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Understanding Limited Liability Companies

What Are They? How Do They Differ from Other Legal Entities?

Limited Liability CompaniesFor most people seeking to start a new business, one of the most important concerns is the limitation of liability. Because of the risks inherent in forming and building a business, entrepreneurs need to know that they can do the things they need to do without fear of losing everything. For centuries, the corporate form was the fundamental way to do that, creating a separate legal entity with sole responsibility for the debts and obligations of the business.

The corporate form can be cumbersome, though, with many annual reporting and filing requirements. In 1977, the state of Wyoming passed a law creating a new legal entity, known as a limited liability company. It took more than a decade, however, for the Internal Revenue Service to approve the new legal structure.

What Is Limited Liability?

To successfully start and build a business enterprise, a company must typically incur debts and other financial responsibilities. As an incentive for individuals to create new businesses, state legislatures routinely allow them to create separate legal entities to take on the debt and other obligations of those businesses. The concept of limited liability restricts the liability of the founders of the company, so that their personal net worth is not jeopardized in the event their company fails.

What Is a Limited Liability Company?

A limited liability company, or LLC, is a separate legal entity, with the legal right to own property, buy and sell goods and/or services, secure financing, and conduct all the other functions of a business. Because an LLC is a separate legal entity, the only risk to those who invest in the company is the potential loss of their investment. The other personal assets of an investor are not at risk.

How Do You Form a Limited Liability Company?

A limited liability company is created by filing Articles of Organization with the appropriate state authority. Typically, an LLC will also create and implement bylaws, and it must register with appropriate revenue agencies.

What Are the Benefits of a Limited Liability Company?

The LLC form offers a wide array of advantages:

  • The personal liability of all LLC members is limited to the amount of their investment in the enterprise.
  • All income from a limited liability company passes through and is recognized by members as personal income—there is no income tax at the company level.
  • The reporting and filing requirements are generally more relaxed for LLCs than for corporations.
  • A limited liability company continues to exist when one of the members dies. In comparison, certain partnerships terminate upon the death of one partner.

What Are the Disadvantages of an LLC?

There are some factors to consider before establishing a limited liability company:

  • LLCs are governed by state law, so engaging in interstate commerce can be complicated; however, the same concern applies to corporations.
  • An LLC’s organizing document must identify what happens to a member’s ownership interest upon their death or withdrawal. If it does not, the LLC may be terminated, based on applicable state laws.
  • Most state laws put limits on the types of companies that can be set up as LLCs. Nonprofits, banks, professional services, and insurance services are often excluded.
  • LLCs can be either self-managed or manager managed. If you self-manage a limited liability company, you may have to pay self-employment tax on any distribution from the company.

What Are the Requirements of an LLC?

Though laws vary from state to state, most jurisdictions have similar requirements. Unlike corporations, there are few, if any, limitations on who may be a member—other LLCs, corporations, individuals, and even foreign entities are typically permitted to be members of an LLC. There’s also no limit on the number of members a limited liability company may have.

The common requirements for LLCs include:

  • Unique business name
  • Registered agent who will accept service of process in any legal action
  • Articles of Organization, filed with the appropriate state agency—Though not required, it’s common for the Articles of Organization to be accompanied by an Operating Agreement, which establishes the rights and responsibilities of all members, as well as other key aspects of the company.
  • Statement of Information form—Required in some states, this is nothing more than a completed and filed form that provides company name, names of members, and the company’s primary office address.

How Does an LLC Differ from a General Partnership?

There are two primary differences between LLCs and partnerships. An LLC will protect the member’s personal assets from access by creditors, but a partnership will not. A creditor may seek to attach the personal assets of a partner to satisfy a debt of the partnership. In fact, every partner in a general partnership is jointly and severally liable for the debts of the partnership. In addition, when a general partner dies, the partnership might terminate by operation of law (although in some situations, there are ways around that). The death of a member of an LLC might result in termination of the entity, or it might not, depending on the terms of the operating agreement.

How Does an LLC Differ from a Corporation?

LLCs do not issue stock as documentary evidence of ownership. Accordingly, LLCs are not traded on stock exchanges. LLCs also typically require fewer annual filings with state business authorities. Most LLCs are treated as pass-through entities for purposes of income tax, meaning the income of the LLC is not taxed at the company level; instead, the income passes through to the LLC members and is taxed only as part of the members’ personal income. Some corporations (but not all) are subject to double taxation–company income is taxed at the company level and then distributions made to shareholders are taxed again as part of their personal income.

Summary

If you’re looking to limit your liability for a new business venture, setting up your enterprise as an LLC can have distinct advantages. You can enjoy the benefits of a Subchapter S corporation—limited liability and pass-through taxation—with fewer annual reporting, meeting, and filing requirements.

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