report to be filed to keep the records maintained by the state current. Other than that, there are generally no other reports or forms to be filed, except tax returns. An LLC may be "manager managed" or "member managed." A Limited Liability Company that is manager managed is similar to a limited partnership where the general partner has the authority to run the operations of the partnership and the other members have little or no input. In short, the "manager-managed" LLC is well suited to accomplish this estate-planning objective. A manager of a manager-managed LLC may, but need not, be a member (this is a corporate concept). The Articles of Organization or Certificate of Formation of an LLC may have to specify whether the Limited Liability Company is member-managed or manager-managed to make this a matter of public record.
An LLC that is member managed is similar to a general partnership where all the members have equal say in the operation or the voting may be based on their ownership interest. An LLC also allows for great management flexibility. The management can be decentralized and informal, such as the management of a general partnership. Alternatively, the Limited Liability Company may adopt a corporate style of management structure with a board of "managing directors." The Board may then appoint a president, CFO and secretary.
Single-Owner LLCs. The IRS treats one-member LLCs as sole proprietorships for tax purposes. This means that the LLC itself does not pay taxes and does not have to file a return with the IRS. As the sole owner of your LLC, you must report all profits (or losses) of the LLC on Schedule C and submit it with your 1040 tax return. Even if you leave profits in the company's bank account at the end of the year - for instance, to cover future expenses or expand the business - you must pay taxes on that money.
Multi-Owner LLCs. The IRS treats co-owned LLCs as partnerships for tax purposes. Co-owned Limited Liability Companies themselves do not pay taxes on business income; instead, the LLC owners each pay taxes on their lawful share of the profits on their personal income tax returns (with Schedule E attached). Each LLC member's share of profits and losses, called a distributive share, is set out in the LLC operating agreement.
Most operating agreements provide that a member's distributive share is in proportion to his percentage interest in the business. For instance, if Jimmy owns 60% of the LLC, and Luana owns the other 40%, Jimmy will be entitled to 60% of the LLC's profits and losses, and Luana will be entitled to 40%. If you'd like to split up profits and losses in a way that is not proportionate to the members' percentage interests in the business, it's called a "special allocation," and you must carefully follow IRS rules.
However members' distributive shares are divvied up, the IRS treats each LLC member as though s/he receives her/his entire distributive share each year. This means that each LLC member must pay taxes on their distributive share whether or not the LLC actually distributes the money to him/her. The practical significance of this IRS rule is that even if LLC members need to leave profits in the LLC - for instance, to buy inventory or expand the business - each LLC member is liable for income tax on her/his rightful share of that money.
Even though a co-owned LLC itself does not pay income taxes, it must file Form 1065 with the IRS. This form, the same one that a partnership files, is an informational return that the IRS reviews to make sure the LLC members are reporting their income correctly. The LLC must also provide each LLC member with a "Schedule K-1," which breaks down each member's share of the LLC's profits and losses. In turn, each LLC member reports this profit and loss information on his or her individual Form 1040, with Schedule E attached.
- What are the Advantages of Operating as an LLC? (Form 1065)
The LLC is treated as a partnership for federal tax reporting. Taxable income and losses pass through to its members (owners) in the same manner, as is the case with partnerships and similar to S corporations. The law allows the inclusion of liabilities of the LLC in order to increase basis for tax purposes (as in the case of a partnership). The liability of all members is limited to their investments in the LLC (unless they personally guarantee other debt incurred by the Limited Liability Company).
Payment to a retiring member may be structured so as to allow part of the payment to be deducted as an expense to the LLC. The Delaware Limited Company Liability Act does not require that a limited liability company agreement be in English. If an LLC has no members in the U.S., and derives no income from sources within the U.S., then, according to current law, as of December 1997, no U.S. federal income taxes will be due by the members who are non-resident aliens of the U.S. An LLC can be formed by one member/manager. Delaware does not require the member/manager be listed in the document. The new IRS ruling allows the LLC to be perpetual.
- What are the Disadvantages of Operating as an LLC?
