LLC

Combining the best of corporations and partnerships

Introduction

Limited liability companies, or LLCs, are becoming more and more popular, and it's easy to see why. They combine the personal liability protection of a corporation with the tax benefits and simplicity of a partnership. In other words, the owners (or "members") of an LLC are not personally liable for its debts and liabilities, but also have the benefit of being taxed only once on their profits. Moreover, LLCs are more flexible and require less ongoing paperwork than an S-Corporation. 

Certified Document Solutions’ law library provides you with general information relating to limited liability companies. It also outlines their advantages, disadvantages, and how they compare to other business entities. 

Certified Document Solutions can also help you easily form an LLC. Simply answer a few questions online with the support of our easy-to-read information, and we will do the rest. We will prepare all of the legal documents you need and can even file the required formation documents with the Secretary of State.

 

What is an LLC?

Like a corporation, an LLC is a separate and distinct legal entity. This means that an LLC can obtain a tax identification number, open a bank account and do business, all under its own name. The primary advantage of an LLC is that its owners, known as members, are not personally liable for the debts and liabilities of the LLC. For example, if an LLC loses a big lawsuit and is forced into bankruptcy, the members will not be required to make up the difference with their own money. If the assets of the LLC are not enough to cover the debts and liabilities, the creditors cannot look to the members, managers or officers for recovery. 

An LLC can be taxed either as a "pass-through" entity, like a partnership or sole proprietorship, or as a regular corporation. By default, an LLC is taxed as a pass-through entity, and the owners of the LLC are not subject to double taxation. This is different from a regular corporation, which pays a corporate tax on its net income (the first tax) and then a second tax when the corporation distributes profits, as the stockholders pay income tax on dividends. With an LLC, the profits "pass through" to the owners, who pay taxes at their individual tax rates.

 

LLCs compared to corporations

Should I form a corporation or an LLC? It is a common question among business owners and one that deserves careful consideration. While both are excellent choices for personal liability protection, each structure offers its own set of distinct advantages. Choosing the right one for your company depends on your particular business, operational needs, and tax strategy. 

Advantages of LLCs:

Fewer corporate formalities. Corporations must hold regular meetings of the board of directors and shareholders, keep written corporate minutes and file annual reports with the state. On the other hand, the members and managers of an LLC need not hold regular meetings, which reduce complications and paperwork. 

No ownership restrictions. S-corporations cannot have more than 100 stockholders, and each stockholder must be a natural person who is a resident or citizen of the United States. There are no such restrictions placed on an LLC. 

Ability to use the cash method of accounting. Unlike a C-corporation, which often must use the accrual method of accounting, most limited liability companies can use the cash method of accounting. This means that income is not earned until it is received. 

Ability to place membership interests in a living trust.Members of an LLC are free to place their membership interests in a living trust. It is difficult to place shares of an S-corporation into a living trust. 

Ability to deduct losses. Members who are active participants in the business of an LLC are able to deduct its operating losses against the member's regular income to the extent permitted by law. Shareholders of an S-corporation are also able to deduct operating losses, but shareholders of a C-corporation are not. 

Tax flexibility. By default, LLCs are treated as a "pass-through" entity for tax purposes, much like a sole proprietorship or partnership. This means that LLCs avoid double taxation. Furthermore, an owner of an LLC is not required to pay unemployment insurance taxes on his or her own salary. However, an LLC can also elect to be treated like a corporation for tax purposes, whether as a C-corporation or an S-corporation. 

Disadvantages:

Profits subject to social security and medicare taxes. In some circumstances, owners of an LLC may end up paying more taxes than owners of a corporation. Salaries and profits of an LLC are subject to self-employment taxes, currently equal to a combined 15.3%. With a corporation, only salaries (and not profits) are subject to such taxes. This disadvantage is most significant for owners who take a salary of less than $97,500 for tax year 2007. 

Owners must immediately recognize profits. A C-corporation does not have to immediately distribute its profits to its shareholders as a dividend. This means that shareholders in a C-corporation are not always taxed on the corporation's profits. Because an LLC is not subject to double-taxation, the profits of the LLC are automatically included in a member's income. 

