Choosing a Business Entity: The Limited Liability Company May Be the Answer

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Partnerships and LLCs

Choosing a Business Entity: The Limited Liability Company May Be the Answer

When a client consults The Busch Firm regarding what form of entity to use for their business, the answer more often than not is a limited liability company (“LLC”). An LLC is a form of entity that has been recognized in California for a number of years and its use is becoming more commonplace for a number of good reasons. The LLC combines some of the best characteristics of a corporation and a partnership. It is a separate existing legal entity which provides the same liability protection for the benefit of its members as a corporation does for its shareholders. However, it can elect to be taxed like a partnership which eliminates income tax at the entity level and avoids double taxation that may result from the use of a corporation.

Limited Liability. Like a corporation, an LLC provides liability protection for all of its members. This means that the members of an LLC will normally not have any personal liability for the debts or obligations of the LLC. This benefit is not available in a general partnership, where all the partners have personal liability for partnership obligations, or even a limited partnership, where the limited partners have limited liability but the general partner (or, for that matter, any partner who actively participates in the management or operation of the partnership), may have personal liability.

Tax Advantages. Like a partnership, an LLC is generally not subject to Federal or California income tax. The IRS recently adopted regulations which greatly simplify the steps required for an LLC to qualify to be taxed as a partnership. The regulations now allow an LLC to choose whether to be taxed as a corporation or as a partnership by checking a box on a form. By electing to be taxed as a partnership, an LLC may avoid income tax at the entity level and all of the LLC’s items of income, gain, loss, and deduction pass through to the members. This feature in an LLC can achieve significant tax savings to the Members overtaxes paid by a company and its shareholders operating as a C corporation. While a corporation may avoid paying entity level income tax by making an S election, there are restrictions on the number and type of shareholders that may own stock in the S corporation, and further, an S corporation may have only one class of stock. These restrictions make an LLC more flexible from a structuring standpoint. An LLC doing business in California is required to pay an annual franchise tax of $800 plus a statutory fee of $500 to $4,500 in any year in which the LLC’s gross revenues are $250,000 or more.

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.” An LLC 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. 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 LLC may adopt a corporate style of management structure with a board of “managing directors.” The Board may then appoint a president, CFO and secretary.

Some states, but not California, allow a one-member LLC which can provide liability protection to someone currently operating their business as a sole proprietorship.

In summary, the use of an LLC can give business owners the same liability protection they would get in a corporation, can provide the flow-through tax benefits of a partnership and can accommodate simple or complex business arrangements. Please note, however, all situations are different and should be separately analyzed. In some circumstances, a C corporation, S corporation or limited partnership may be the entity of choice. For instance, a C corporation may be the best choice for a business contemplating a public offering.