The benefits for owner-employees, such as health care or life insurance, are only partially deductible from these members' individual federal income tax returns. If you want your LLC to have a fiscal year other than a calendar year, a special election is required. There is a legal requirement for a Limited Liability Company Agreement among its members. It should be drafted by an attorney competent in corporate, contract and tax law. Tax treatment of the LLC as a corporation or partnership is going to be governed by the Agreement. And, regardless of the nature of the Agreement drafted, tax treatment is completely predictable only if you obtain a Private Letter Ruling from the Internal Revenue Service on a case-by-case basis.
- Delaware Limited Liability Company (LLC) Formation
A Delaware LLC is a membership entity formed under the authority of the Delaware Limited Liability Company Act. Any natural person, entity or association may be a member of an LLC. In order to form and organize an LLC, there must be a Limited Liability Company agreement (the 'LLC Agreement'). Generally, an LLC Agreement, which is not filed with any governmental agency, will govern the internal affairs of the LLC and the conduct of its business. While an LLC Agreement is the cornerstone of an LLC, in order to form a Delaware LLC, one or more authorized persons must also execute and file a certificate of formation. An LLC is deemed to have been formed at the time a certificate of formation is filed with the Secretary of State of Delaware.
A certificate of formation must set forth (i) the name of the LLC, (ii) the address of the registered office and the name and address of the registered agent for service of process on the LLC in Delaware, and (iii) if the LLC is to have a specified date of dissolution, the latest date on which the LLC is to dissolve, and may include any other matters that the members determine to include in the certificate. The Delaware Act requires disclosure of only the information needed to put the public on notice of the formation of the LLC. Information such as the identity of the members, their addresses, the amounts of their investment, the nature of the business of the LLC and the LLC's capital structure need not be set forth in a certificate of formation. A Delaware LLC may carry on any lawful business, purpose or activity, with the exception of the business of granting policies of insurance, assuming insurance risks or banking. An LLC Agreement should contain provisions dealing with the purposes and powers of the LLC, the powers of the LLC's members and managers and any desired restrictions on particular LLC activities.
Select the name of the Limited Liability Company. Finding a good name for your new Delaware Limited Liability Company can sometimes be the most difficult piece of the formation puzzle. Ideally, you want a name that: (i) will afford strong federal trademark protection, but will not infringe on anybody's trademark or service mark, (ii) will be easy for your customers to remember, (iii) will describe your products or services, and (iv) will allow you to obtain .com, .net., .org, .biz and .info domain names.
One way to check if your desired company name will infringe on a federally registered trademark or service mark is to search your prospective name and variations thereof on the searchable database of the United States Patent & Trademark Office.
When you have selected at least one possible company name, we will check if your prospective company name(s) is/are available in the state.
Every Delaware Limited Liability Company or LLC qualified to do business in Delaware must have and maintain a statutory agent (registered agent) located in Delaware. The purpose of a statutory agent is to give notice to the public of a person or entity authorized by the company that can be served with legal documents as the agent of the company. The statutory agent is the person or entity that can be served with a summons and complaint filed in a lawsuit. The statutory agent must have a Delaware street address rather a post office box.
Sign an Operating Agreement. When a company is owned by more than one member, LLC lawyers recommend that the members enter into an agreement called an "Operating Agreement." This is an agreement that governs how the members will deal with their LLC ownership interests and important company matters.
Operating Agreements typically deal with the following types of issues:
Requiring super majority approval or unanimous approval of members for major company decisions such as borrowing large amounts of money, entering into major contracts, amending the articles of organization, changing the capital structure of the company, hiring or firing people related to members and managers, setting compensation of key employees, and entering into contracts with related parties or companies affiliated with members or managers.
Restrictions prohibiting members from selling, encumbering or transferring their interests in the LLC without first giving the company and other members a right of first refusal to acquire the membership interest.
Rules governing rights of the company and members following a member's death, disability, divorce or incapacity. The agreement can obligate the company to purchase the interest of a deceased member or give the company and other members options to purchase the interest of a deceased member.