Fewer fringe benefits. Employees of an LLC who receive fringe benefits, such as group insurance, medical reimbursement plans, medical insurance and parking, must treat these benefits as taxable income. The same is true for employees who own more than 2% of an S-corporation. However, employees of a C-corporation who receive fringe benefits do not have to report these benefits as taxable income.

 

LLCs compared to sole proprietorships and partnerships

The following section outlines the advantages and disadvantages of an LLC as compared to a sole proprietorship and partnership.

Advantages:

Owners are not personally responsible for company debts. This is the most important attribute of an LLC. In a sole proprietorship and partnership, the owners are personally responsible for the debts of the business. If the assets of the sole proprietorship or partnership cannot satisfy the debt, creditors can go after each owner's personal bank account, house, etc. to make up the difference. By contrast, if an LLC runs out of funds, the owners are usually not liable.

Please note that under certain circumstances, an individual member may be liable for the debts of an LLC. These circumstances include:
  • If a member personally guarantees a debt.
  • If the LLC fails to have a separate bank account and personal funds are intermingled with LLC funds.
  • If the LLC has minimal capitalization or minimal insurance.
  • If the LLC fails to pay state taxes or otherwise violates state law (like defrauding consumers).

Easier to raise money. An LLC has many avenues to raise capital. It can admit new members by selling membership interests, and it can create new classes of membership interests with different voting or profit characteristics. Plus, investors will be assured that they are not personally liable for company debts.

Ease of transfer. Ownership interests in a limited liability company may generally be sold to third parties without disturbing the continued operation of the business. The business of a sole proprietorship or partnership, on the other hand, cannot be sold whole; instead, each of its assets, licenses and permits must be individually transferred. New bank accounts and tax identification numbers are also required.

Disadvantages

Cost. LLCs cost more to set up and run than a sole proprietorship or partnership. For example, there are the initial formation fees, filing fees and annual state fees. These costs are partially offset by lower insurance costs.

Formal organization. Although an LLC requires fewer formalities than a corporation, there is still more paperwork involved than a sole proprietorship or partnership. A sole proprietorship or partnership can commence and operate without any formal organizing procedures; not even a hand written agreement is required.

Separate records. In order to maintain the separate form of the LLC and maintain the liability protection of its members, the owners of the LLC must carefully maintain separate records and keep their personal business separate from the LLC's business. Even more importantly, the LLC's money should never be intermingled with personal money.

 

Forming an LLC

The life of an LLC begins upon the filing of the articles of organization with the secretary of state's office. Prior to filing the articles, the following issues should be considered. 

1.    Where should I form the LLC?

An LLC can be formed in any of the 50 states and the District of Columbia

Many people choose to form LLCs in their home state. This may save you money because the LLC will not need to register as a "foreign LLC" if it does business in its home state, and there is no need to pay another person to serve as the registered agent. 

If your home state has high annual LLC fees or income taxes, and your LLC does not "do business" in that state, it may be wise to form the LLC elsewhere. "Doing business" means more than just selling products or making passive investments in that state - it usually requires having an office or otherwise having an active business presence. 

Many people choose to form an LLC in Delaware because of its history, experience, popularity and pro-business climate. Nevada has also gained popularity due to its pro-business environment and lack of a formal information-sharing agreement with the IRS. Nevada does not have corporate income taxes, Delaware does not tax out-of-state income and business filings in these states can usually be performed more quickly than in other states.

2.    Choosing a name

In general, the name of a limited liability company must end with the words "LLC", "L.L.C.", "Limited Liability Company" or "Ltd. Liability Co." The name of a person may be used as part of the name of the limited liability company. Please note that a name will not be accepted if it is likely to mislead the public or if it too closely resembles the name of another LLC formed in that state.

Before you choose the name, you should do a little research to see if the name is taken. Contact the secretary of state to see if the name you have chosen is already in use.

If the name of the LLC is used in connection with goods or services, you may wish to consider obtaining federal trademark protection for the name. This ensures that no one else in the U.S. may use that name in connection with the same general type of goods or services (except in areas where someone else is already using that name).

3.     Management by members or managers

A limited liability company may be managed either by (a) the members or (b) one or more managers. A "member" is an owner of the limited liability company. If a limited liability company is managed by the members, then the owners are directly responsible for running the company.

A "manager" is a person elected by the members to manage the limited liability company. In this context, a manager is similar to a director of a corporation. A manager can be, but is not required to be, a member. If a limited liability company is managed by managers, then its members are not directly responsible for running the company.

