A limited liability company (LLC) is a flexible form of enterprise that blends elements of partnership and corporate structures. It is a legal form of company that provides limited liability to its owners in the vast majority of United States jurisdictions. LLCs do not need to be organized for profit.
Often incorrectly called a “limited liability corporation” (instead of company), an LLC is a hybrid business entity having certain characteristics of both a corporation and a partnership or sole proprietorship (depending on how many owners there are). An LLC, although a business entity, is a type of unincorporated association and is not a corporation. The primary characteristic an LLC shares with a corporation is limited liability, and the primary characteristic it shares with a partnership is the availability of pass-through income taxation. It is often more flexible than a corporation, and it is well-suited for companies with a single owner.
It is important to understand that limited liability does not imply that owners are always fully protected from personal liabilities. Courts can and sometimes will pierce the corporate veil of corporations (or LLCs) when some type of fraud or misrepresentation is involved.
Flexibility and Default Rules
The phrase “unless otherwise provided for in the operating agreement” (or its equivalent) is found throughout all existing LLC statutes and is responsible for the flexibility the members of the LLC have in deciding how their LLC will be governed (provided it does not go outside legal bounds). State statutes typically provide automatic or “default” rules for how an LLC will be governed unless the operating agreement provides otherwise.
Similarly, the phrase “unless otherwise provided for in the bylaws” is also found in all corporation law statutes but often refers only to a narrower range of matters.
Advantages of LLCs
- Check-the-box taxation. An LLC can elect to be taxed as a sole proprietor, partnership, S corporation, or C corporation (as long as it would otherwise qualify for such tax treatment), providing for a great deal of flexibility.
- Limited liability. The owners of the LLC, called “members,” are protected from some or all liability for acts and debts of the LLC depending on state shield laws.
- Less administrative paperwork. LLCs demand less record keeping than a corporation.
- Pass-through taxation (i.e., no double taxation). This applies unless the LLC elects to be taxed as a C corporation. Using default tax classification, profits are taxed personally at the member level, not at the LLC level.
LLCs in most states are treated as entities separate from their members, whereas in other jurisdictions case law has developed deciding that LLCs do not have separate legal standing from their members.
LLCs in some states can be established with just one natural person involved. It is less likely to be “stolen” by fire-sale acquisitions and provides more protection against “hungry” investors. For real estate companies, each separate property can be owned by its own, individual LLC, thereby shielding not only the owners but also their other properties from cross-liability.
Disadvantages of LLCs
- Although there is no statutory requirement for an operating agreement in most states, members of a multiple member LLC who operate without one may run into problems. Unlike state laws regarding stock corporations, which are very well developed and provide for a variety of governance and protective provisions for the corporation and its shareholders, most states do not dictate detailed governance and protective provisions for the members of a limited liability company. Thus, in the absence of such statutory provisions, the members of an LLC must establish governance and protective provisions pursuant to an operating agreement or similar governing document.
- It may be more difficult to raise financial capital for an LLC, as investors may be more comfortable investing funds in the better-understood corporate form with a view toward an eventual initial public offering. One possible solution may be to form a new corporation and merge into it, dissolving the LLC and converting into a corporation.
- The District of Columbia considers LLCs to be taxable entities, thus eliminating the benefit of flow-through taxes by subjecting members to double taxation. Typically, LLCs will choose to be taxed as a partnership to avoid double taxation, which occurs in corporations. This allows companies to distribute their income among members who then report it on their personal tax returns.
- Renewal fees may also be higher. Maryland, for example, charges a stock or nonstock corporation $120 for the initial charter, and $100 for an LLC. The fee for filing the annual report the following year is $300 for stock corporations and LLCs and zero for non-stock corporations. In addition, certain states, such as New York, impose a publication requirement upon formation of the LLC requiring members of the LLC to publish a notice in newspapers in the geographic region that the LLC will be located to announce its formation. For LLCs located in major metropolitan areas, the cost of publication can be significant.
- The management structure of an LLC may be unfamiliar to many. Unlike corporations, it is not required to have a board of directors or officers. (This can also be seen as an advantage to some.)
- Taxing jurisdictions outside the United States are likely to treat a U.S. LLC as a corporation, regardless of its treatment for U.S. tax purposes (e.g., if a U.S. LLC does business outside the U.S. or a resident of a foreign jurisdiction is a member of a U.S. LLC).
- The principals of LLCs use many different titles (e.g., member, manager, managing member, managing director, chief executive officer, president, or partner). As such, it can be difficult to determine who actually has the authority to enter into a contract on the LLC’s behalf.
For U.S. federal income tax purposes, LLCs are treated by default as a pass-through entity. If there is only one member in the company, the LLC is treated as a “disregarded entity” for tax purposes, and an individual owner would report the LLC’s income on his or her individual tax return. For LLCs with multiple members, the LLC is treated as a partnership and must file IRS Form 1065. The members of the LLC would be treated as partners and each would receive a K-1 reporting the share of the LLC’s income or loss on that member’s tax return.
As an option, LLCs may also elect to be taxed as a corporation by filing IRS Form 8832. They can be treated as a regular C corporation (taxation of the entity’s income prior to any dividends or distributions to the members and then taxation of the dividends or distributions once received as income by the members), or an LLC can elect to be treated as an S corporation. Some commentators have recommended an LLC taxed as an S corporation as the best possible small business structure. It combines the simplicity and flexibility of an LLC with the tax benefits of an S corporation (self-employment tax savings).