The acquisition of life insurance to fund the purchase of the interest of a deceased member. Fixing the value of membership interests in certain situations such as the purchase by the company of the interest of a deceased member. Requiring minority members to sell their interests when the majority of the members want to sell the company. Requiring members to cooperate if the company makes a public offering of securities. "Shot-gun" buy-out procedures that can be used to terminate the ownership of members when they cannot get along or work together.
The best and easiest time to adopt an Operating Agreement is when the company is formed. An Operating Agreement is like insurance, i.e., if you never need it, you don't miss it, but if you need it and don't have it, you may suffer greatly.
Adequate Capitalization. You must invest in the company an adequate amount of capital for the nature of the company's business. You cannot simply lend the company the money. In the case where the company is not adequately capitalized, a court may permit a creditor to look through the company and hold the owners liable for the company's obligation. Courts have held that inadequately capitalized companies can be considered to be shams. The question of how much is adequate is fact specific and should be discussed with your attorney or accountant.
- The Organisation of LLC Capital Interests
The initial members of a new LLC ordinarily make financial contributions (called "capital contributions" in business lingo) to the business to get it started. These contributions can consist of: cash, property, services, or a promise to contribute cash, property or services in the future.
In return, each LLC member normally gets a percentage of ownership in the assets of the LLC (this is called a member's "capital interest"). This interest reflects the portion of the assets of the LLC that each member is entitled to when an LLC member sells his membership interest or when the LLC itself is sold. For example, if a member has a 50% capital interest in an LLC whose assets, including goodwill, are valued at $500,000, he can expect to be paid approximately $250,000 if he asks the other LLC members to buy out his interest. Of course, a good LLC operating agreement (or buy-sell agreement) will clearly say how members' interests will be valued so that a member can anticipate how much he'll get when he sells his interest and when he'll get it (in a lump sum, in instalment payments or in a combination of the two).
If your LLC members simply contribute cash to start up your LLC, the tax considerations are straightforward. The members are not taxed on the transaction. Instead, their membership interest is given an "income tax basis" equal to the amount of cash each member invests. This tax basis will go up and down during the life of the LLC as profits and losses are allocated and paid to members and as the LLC's liabilities fluctuate. When a member finally sells his membership interest or when the LLC itself is sold, the tax basis at that time will be used to compute the amount of gain that the member owes taxes on.
Another popular way to fund an LLC is through the contribution of property. For example, a member may transfer her title (ownership document) to a piece of real estate to her LLC in return for a membership interest. Vehicles, business equipment and machinery, as well as patents and trademarks, are also commonly exchanged for membership interests. As long as other LLC members (if there are any) accept the property at an agreed upon value, there is no legal impediment to doing this. But in some circumstances, contributions of property (especially property that has appreciated in value) can lead to special tax consequences. Tax issues arise when a member contributes property that has increased in value (appreciated) since the time it was purchased, inherited or received by gift. Appreciation is most likely to have occurred on real estate (a building or land) prior to its transfer to the LLC. First - the good news. Contributions of appreciated property to an LLC are generally tax-free at the time they are made (there are some technical exceptions, of course - see just below). The not-so-good news is that a member who transfers appreciated property to the LLC must eventually pay taxes on the past appreciation (the increase in value that occurred prior to transferring the property to the LLC). Typically, the member who originally transferred the property to the LLC pays taxes on the past appreciation when his interest in the LLC, or the entire LLC itself, is sold.
- The Organisation of LLC Distributive Shares (Profit and Loss Interests)
When LLC members receive a capital interest in an LLC in exchange for cash, property or services, they are also given a share of its profits and losses, called their "distributive share." (This only applies to LLCs with pass-through taxation. Owners of LLCs that elect corporate tax treatment instead receive their share of profits as salaries or dividends.) You'll see the term "distributive share" a lot in IRS publications and tax forms.
