LLCs are more flexible in structure and operation than corporations; they are not subject to double taxation and offer limited liability protection for their investors. Nevertheless, certain potential pitfalls are inherent in the LLC form of business organization. Proper planning and an understanding of how LLCs work can help businesses avoid these pitfalls.
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The Operating Agreement
Since no states require LLCs to use operating agreements, many LLCs operate without one. If a dispute arises, two types of problems may occur: First, state default rules may kick in, resulting in unintended consequences. For example, state law may provide for equal voting rights for each member regardless of capital contributions unless an operating agreement provides otherwise. Second, state law may not regulate the matter in dispute at all, rendering it difficult to apply any standard at all. Every LLC with more than one member should draft and execute a comprehensive operating agreement that clearly spells out financial and management policies.
The Taxation Decision
Unless an LLC elects to be treated as a corporation for federal tax purposes, the LLC itself will not be subject to federal taxation, and all of its income will be deemed to pass through the LLC directly to its members in proportion to each member's allocation of LLC's profits and losses. This becomes a problem when the LLC fails to distribute much income to its members during a given tax year -- members are taxed on income they do not receive. If the LLC elects to be taxed as a C corporation, members will be taxed only on distributions, but the LLC itself will be taxed at corporate tax rates, resulting in double taxation of distributions. If the LLC qualifies as an S corporation and elects to be taxed accordingly, the LLC will not be taxed, except on passive income and members will be subject to individual income tax on all LLC income, but will be assessed self-employment tax only on distributions. Because of its complexity, the taxation decision is individual to each LLC.
Preserving Limited Liability
Although LLCs generally enjoy limited liability, an LLC can be stripped of limited liability if it acts in a manner inconsistent with this status. Furthermore, members remain personally liable for their own negligent acts and omissions during the course of business. The LLC should establish a bank account in its own name and avoid mingling LLC assets with member assets. Members should obtain liability insurance to protect them against their own negligence.
Every state requires out-of-state LLCs to register before doing business within the state. Some states will impose a flat annual fee for this privilege, while others will tax out-of-state LLCs on income derived from activity within the state. Some states tax LLC income only above a certain threshold. If the LLC operates nationwide, it might find its tax accounting complicated by the tax law of dozens of different jurisdictions. It might also find that its name, while unique in the state of its formation, is not unique in another state, resulting in the need to operate under different names in different states. It is important to research state law to determine exactly what type of activity qualifies as "doing business" there.