Whether an LLC should be managed by members or managers depends on several factors, including:

o    The number of owners;

o    The type of business;

o    Where the owners are located;

o    How involved the members will be in the operations of the LLC.


Management by members is usually the best option for LLCs that have only one member or just a few members, all actively participating in the affairs of the LLC. If there are many members, on the other hand, including some that do not actively participate in the operations of the LLC (such as silent partners), then management by managers may be the best option.

4.    Officers

Regardless of how a limited liability company is managed, it can still appoint officers to run the day-to-day operations of the company. An LLC is not, however, required to have officers. Officers serve at the pleasure of either (a) the managers, if the limited liability company is managed by managers, or (b) the members, if the limited liability company is member-managed. Members or managers may both be officers. There is no limit on the maximum number of officers, nor is there a limit on the number of offices that a person may hold. In fact, the same person may hold all offices.

5.     Registered Agent

Each LLC must have a registered agent, the person designated to accept official notice if the LLC is "served" with a lawsuit. A registered agent must be either (1) an adult living in the state of formation with a street address (P.O. boxes are not acceptable) or (2) a company registered with the Secretary of State in the state of formation.

As previously mentioned, one of the advantages of forming an LLC in your home state is that any of the members, managers or officers can act as the registered agent. However, there are some advantages to having another person or company act as your registered agent. First, this adds an extra layer of privacy, since the name and contact information for the registered agent is publicly available. Second, this ensures that if your LLC is named in a lawsuit, no one will surprise you at home on a Sunday night with court papers.

 

Capital Contributions and Ownership

Ownership in an LLC can be expressed in two ways: (1) by percentage; and (2) by membership units, which are similar to shares of stock in a corporation. In either case, ownership confers the right to vote and the right to share in the profits of the LLC. 

Unlike a corporation, an LLC can distribute its ownership interests as it pleases, without regard to how much money or property a member contributes to the company. For example, if Sam contributes $10,000 to the company and is a silent partner, and Rick contributes no money but runs the company on a daily basis, they could still decide to split the membership interest’s 50%-50%. 

A limited liability company can also be organized with different classes of ownership interests, which provides flexibility for special allocations of profits and voting power. For example, you can create a special class of "super-voting" units that provide 10 votes per unit or pay a certain level of profit before the "regular" units. 

The sale of membership interests is subject to federal and state securities laws. Generally though, if you are not advertising the sale and are dealing only with a small number (less than 35) of knowledgeable and sophisticated investors, then you will be exempt from the regulations. If, however, you are seeking to raise a significant amount of money from a large number of investors, it will be necessary to consult an attorney.

 

Running an LLC

Here are a few things to keep in mind when running your LLC.

1.    Keep things separate

As previously mentioned, it's important to keep the business and affairs of the LLC separate from a member's or manager's personal affairs. This means setting up a separate bank account, maintaining separate records, and keeping separate accounts.

2.    Meetings

Regular or annual meetings of the members or managers are not required. The operating agreement states that meetings may be held as the members or managers deem them necessary to run the company. Even though it's not required by law, it may be a good idea to keep records of the actions taken or approved at the meetings.

3.    Transfer of ownership interests

Transfer of membership interests generally requires the consent of other members. This is an important issue to consider for any LLC with more than one member. On one hand, you may wish to sell or transfer your membership units to anyone you wish. On the other, if you consider the other members of the LLC your business partners, you may want approval over whether they can transfer their interest and who they can transfer it to.

4.     Tax forms and licenses

Many LLCs are required to obtain a federal tax identification number, which is similar to an individual's social security number. However, there are some situations where an LLC can simply use the social security number of the owner. Single-member LLCs that do not have employees generally do not need a separate federal tax ID. City and county business licenses may also be required. Please check with an accountant about the need for a tax ID number and your city and county to see which types of licenses are needed.


Tax Reporting

By default, LLCs do not pay income tax at the entity level. Instead, the LLC's income is passed through to the members, who must recognize their allocated income or loss on their personal tax returns. For a single-member LLC, this income is reported on the individual owner's Form 1040, Schedule C. 