It refers to how much of the LLC's profits and losses will be allocated to each LLC owner at the end of the year. It is a bit of a misnomer, because under the pass-through tax rules an LLC's owners are taxed on all of the profits allocated to them at the end of each LLC tax year, even if these profits are not distributed. An owner's distributive share is sometimes also referred to as his "profits interest" in the LLC. Each member's distributive share of profits and losses must be specified in the LLC operating agreement. Most often, an operating agreement will provide that each member's distributive share corresponds to his capital interest in the LLC.
One flexibility of doing business as an LLC is that the operating agreement can provide that profits and/or losses can be distributed in a manner that is not proportionate to capital interests. For example, an LLC member with a 30% capital interest could receive 40% of the yearly profits. The ability to mete out allocations of profits and losses in different ways is one of the special advantages of setting up an LLC (or a partnership). By contrast, the founders of a corporation are unable to do this sort of disproportionate profit splitting without a lot of tinkering with the standard corporate model. Splitting of profits and losses that are disproportionate to members' relative capital interests are called "special allocations" under the tax law and are subject to IRS tax rules.
Maintaining Corporate Identity. You don't need to be left out on your own to prepare the minutes of organization meeting, minutes of the first meeting, special minutes of meetings and annual minutes of meeting. You do not need to be kept in the dark about which should be dealt with immediately after you form your company and what you must tend to keep your company viable for the future. In addition to the issues discussed in the previous paragraph, there are a number of steps which you should take to preserve your corporation or LLC's identity separate from its owners: make all annual filings with the Secretary of State and pay the franchise fee on time. Operate the company under its proper name or properly filed trade name. Make sure that people dealing with your company understand that it is a corporation or LLC and that they are not dealing with you as an individual. Avoid, to the extent possible, giving personal guarantees.
Any document signed on behalf of the company should clearly indicate that the person signing is doing so as an officer of the corporation or as a member or manager of the LLC without personal guarantee. As noted above, treat the company as a separate financial entity. Payments to the company need to be documented as capital contributions, loans, compensation, dividends or loan repayments. These are items which should be enumerated in the annual minutes of the Board of Directors. Stock or Membership certificates are only evidence of ownership and not necessary for ownership. Stockholder and members are not required to be US citizens and are not required to be US residents. Ownership must appear in the company's minutes and on the transfer records. It is the better practice to issue stock or membership certificates. Any restriction on transfer must appear on the certificate to be effective against third parties. If you let employees drive their own cars on company business, make sure that both your and their insurance is sufficient and make sure that your company is listed as an "additional insured" on their policy of insurance. Do not take inconsistent positions with your insurance company (no business use) and then deduct car expenses on your company's tax return.
If you lend money to the company the company should adopt a resolution authorizing the borrowing and should issue a note. If you have a pension plan, consult your accountant or plan administrator at least annually for a review because of changes in the law or regulations. Annually review minutes and records with your attorney and accountant. Except in the case of S corporations, the company should have a written employment contract with an owner employee and the company's minutes should reflect the adoption of the contract. If an owner leases property to the company the lease should be either favorable to the company or at arms length with the owner. Rent and expense obligations need to conform to the lease to make it deductible. If you have multiple companies, steps must be taken to avoid confusion. Just as with the case of your need to maintain your company as a separate financial entity, the same must be observed with parent subsidiary relationships as well as brother sister relationships. Document all inter company transactions and maintain financial separation.
- Limited Liability Companies Taxation
Unless you choose otherwise, "pass-through" income tax status is automatic for all new LLCs. This means that all of the LLC's profits and losses "pass through" the business and are reflected and taxed on the owners' individual tax returns. The LLC is a vehicle designed to provide general limitation of liability while also permitting, if desired, U.S. federal and Delaware income-tax treatment as if the organization were a partnership. It is important to recognize that merely complying with the Delaware Limited Liability Company Act will not guarantee partnership tax treatment, since the Delaware Act is a statute that permits the members of a Limited Liability Company to determine contractually which corporate tax characteristics, if any, the Limited Liability Company will fail to possess. The Delaware Act has been drafted in such a manner, however, that partnership tax treatment should result if the drafters of an LLC Agreement do not contractually override the default provisions of the Delaware Act relating to the lack of continuity of life, centralized management and free transferability of interests.
