Limited liability companies (LLCs) operate as a cross between a partnership and a corporation. The owners, known as members, enjoy the protection that a corporation's shareholders receive against the company's debts. They also have the operating freedom that the owners of partnerships and sole proprietorships receive. Since their introduction in the 1970's, limited liability companies have been a popular choice when starting a small business.
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The concept of a limited liability company is not a creation of the IRS. Instead, they are entities designed by the states on their own terms. The LLC exists as a method of encouragement for small business owners and entrepreneurs by offering them protection from some of the liabilities of being in business, fewer operating restrictions than corporations and the tax benefits of corporations or partnerships.
As the name suggests, limited liability companies enjoy limited liability. This means the company's members, who are similar to a corporation's shareholders, are not liable for all the debts of the business in the event that it goes bankrupt. Unlike a corporation, which can theoretically last forever, LLCs have a limited lifespan of around thirty years, although this varies from state to state; members can also address this issue in the LLC's operating agreement.
The LLC is a creation of the states without the involvement of the IRS. Consequently, there is no separate tax classification for an LLC. LLCs are, therefore, usually classified as “disregarded entities” when owned by a single member, who is taxed as a sole proprietor, while multi-member LLCs are taxed as partnerships. Each can file a request to be classed and taxed as a corporation, however.
The benefit of limited liability is not absolute. Courts may remove liability in some circumstances, such as where limited liability has been used to avoid repayment of a debt. The process is sometimes referred to as “lifting the veil.” Similarly, some creditors, especially when dealing with new LLCs, will demand members personally guarantee credit using their own assets, which negates limited liability entirely with respect to the debt in question.