If an LLC elects to be taxed as a partnership and its fiscal year ends on December 31, the tax return is due April 15. The LLC must file a tax return on Form 1065 even if it does not have income or no tax is due. Amounts distributed to members or managers are accounted for on schedule K-1 to Form 1065. 

An LLC with employees is required to pay federal (and sometimes state) payroll taxes, and unemployment insurance. Furthermore, some states, including California, have an annual LLC fee that is based loosely on the company's net income.

 

Checklist for Businesses

Forming an LLC is just one step in starting a new business. There are other federal, state, and practical considerations as well. The following is a list of things to do or think about once you have formed a new LLC.
  • Consider registering a DBA if you want to do business under a name other than the official entity name.
  • Establish a corporate banking account.
  • Contact the state tax board for information about state taxes and obtaining a state tax number.
  • Check with the state department of consumer affairs to obtain any required business licenses or permits.
  • Contact the Internal Revenue Service for information on filing your federal tax schedules.
  • Find out about workers' compensation if you will have employees.
  • Protect your trade name 
  • Check zoning laws.
  • Obtain city and/or county business licenses or permits.
  • Get adequate business insurance or a business rider to a homeowner's policy.
  • Get tax information such as record-keeping requirements, guidelines for withholding taxes (if you will have employees), information on hiring independent contractors, facts on estimating taxes, forms of organization, etc.
  • Have business cards and stationery printed.
  • Get an email address.
  • Get your website set up.

 

The United States Small Business Administration (SBA) offers additional information and resources on starting a new business. You can visit them on the internet at www.sba.gov, or you can contact your local branch office by phone.

What is a Family Limited Partnership?

Although not officially recognized by the IRS, the term "Family Limited Partnership" or "FLP" is frequently used by financial planners to describe limited partnerships that are set up specifically to hold family businesses or investments. The idea is that individuals can use an FLP to bestow limited partnership interests as gifts to their children. In recent years the Family Limited Partnership has become an extremely popular wealth transfer strategy. With an FLP, individuals can reduce the taxable value of their estate by placing their assets in a limited partnership and then allocating ownership interests to other family members. For parents, it's an effective way to lower their tax burden while ensuring that family businesses or personal assets remain in the family. 

As with conventional limited partnerships, family limited partnerships are comprised of both general and limited partners. The only difference is that these positions are held by family members. To form a limited partnership, members must file a certificate with the state. Once formed, the FLP is considered a legally distinct entity and assigned a tax identification number. The FLP can then own assets and conduct most business activities.

 

How is an FLP formed?

As with conventional limited partnerships, family limited partnerships are comprised of both general and limited partners. The only difference is that these positions are held by family members. To form a limited partnership, the partners must file a certificate with the state. Once formed, the FLP is considered a legally distinct entity and assigned a tax identification number. The FLP can then own assets and conduct most business activities.

 

How is an FLP taxed?

A Family Limited Partnership is typically taxed like a general partnership. Profits are passed directly to partners based upon their ownership interest and reported as personal income on their individual tax returns. Unlike a corporation, there is no corporate tax imposed on a Limited Partnership. And unlike with an S Corporation, taxes are not collected on assets that pass from the partnership to its partners.

 

The Partners in an FLP

General Partners (typically the father, mother or both) create the partnership specifically to gift limited partner shares to their children or other family members. General partners retain control of the FLP and make day-to-day investment decisions. They can also draw a percentage of the FLP's income in the form of a management fee. 
Limited Partners (typically children or other family members) have an ownership interest in the FLP but limited or no control over the partnership's management. They receive a share of income generated by the FLP based upon their ownership percentage. When the FLP dissolves, a proportionate amount of FLP property will pass to each limited partner.

 

Setting up an FLP

Setting up an FLP requires placing your assets into the partnership using your estate tax credit. For example: 

A husband and wife can each transfer up to $1,500,000 ($3 million total) into an FLP without paying estate taxes and then allocate those assets to the limited partners. They can then place a smaller amount (typically 1% of total assets) into the FLP and assign ownership of this amount to the general partners. There are usually no taxes incurred when funding an FLP as long as you do not exceed the maximum contribution. 

At first, you and your spouse own both general partner and limited partner shares. Over time, you can grant your family members limited partner shares using your annual $11,000 gift exclusion. Don't worry about giving away too many of your shares. Based on current tax law, general partners may own as little as 1% of the FLP's assets and still retain control of the partnership. That means you can still buy and sell assets, dispose of property and distribute additional FLP shares. 