The Internal Revenue Service has issued a Revenue Ruling addressing the federal income-tax classification of LLCs formed under the Delaware Limited Liability Company Act. The Revenue Ruling gives considerable comfort as to the federal tax treatment of Delaware LLCs. The Revenue Ruling addressed two hypothetical fact situations. In the first hypothetical, an LLC was structured so as to comply with the Delaware Act's default rules, and the Internal Revenue Service ruled that the LLC would be classified as a partnership for federal income-tax purposes. (Under the Delaware Act's default rules (i) management is vested in all of the LLC's members, (ii) the LLC's debts, obligations and liabilities are solely those of the LLC, and no member is obligated personally for such debts, obligations or liabilities, (iii) all remaining members must agree to continue the business of the LLC if the membership of a member terminates, and (iv) the assignee of a member does not become a substitute member and does not acquire all of the attributes of the member's interest in the LLC unless all of the remaining members approve the assignment.) In the second fact hypothetical, the LLC's debts, obligations and liabilities continued to be solely those of the LLC. With respect to other aspects of the LLC, however, the LLC Agreement provided that (i) management was vested in three managers elected by the members, (ii) an assignee of a member could participate in the management of the business and affairs of the LLC and become a member after the assignee merely provided the LLC with written notice of the assignment, and (iii) the LLC continued following the termination of membership of a member. The Service held that under this second hypothetical the LLC would be classified as an association taxable as a corporation (and not as a partnership) for federal income-tax purposes.
The Revenue Ruling deals with two examples at opposite ends of the spectrum and provides guidance if a Delaware LLC is structured in a manner consistent with either example. The Revenue Ruling also confirmed that the flexible nature of the Delaware Limited Liability Company Act does not preclude partnership income-tax treatment if the Delaware Act's default provisions are not followed. However, caution and careful tax analysis are strongly recommended before deviating from the Delaware Act's default rules.
Limitation Of Liability. As noted, a fundamental policy of the Delaware Limited Liability Company Act is to protect against liability to third parties of members and managers of LLCs. The Delaware Act provides that, except as otherwise provided in the Delaware Act, the debts, obligations and liabilities of an LLC, whether arising in contract, tort or otherwise, shall be solely the debts, obligations and liabilities of the LLC. In addition, the Delaware Act provides that, except as otherwise provided by the Delaware Act, no member or manager of an LLC shall be obligated personally for any debt, obligation or liability of an LLC solely by reason of being a member or acting as a manager of the LLC. Thus, regardless of the fact that a member or manager actively participates in the business of a Delaware LLC, or controls a Delaware LLC, such member or manager will not be generally liable for the debts and obligations of the LLC.
However, unlike the Limited Liability Company statutes in most states, the Delaware Act specifically provides that a member or manager may agree in a Limited Liability Company agreement or other agreement to be obligated personally for any or all of the debts, obligations and liabilities of a Delaware LLC. Although it would be unusual for a Limited Liability Company agreement to contain such a provision waiving limited liability, this flexible feature of the Delaware Act can be useful in a situation where a lack of limited liability is needed for an LLC to obtain partnership classification for income-tax purposes.
Distribution of profits to LLC members. In an unincorporated business like a partnership or an LLC, the owners share in the net profits of the business. They usually don't pay themselves a salary up-front - instead, each year (or often, each quarter), they see how much net profit remains after deducting all regular business expenses. Then they decide how much of this profit to distribute to themselves and how much to retain in the business. The next step is to calculate how much income must be allocated to each owner for income tax purposes according to each owner's "distributive share," or "profits interest," as set out in the LLC operating agreement. (See Chapter 3 if you are hazy on how this works.)
Even if some owners operate the business full-time and others (passive investors) don't work in the business at all, the working/ managing owners usually do not get a guaranteed salary. Instead, the working owners split the net profits with the passive owners according to their LLC operating agreement. In recognition of the larger contribution made by the active owners, typically the operating agreement states that they get a larger share of profits than the passive owners do. In addition, the working owners sometimes get all business profits up to a certain level, with any additional profits divided with the passive owners according to the operating agreement.
