What You Need to Know About LLCs

by David Carnes
LLCs are often small businesses.

LLCs are often small businesses.

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The limited liability company, or LLC, was created by state governments in response to concerns that corporations were cumbersome business vehicles with unfavorable tax structures, while partnerships and sole proprietorships were flexible and informal but lacked limited liability. The LLC form is not for every company, however. Before establishing an LLC, It is important to understand the consequences.

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Limited Liability

One of the advantages that LLCs have over partnerships and other unincorporated business forms is limited liability protection for investors. This means that creditors of the LLC cannot sue you for the LLC's debts, even if the LLC cannot satisfy them. This limitation is not absolute, however; if the LLC acts in a way that is inconsistent with its grant of limited liability, a court might strip the LLC of limited liability, opening the way for creditors to sue all LLC members in their personal capacity.The LLC must present itself to the public as a limited liability entity, refrain from commingling company and personal assets, and keep the LLC reasonably well funded. Despite limited liability, LLC members can be held personally liable for damages caused by their own negligence in furtherance of LLC business.

Pass-Through Taxation

The IRS and some state governments will not tax LLCs. Instead, LLC income is attributed to each member in proportion to that member's stake in LLC profits and losses. However, members will be taxed on all LLC income, minus applicable deductions, even if the LLC does not distribute any of its income to its members. For example, if the LLC earns $200,000 and buys office space with it, and you have a 50 percent stake in the LLC, you will have to report $100,000 in LLC income as your personal income, even though you received no personal income from the LLC. If you actively participate in the business of the LLC, you must pay a self-employment tax of up to 15.3 percent instead of Social Security and Medicare taxes.

Operational Flexibility

Unlike a corporation, an LLC does not have to appoint a board of directors or keep minutes of meeting. It may be managed by members or non-members. You may assign your interest in the LLC to another, and you may assign the economic rights of your shares while reserving voting rights. Some restrictions apply, however: for example, in some states an LLC may not require the unanimous consent of members in order to dissolve the LLC.

Corporate Taxation Options

Since members are taxed on undistributed LLC income, an LLC may find it advantageous to be treated as a corporation by the IRS. The IRS will allow any LLC to be taxed as a C corporation, and qualifying LLCs to be treated as S corporations. If the LLC is taxed as a C corporation, you will be taxed on distributions only, but the LLC will also be taxed at corporate tax rates. If the LLC is treated as an S corporation, the LLC will not be taxed. Income tax will be assessed against you even if income is not distributed, but self-employment tax will be assessed only on distributions.