LLC Issues & Questions

by David Carnes
LLCs offer flexible and informal operational structures.

LLCs offer flexible and informal operational structures.

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The limited liability company, or LLC, was first introduced in the late 1970s and created by state law. It offers three main advantages: limited liability, multiple taxation options, and relaxed rules of structure and operation. It is important to understand how an LLC works in order to maximize its advantages and minimize its disadvantages.

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Operating Agreements

State regulation of the structure and operation of LLCs is not nearly as dense as it is for corporations and most states do not require LLCs to execute operating agreements. However, the lack of an operating agreement could lead to internal disputes that might be difficult to resolve. In particular, states have enacted default rules concerning the structure and operation of LLCs that apply only if the LLC has not addressed the issue in an operating agreement. Some state default rules state that each member is entitled to one vote, for example, regardless of a member's relative capital contributions. An LLC should execute an operating agreement that addresses all pertinent issues of structure and operation.

Self-Employment Tax

LLCs themselves are not taxed by the IRS unless they opt to be taxed as corporations. LLC members, however, can be assessed self-employment tax on LLC income that is attributed to them, amounting to as much as 15.3 percent of their allocated share of LLC income in some tax brackets. Furthermore, LLC income is allocated among members in proportion to their allocated shares of LLC profits and losses, even if the LLC distributes no income to its members during a given tax year. This means that LLC members can end up paying self-employment tax on income they do not receive. In response, qualifying LLCs sometimes opt to be treated as S corporations by the IRS, so that they will be liable for self-employment tax only on distributions that they receive from the LLC, yet avoid the double taxation of distributions that LLCs taxed as C corporations face.

C Corporation Taxation

Even though LLCs that opt to be treated as C corporations are taxed at corporate tax rates by the IRS, resulting in double taxation of dividends when the member receives them as his personal income, the IRS will not assess individual income tax or self-employment tax on any undistributed LLC income. Thus, the decision of whether or not C corporation taxation will lower the federal tax burden on LLC income depends on a comparison between how much corporate tax the IRS assesses and how much tax members save by avoiding taxation of undistributed LLC income.

Limited Liability

LLC members are liable for LLC debts only to the extent of their capital contributions -- generally, LLC creditors cannot come after their personal assets. A member's personal assets might be placed at risk, however, under two circumstances: First, an LLC might be stripped of limited liability if it presents itself to potential creditors in a manner that leads them to rely on the personal assets of the members to satisfy its debts, for example, by exclusively using a trade name that omits the term "LLC" or "limited liability company. Second, a member may become liable for acts of personal misconduct or negligence committed in furtherance of LLC objectives.