Of course, it's also possible for an LLC owner who works in the business to receive a salary. This is particularly likely in a small business that produces profits year after year, or in a business where one managing owner does all the work for a bunch of passive investors. In this scenario the working/managing owners may receive a guaranteed salary that is paid regardless of yearly fluctuations in the profit-level of the business. Since the salary is guaranteed to be paid regardless of profits, it is a business expense and can be deducted by the business in computing its net profit. This, in turn, reduces the amount of profits the other owners are allocated and taxed on (of course, the other owners also receive less profits under this scenario). The working/managing owners who are paid guaranteed salaries pay individual income taxes on the salary payouts plus, of course, their allocated share of any additional money (profits) they divide with the other business owners. But again, arrangements of this sort are the exception, not the rule, for most smaller unincorporated businesses. Before setting up a guaranteed salary for you or one of your co-owners, talk to your tax advisor.
Members pay income taxes even if they aren't paid any profits. This is a good time to step back and consider the implications of pass-through tax treatment. A big one is that, while LLC members must pay individual taxes on all LLC net profits "allocated" to them each year under their operating agreement, their LLC is not required under the tax laws to distribute all - or, for that matter, any - of the LLC's profits at the end of the year. (If it helps you grasp this concept, think of an owner's allocated profits as profits that are "earmarked" as belonging to that owner, but that may or may not actually be distributed to that owner.) It follows that even if a member's allocated profits are retained by the LLC, the member must pay income taxes on those profits as if she received them. At bottom, this is the big idea behind pass-through tax treatment - the IRS wants its income tax money each year; it doesn't want to wait until the LLC decides to put the money in the owners' pockets. If the owners were allowed to avoid taxes on profits by waiting until they felt like paying them out, you can be sure that in very good income years, when profits would cause LLC owners to be taxed in higher marginal tax brackets, owners would retain the profits in the business. Then in leaner years, when LLC owners would otherwise receive little or no income, they would pay them out so as to be taxed in lower individual tax brackets.
To deal with the potential problem of owing taxes if you don't receive a payout of profits one year (say the majority of LLC members vote to keep the money in the business), many LLC operating agreements contain a provision that says the owners must receive (actually have distributed to them) at least a minimum percentage (typically 25% to 30% or more) of their share of allocated profits each year. This minimum payout assures each owner will have at least enough cash on hand to pay individual income taxes on his share of allocated profits. (State and federal individual income taxes, after taking into account individual deductions; exemptions and credits, often reach the 25% or 30% figure.)
When it comes to actually paying out profits to the members, LLCs do have to pay attention to a few legal rules. In many states, there are financial tests that an LLC must meet before profits can be paid out. In general, a distribution of profits is valid if, after the distribution: the LLC remains solvent - that is, the LLC will be able to pay its bills; as they become due in the normal course of business, and LLC assets remain equal to or exceed LLC liabilities (or, in some states, a statute sets out a higher asset-to-liability ratio that the LLC must be able to satisfy after distributing profits).
- Reasons For a Single Member LLC in a Service Business
Asset Protection. A Limited Liability Company ("LLC") offers the same asset protection as a corporation in Delaware and almost every other state. If you sign agreements in the name of the LLC, then the LLC is the responsible party on the agreement, not you as an individual owner. If the business is not successful, or if it incurs a large unexpected debt (which you did not personally guarantee or sign for), then your other personal assets (like home, auto, investments, etc.) are protected from the LLC creditors.
In order to have the asset protection benefits of an LLC, especially a sole member LLC, the owner must observe the formalities and operate the business as an LLC. There should be adequate capitalization depending on the nature and extent of the business. The owner should have annual meetings and produce statements about the past business year and expectations for the future. The owner must be careful to enter into contracts through the LLC, and not personally. The owner should use checks and stationery to give notice to third parties that they are dealing with an LLC. These formalities are easy to observe after discussion with the lawyer and review of helpful documents which we will provide.
