Limited Liability Corporation

A limited liability company, or LLC, has several features that create favorable tax treatments, as well as protection an owner from personal liability. Since the status of the LLC form of organization varies somewhat from state to state, be certain to find out how your state's law applies.

An LLC allows for multiple owners, or members, who enjoy limited liability, as well as a managing member, who also enjoys limited liability and typically is the person responsible for managing the business. The profits or losses of the business pass directly through to the owner's personal income tax return, Form 1040. The LLC files a Form 1065, and then lists each member's taxable profit on Form K-1. The bottom-line profit of the business is not considered to be earned income to non-managing members, and therefore is not subject to self-employment tax.

Advantages Of An LLC

An LLC allows for an unlimited number of members; however, if the LLC has just one owner, it will be taxed as a sole proprietorship.
The LLC allows for the "special allocation" of profits--the disproportionate splitting of member profits and losses (in different percentages than their respective percentages of ownership). This means that members can enjoy the benefits of receiving profits (and writing off losses) in excess of their individual ownership percentage.
The members enjoy limited liability, which means they are personally protected from any liability of the LLC and successful judgments, as well as from the LLC itself.
A managing member's share of bottom-line profit is considered earned income because the managing member is considered to be an active owner--therefore qualifying the managing member for special "fringe benefit" treatment.
A non-managing member's share of the bottom-line profit of an LLC is not considered earned income, and therefore is not subject to self-employment tax.
Members are compensated using either distributions of profit or guaranteed payments. A distribution of profit allows each member to pay themselves by merely writing checks--whenever they need the money (provided the business has the available cash). Guaranteed payments represent earned income to the members, thereby qualifying them to enjoy the benefits of tax-favored fringe benefits.
The managing member of an LLC can deduct 100 percent of the health insurance premiums he or she pays--up to the extent of their pro-rata share of the LLC's net profit, because the profit is considered earned income. Note: If a member has earned income, he or she will also qualify.
A corporation can be a member of an LLC. This allows you to create an additional level of ownership, which is designed to create an entity that can offer such traditional fringe benefits as retirement plans and an additional level of protection from liability.
As a member, you can contribute capital or other assets to the LLC, or loan the LLC money to put dollars or value into the business. You can take dollars out by taking a repayment of your loan (plus interest), a distribution of profit or a guaranteed payment. If any of the members die, the LLC can continue to exist--subject to the unanimous positive vote on the part of all remaining members.

Disadvantages Of An LLC

Each member's pro-rata share of profits represents taxable income--whether or not the profit is distributed to him or her.
The managing member's share of the bottom-line profit of the LLC is considered earned income, and therefore is subject to self-employment tax.
The non-managing members' share of bottom-line profit is not considered earned income because the members are considered to be inactive owners; therefore, the members do not qualify for special tax-favored "fringe benefit" treatment.
As a member of an LLC, you are not allowed to pay yourself wages. (If your business is seasonal, you might want to consider an S-Corp or C-Corp instead so you can pay yourself a salary and provide unemployment and disability insurance to yourself. Consult your accountant and attorney to see which legal business structure is better for your specific business.)
A LLC is a separate legal 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. An LLC is created and comes into existence when articles of organization are filed with the proscribed fees, and accepted by the proper state authority.
An LLC is owned by its members. The members of an LLC are like partners in a partnership or shareholders of a corporation. A member will more closely resemble a shareholder if the LLC utilizes a manager or managers, because under that situation the members will not participate in the management of the LLC. However, if the LLC does not utilize managers, then the members will more closely resemble partners because they will have decision making powers in the LLC.
The member’s ownership in the LLC is represented by their respective "membership interest", in the same manner as a partner has an "interest" in a partnership or a shareholder has stock in corporation.
Pass-Through Taxation LLC’s allows the earnings of an LLC to be taxed only once. The earnings from an LLC are treated in a similar manner as earnings from a partnership, sole proprietorship and most S corporation.

Additional Requirement

In all states, an individual or service company must be responsible for receiving important legal and tax documents. This service is provided by an "agent" of the LLC who is "registered" with the state of incorporation. Thus, the term "Registered Agent." The registered agent must have a valid street address within the state of formation, and be available during normal business hours to receive documents.

It is possible for you to act as your own registered agent as long as your registered address is within the state that you are forming the LLC in.

Final Word

I've briefly described the advantages and disadvantages of LLC status. All of the rules and regulations governing LLCs, as well as recent decisions and current issues presently before the various courts today, would require a discussion of LLCs beyond the scope of this article. The information contained in this article is presented to provide a general understanding of the benefits and cautions in selecting LLC status.

For more detailed information and specific advice for your business contact your local small business development center, your accountant or your attorney