LLC Explained

By Rob Jennings J.D.

A limited liability company (LLC) is a type of company that exhibits characteristics of both partnerships and corporations. Like a corporation, an LLC has a legal existence separate from that of its owners, who are called "members." Like a partnership, though, it avoids the double taxation problem that frequently accompanies corporations. Limited liability, flexibility in tax treatment and simplicity of operation have made the LLC a popular choice for small business start-ups.

Limited Liability Protection

The members of an LLC enjoy protection from the torts, or civil wrongs, committed by other members or employees of their company. With traditional partnerships, the partners can be responsible for the acts not only of their employees, but also the other partners. In an LLC, employees and members acting in the course of business are considered agents not of the individual members, but rather of the company. This protection is often referred to as the "limited liability shield," akin to the "corporate veil" of a corporation. The limited liability shield does not, however, protect a member from liability for his own acts.

Taxation

LLC members also enjoy a level of flexibility in taxation that is not available to the shareholders of all corporations. Under current law, a multi-member LLC can elect taxation as either a corporation or a partnership and a single-member LLC as either a corporation or a "disregarded entity," which essentially means "sole proprietorship." For an LLC, sole proprietorship and partnership taxation mean that the company's profits are reported on the members' individual returns. With traditional corporations, company profits are taxed once at the corporate level and again on the shareholder level. This "double taxation" is one reason some entrepreneurs choose to organize as an LLC.

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Flexibility in Membership

While limited liability and pass-through taxation are available to shareholders in a corporation that files under Subchapter S of the Internal Revenue Code, not every company will qualify as an S corp. Under current IRS regulations, partnerships, corporations, LLCs and nonresident aliens cannot be shareholders of an S corp. Although individual state law controls the rules applicable to LLCs, membership in LLCs is generally far more open, allowing corporations, partnerships and existing LLCs to add another level of ownership and limited liability by becoming members in a new LLC.

Transferability

For many, the main limitation of the LLC concerns the transferability of ownership interests. Operating agreements often prohibit the sale or transfer of a membership interest, and in places where sale is allowed, the member may only be able to transfer the economic benefits--the profit sharing--of the interest and not management or voting rights. Also, individual state law may dissolve an LLC upon a member's death or bankruptcy, with even more stringent transfer restrictions applying to single-member LLCs. Shares in a corporation, on the other hand, are generally transferrable and inheritable. The company continues on even after the death of a shareholder.

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What Are the Tax Advantages of LLCs?

References

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