The single member LLC should be operated as a separate business. This is not at all difficult. The owner needs a separate business checking account, and set of books. The same should be done even if operating as a sole proprietorship. The end of year tax work can be done by an accountant quickly and efficiently if you have a separate set of books for your business. The sole member LLC will not require a separate federal income tax filing. The income tax can be reported on schedule C of your personal tax return. For federal income tax purposes the single member/owner LLC is disregarded.
Cautions. An LLC will not protect the owner against a claim based on the negligence or professional malpractice (if the owner is a licensed professional) of the owner. These types of claims are distinguished from contractual claims. The LLC will not protect the owner from LLC debts which the owner has personally guaranteed. Nor will it protect against claims against the owner who has fraudulently used the LLC for an inequitable purpose to the detriment of the claimant. Having given all these cautions, the courts in Washington understand that one of the primary features of an LLC or a single owner corporation is to limit liability, and this is a legitimate function of the corporation or the LLC.
Running an LLC can be as routine as running a corporation or partnership or other business entity. However, setting up an LLC can be complex. If the LLC will hold real estate, there will be title transfer issues such as title insurance endorsements, liability insurance coordination and review of policies, a deed to be prepared to transfer title. If the LLC will operate a business you will have to consider such matters as coordination of business license, liability insurance, transfer of assets that will be used in the LLC, and employment identification number questions. We have helped many people with their LLCs and would be pleased to assist you in setting up your LLC.
- How LLCs Report and Pay Federal Income Taxes
If your LLC has only one member (and you haven't elected corporate tax treatment), the tax reporting process is simple. The LLC itself does not have to prepare and file any tax returns. The owner simply files his regular 1040 form and attaches Schedule C, Profit or Loss From a Business, on which he reports his share of allocated LLC profits or losses, and Schedule SE, Self-Employment Tax Return, on which he figures the self-employment (Social Security and Medicare) tax he owes.
Tax tip: use a double-entry bookkeeping system. Some smaller LLCs use a single-entry bookkeeping system such as a simple business check register to keep track of their expenses and income. However, double-entry procedures help owners to organize and track the financial progress of the business better. So even if yours is a one-person or small multi-member LLC, consider setting up a double-entry system for your business.
For LLCs with two or more owners, the LLC itself must prepare and file IRS Form 1065, the same tax forms used by a partnership, unless it elects corporate tax treatment as explained in Section C, below. Since LLCs themselves don't pay income taxes on profits (their owners do), this annual partnership income return is informational only. Unfortunately, Form 1065 is a bit complicated for the uninitiated. It requires that the business use a standard double-entry bookkeeping system, with a journal of accounts that are periodically posted to a general ledger. These general ledger accounts, in turn, are used to generate an income statement and balance sheet, both of which are necessary to complete Form 1065. The form must also show a reconciliation of each owner's capital (ownership) account that shows his capital contributions and distributions as well as the allocations and distributions of profits to each owner.
Form 1065 also includes Schedule K, where the income, losses, credits and deductions allocated to all owners must be reported. And finally, the LLC must give a Schedule K-l form to each owner, on which it reports the profits, losses, credits and deductions allocated to that owner—called the owner's "distributive share." Each owner uses the Schedule K-l to prepare her individual income tax return for the year and then attaches a copy of it to her 1040.
- Member Vs. Manager Management
LLC Member-Management. The owners of most smaller LLCs choose the standard member-management approach. Again, this means that all LLC members are responsible for managing the LLC. (A few states, such as Minnesota and North Dakota, have copied terminology found in their unincorporated association statutes, and call the managers "governors.") The reason this approach makes sense is that, in most smaller LLCs, all members plan to be active in the business, and all want to be able to vote to decide how the LLC will be run.
LLC Manager-Management. Member-management, however, isn't the best choice for all LLCs. Under the other management option - manager-management - an LLC is managed by a single manager or a small group of managers consisting of: one or more selected LLC members; one or more non-members (usually either officers or outside investors), or a mixture of the two.The main reason to opt for manager-management instead of member-management is that you're planning to bring in outside investors who do not want to take a management role in your business.
