Is There a Limited Liability Company in Your Future?
In 1994 New Jersey provided by statute for the organization of limited liability companies ("LLCs"). Prior to that date many other states had enacted legislation to allow for the creation of limited liability companies but their popularity didn't blossom until 1988 when the Internal Revenue Service issued a Revenue Ruling as to how these new entities would be taxed.
A LLC is a hybrid form of doing business that combines characteristics of the corporate structure and the partnership structure. It is a separate entity like a corporation and therefore carries liability protection for all of its' members, but (if structured properly) is taxed like a partnership where the benefits flow through to the individual partners.
The owners of an LLC are called members. Members can be virtually any entity including individuals (residents or foreigners), corporations, other LLCs, trusts, pension plans etc. New Jersey even permits a one member LLC. If there is only one member and no employees an LLC does not need a taxpayer identification number but rather uses the sole member's social security number.
An LLC is formed by filing a form, usually called a Certificate of Formation, within the appropriate state authority. Most states require an annual report be filed to keep them apprised of current status, but other than that, no other ongoing reports or forms are mandated. The LLC is not a tax paying entity. Profits, losses etc. flow directly through to and are reported on the individual members tax returns. The LLC files an informational return under Subchapter K of the Internal Revenue Code.
Most states require that the LLC have an Operating Agreement of some kind and a written, carefully drafted one is the prudent practice. The Operating Agreement is the agreement between the members as to how the LLC will be managed and contains provisions that will qualify it for partnership tax treatment. Other provisions deal with the capital contributions from members, future contributions, restrictions on member's authority, transfer of membership interests and dissolution.
Small businesses or a single individual business person who wishes liability protection and a simple tax structure can also benefit from forming an LLC. Usually ownership interests in an LLC are stated as a percentage of the company's capital as in a partnership. Control can be vested in one member or in several members requiring all or some of the members to approve all business decisions. LLC interests may be transferred according to the terms of the Operating Agreement but usually there are some restrictions as to transferability which might include a right of first refusal for the remaining members. There may be concerns about what happens if a member dies or becomes disabled and wishes to have his/her interest purchased by the other members of the LLC.
So why are LLC's useful? For real estate investors they allow an individual or group to own real properties and have personal protection against claims which might arise by virtue of owning the investment. An LLC would offer protection from claims by creditors, mortgage lenders or catastrophic losses on account of fire, explosion, building collapse or environmental contamination.
In estate planning, many people consider a family limited partnership which pools various family assets as a means to transfer wealth from one generation to another. An LLC can serve as the General Partner of a family limited partnership or it can stand alone as the transferring entity. In such a case the General Partner of the limited partnership would have added protection from liability claims and lawsuits.
Besides liability protection a key issue for LLC organizers is to determine whether the LLC qualifies for partnership tax treatment or whether it is too much like a corporation. Fortunately, there is a test and it boils down to four basic characteristics that corporations have. The LLC can only have two and still retain its partnership tax status. They are limited liability, continuity of life, centralized management and, free transferability of interests. Selecting the two that your LLC will have and making sure you don't have three is the tricky part and where the importance of proper drafting of the Operating Agreement comes in. The IRS has approved a simplified process called "Check the Box", wherein the LLC organizer can just elect what tax treatment is preferred. Not all states have adopted "Check the Box" and currently the safest way to organize is to comply with the original guidelines with respect to corporate characteristics.
The LLC would be a good choice for many businesses particularly those that distribute their income and the owners are not active in the business. While retaining income in a C Corporation does not result in permanent tax deferral, businesses that reinvest their earnings are better candidates for C Corporations. In addition, if salaries to owners eliminate all taxable income, an LLC has no tax advantage over a C Corporation. Owners of businesses that have losses, however, do get pass through treatment in an LLC, unlike a C Corporation.
Call us to further explore the choices of organizational form available to new and existing businesses.
