A Limited Liability Company (LLC) can be a great way to protect hard earned assets. A common use for an LLC is for the protection of real estate such as rental or income property. Placing the property in an LLC will shield you from personal liability if something, such as an injury, happens on the property. Also, the property will be shielded from liability created by you personally.
What is a Limited Liability Company?
The LLC is not a partnership or a corporation. It is a distinct business entity that offers an alternative to partnerships and corporations by combining the corporate advantages of limited liability with the partnership advantage of pass-through taxation.
What are the advantages of an LLC?
These are just a few of the many advantages that LLCs offer:
- Pass-Through Taxation - LLCs allow for pass-through taxation. This means that earnings of an LLC are taxed only once. The earnings of an LLC are treated like the earnings from a partnership, sole proprietorships and most S corporations.
- Limited Liability - The LLC owner's liability is generally limited to the amount of money which the person has invested in the LLC. Thus, LLC members are offered the same limited liability protection as a corporation's shareholders.
- Flexible Management Structure and Flexible Ownership is Permitted - Like general partnerships, LLCs are generally free to establish any organizational structure agreed on by its members. Thus, profit interests may be separated from voting interests.
What are the disadvantages of an LLC?
Some of the disadvantages of an LLC include:
- More Paperwork Than an Ordinary Partnership - Documents must be filed at the state level to create an LLC, which is not the case with a general partnership
- Dissolution Date - Some states require that a dissolution date be listed in the articles of organization. This date may be amended. Further, certain events, such as death of a member, a member leaving, bankruptcy, etc. can be a dissolution event. A corporation has unlimited life and this events are not dissolution events for a corporation.
- Newer Entity Type - The LLC is a newer entity, and people are not as familiar with the LLC as a corporation.
Should I choose an LLC or an S corporation?
While the S corporation's special tax status eliminates double taxation, it lacks the flexibility of an LLC in allocating income to the owners.
An LLC may offer several classes of membership interests while an S corporation may only have one class of stock.
Any number of individuals or entities may own interests in an LLC. However, ownership interest in an S corporation is limited to no more than 75 shareholders. Also, S corporations cannot be owned by C corporations, other S corporations, many trusts, LLCs, partnerships or nonresident aliens.
LLCs are allowed to have subsidiaries without restriction. S corporations are not allowed to own eighty percent or more of another corporation's shares.
What is the organizational structure of an LLC?
An LLC is owned by its members. They are analogous to partners in a partnership or shareholders in a corporation, depending on the how the LLC is managed. A member will more closely resemble shareholders if the LLC utilizes a manager or managers because then the members will not participate in management. If the LLC does not utilize managers, then the members will closely resemble partners because they will have a direct say in the decision making of the company.
A member's ownership of an LLC is represented by their "interests," just as partners have "interest" in a partnership and shareholders have stock in a corporation.
How is an LLC managed?
An LLC may be managed by its members (owners) or by selected managers.
If the LLC is to be managed by its members, it operates much like a partnership. Each member has an equal say in the decision making process of the company.
If the members choose, they may elect a manager or managers to act in a capacity similar to a corporation's board of directors. These managers are in charge of the affairs of the corporation.
Member management is the normal default rule of state law. This means that if managers are not selected in the articles of organization the members will direct the affairs of the LLC
Taxation of LLCs
One owner LLCs are treated the same as sole proprietorships. Profits are reported on Schedule C as part of your individual 1040 tax return. Self-employment taxes on LLC net income must be paid just as you would with any self-employment business.
Multiple owner LLCs are treated as a partnership by the IRS. The tax return that the LLC completes and files is IRS Form 1065, Partnership Information Return. On this form, LLC profits are reported and allocated to each of the owners according to the LLC's operating agreement. Each owner is given a Schedule K-1, which shows each owner's share of LLC income or loss. The owner then reports and pays taxes on this income on the owner's annual 1040 income tax return.
Please note that as with a sole proprietorship, all profits of the LLC are taxed to the owners, even if they are not actually distributed by the LLC. This situation could happen when the LLC needs to use its profits to meet ongoing expenses.
There is a possible third tax treatment that an LLC could elect if it did not want pass-through taxation. The LLC may elect to be taxed as a corporation by completing IRS Form 8832 and checking the corporate income tax treatment box. After making this election, the LLC is taxed as a C corporation by the federal government. Because the corporate income tax rates for the first $75,000 of corporate taxable income are lower than the individual income tax rates that apply to the taxable income of non-corporate taxpayers, it is possible a net income tax savings can result from this tax election.
The state income tax treatment of LLC profits typically mirrors the IRS tax treatment as discussed above. Some states have different rules and for specific information on your state rules visit your state's web site. The web address can be found on our detailed state information page.
Please note that California LLCs are subject to a annual minimum franchise tax of $800 per year. The first payment must be made within 3 months of forming your LLC. The state of California does send a bill to help you make this payment.
