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Limited Liability Company

The limited liability company is a relatively new and unique form of business organization created under state laws. The limited liability company (LLC) combines the corporate characteristic of limited liability with the conduit tax treatment of partnerships. Like a corporation, an LLC is created by following the requirements of state law. It is treated as a legal entity, separate from its individual owners, and is recognized as the owner of the trade or business property.

"Member" is the term generally used to refer to individuals or other organizations with an ownership interest in an LLC and the right to manage it. This reduces confusion since owners of a partnership are called partners, and owners of a corporation are called shareholders. It is possible, however, to have in effect two classes of ownership interests in an LLC. An individual or other organization owning an interest but not the right to manage is simply called an owner. This provides the organizational flexibility of a limited partnership. Most states also allow the centralization of management in the hands of a few members, or by non-members.

Like an S corporation an LLC provides pass-through of capital gains, tax credits, and other tax items from the business to the member's individual tax return. They both also provide liability protection for the members. The liability protection in an S corporation comes from incorporation. Its pass-through comes from qualifying for and making the election to be taxed as a partnership. These two benefits can also be achieved with a limited partnership, however, only limited partners get both. The cost to limited partners is not being involved in the management of the business.

A LLC provides complete pass-through, limited liability, and management participation by all "members"

Chartered by state - An LLC is formed by filing articles or organization with your state, usually the same office where you would file articles of incorporation. The entity must have two or more members, have an objective to carry on a business, and establish a specific method for dividing the profits and losses from the business. LLC's conducting business outside the state of organization may also need to file for certificate of authority to transact business with the other states in which they intend to conduct business. Once approved by the appropriate state office an LLC becomes a legal entity separate from its members. It may own property, incur debts and enter into contracts, and sue or be sued. An ownership interest in an LLC is personal property, not an interest in real estate, even if the LLC's principal assets are land and timber.

Partnership tax treatment - Treatment of an LLC as a partnership for Federal income tax purposes is based on long-standing criteria distinguishing an activity by whatever name that has a majority of the characteristics of a corporation from one that doesn't. An organization having a majority of the characteristics of a corporation is taxed as a corporation, regardless of what it's called. Thus, an LLC's treatment as a partnership for tax purposes generally requires including in the articles of organization restrictions on the transfer of membership. The typical restriction is to require consent of the other members for transfers of interest.

LLC also usually don't have the corporate characteristics of perpetual life, although some states allow it. Your attorney can discuss with you how the statutes authorizing LLC's in your state match the Internal Revenue Code requirements to be taxed as a partnership. If the statute is "bullet proof" complying with it will assure taxation as a partnership. If your state's statute is "flexible" your articles of organization would have to be crafted to assure partnership treatment. Most states are flexible.

As a partnership an LLC files IRS Form 1065 for federal income tax purposes and the corresponding state tax form, if any. All LLC members are treated as partners. No distinction is made between general and limited partners. Distributions of income, losses, tax credits, and other items are usually based on the value of each members capital contribution.

The tax accounting process for partnerships is quite burdensome and complex. The concern isn't the rules for determining annual net income, it's the rules for partner's basis and resulting distributions that can get complex. If you currently do your own tax accounting read through IRS Publication 541 before becoming a partnership's or LLC's accountant.

When LLC's are not appropriate - LLC's are not suitable for a large number of owners. The requirement to obtain consent when ownership interests are transferred is the main concern. In such cases a limited partnership, or some combination of partnership, or an LLC or S corporation combined with a partnership might be better.

LLC's are not suitable for one owner. Although some states allow single member LLC, the IRS has indicated it won't consider such an entity to be a partnership for tax purposes.

The LLC is a relatively new entity in the United States, and as such little case law has been established in either state or federal courts. Thus, there is some uncertainty as to how state courts will interpret the statutes in the context of limited liability and how the federal courts will apply the Internal Revenue Code to LLC's. Whenever in doubt consult your attorney if you think an LLC might be appropriate for you.