Manager-management also may make sense for an LLC if: the LLC owners decide to hire a chief exec more qualified or suitable than the current LLC members to manage the LLC. The LLC wishes to give an outsider (a non-member) a vote in management (for instance, an outsider wishes to lend money to the LLC, but only on the condition that he be given a say in management decisions). To give the non-member management authority, the LLC must select manager-management and create a management group made up of the members of the LLC and the outsider. The sole member of an LLC wants to manage the business but gifts membership interests to non-managing family members, who will step into a management role only when the current owner-manager steps down.
As these bullet points indicate, the people you select as managers do not need to be owners of the LLC. You can select LLC officers and executives or anyone else you wish as a manager.
Fortunately, an LLC can easily choose manager-management to handle any of these situations. You just select manager-management in your articles (required in most states) or in your operating agreement (required in the other states). In all states, just one manager is required to manage a manager-managed LLC, but there is no limit to the number of managers you can have. In most small LLCs, managers serve for an indefinite term - that is, until the members of the LLC vote to replace or remove them. Typically, LLC operating agreements allow an LLC manager to be removed or replaced for any or no particular reason upon the vote of the full membership (non-managing members as well as managing members). Another way of saying this is that state law lets LLC members decide for themselves when managers can be removed. Some larger LLCs, however, prefer to have managers serve for a definite term, such as one year, at the end of which the members re-elect or replace the managers. This procedure is usually only used in more formal LLCs with at least several outside investors (who are non-managing members). That's because, unlike corporations, where shareholders re-elect or replace the board of directors each year, most LLCs choose not to deal with the formality of a periodic review and election of managers, unless they have outside investors who demand it. In fact, most LLCs pick an initial management team and stick with it for the long term, unless there is a problem and one or more managers need to be replaced.
Manager-management will not affect limited liability. In a manager-managed LLC, all members, managing as well as non-managing, get to keep their personal liability protection. Note that this is a fundamentally different approach than the liability protection that applies to limited partnerships, where at least one general partner must be personally liable for partnership debts and liabilities.
If you do choose to go the manager-management route, it's important to realize that state law still leaves certain voting rights in the hands of the non-managing members. As just mentioned, LLC members have the right to remove and replace managers. Also, non-managing members have the right to approve fundamental changes to the LLC and its membership, including the power to amend the articles or operating agreement of the LLC, to merge or dissolve the LLC, to approve or deny the admission of new members and to approve or deny the transfer of an LLC membership from an existing member to an outsider.
Members who don't work in or manage the LLC do not pay self-employment taxes. Under current IRS regulations, LLC members who are not active in the business should be able to avoid paying self-employment taxes on their share of allocated LLC profits. This is because the IRS does not consider non-managing members' profits to come from their own efforts, but from the work of others. If you choose manager-management for your LLC, ownership interests in your LLC may be classified as securities because some owners will be investing their money in a business that they're not actively participating in - again, they'll expect to make money from the efforts of others.
- LLC vs. Corporations
A major problem with a corporation is that the creditors of any shareholders can become shareholders, absent any restrictive transfer provisions in the corporate by-laws or buy/sell agreements between the shareholders. If a creditor gets a controlling interest in a corporation, the creditor can then force a liquidation of the corporation. With a LLC, creditors may be able to get some of the rights of members (similar to a charging order) but they can't become full members without the consent of the other members, as specified in the operating agreement of the LLC.
While you can avoid double taxation with an S corporation, the LLC isn't subject to the numerous tax law restrictions and limitations that apply to S corporations. A major problem with S corporations is that the shareholders must be individuals or certain types of trusts (as provided in tax code section 1361). With a LLC, the business can be partly owned by a trust that can provide substantial flexibility in arranging the distribution of income or the eventual distribution of the family business. In addition, the LLC doesn't require quite as much operating formality as a corporation. The LLC also offers some partnership tax benefits not available to an S co
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