It's important to note that FLPs have come under increasing scrutiny by the IRS, which is always on the lookout for abusive tax shelters. To avoid unwanted scrutiny, be sure to take care when assessing the value of your assets (see section on Estate Tax Credit).

 

What type of assets work in an FLP? 

Any type of business or investment asset can work in an FLP. Assets related to an operating business, such as a store or ranch, work particularly well. But some families set up an FLP solely with investment-type assets. When making decisions about how to fund the partnership, it's very important to understand the difference between Safe Assets and Dangerous Assets

Safe Assets:

These are assets that do not by themselves carry a high degree of lawsuit risk. For example, if you own investment securities such as stocks, bonds or mutual funds, it is highly unlikely that these assets alone will ever put you at risk for a lawsuit. 

Dangerous Assets:

Dangerous assets are those that carry an inherent and substantial liability risk. These are generally active, business-type assets such as rental property or motor vehicles—both of which could invite a lawsuit. Many people choose to either remove dangerous assets from their FLP or set up separate FLPs to isolate dangerous assets from each other and from safe assets. The reason is this: If a dangerous asset winds up the target of a lawsuit, all of the assets in your FLP become vulnerable to a lawsuit judgment.

 

Estate Tax Credit

In many cases, you can contribute more than the maximum $1.5 million ($3 million per couple) Estate Tax Credit by transferring a greater ownership percentage to your limited partners. The logic works like this: A gift of $1.5 million in limited partnership interests is worth less than $1.5 in general partnership interests. After all, limited partner shares do not come with any decision-making powers and cannot be sold or transferred to others. In other words, there is no "market" for limited partner shares so you can appraise them at a lower value. This practice of appraisal reduction is often referred to as "discounting" the value of limited partnership units. But be careful not too discount too heavily as this could raise red flags at the IRS and potentially invalidate your FLP.

 

Advantages of creating an FLP

Advantages of creating an FLP include:
  • Controlled Distributions 
    General partners control the partnership and its distributions. Income and profits from the partnership do not have to be distributed; they can be reinvested.
  • Control over Limited Partners
    General partners can restrict limited partners from transferring, selling or otherwise "losing" their ownership interest.
  • Valuation Discounts 
    You can discount the value of limited partnership interests given to family members.
  • Creditor Protection 
    Owning an interest in a limited partnership comes with a certain degree of built-in credit protection. A limited partner's creditor(s) cannot directly go after partnership assets, and they cannot "take" a limited partner's interest in a limited partnership. Current law only allows for a "charging order," which requires that any monetary distributions from the LP to a particular partner be given to that partner's creditor(s). To avoid this handover, the partnership can choose to simply reinvest earnings instead of making distributions.
  • Arbitration to Settle Disputes 
    A Family Limited Partnership Agreement can include an arbitration provision to resolve any family conflicts among partners. The partners simply agree in advance to settle any disputes through arbitration.
  • Buy-Sell and Right of First Refusal 
    A Family Limited Partnership Agreement can include buy-sell and right of refusal provisions to prevent unwanted persons from becoming partners. A buy-out provision can stipulate that partnership interest may be purchased by other partners at the partnership's fair market value or at a discount.
  • Asset Protection in the Event of Divorce 
    The FLP can be used to separate individual property from communal marital property. In the event a limited partner divorces his or her spouse, the FLP can be structured to protect the partner's ownership interest, ensuring that it remains in the family.
  • Flexibility 
    Unlike an Irrevocable Trust, a Family Limited Partnership is very flexible. A Family Limited Partnership may be amended or terminated if all of the members agree to do so.
  • Reduced Costs 
    Placing family assets in a single FLP costs less than placing them in several entities or trusts, as there are fewer administration expenses involved.
  • Intangible Assets
    An FLP is considered an "intangible asset." This means it's likely that only your home state (state of residence) will be able to impose any inheritance tax on partnership units. This is ideal for real property owners who own property in several states.
How can a Family Limited Partnership help your family? 

FLPs are ideal for families who own business assets in common. This includes assets they one day wish to pass down to other family members. 

FLPs can protect partners from lawsuits, creditors and divorce claims.

Say a father sets up a Family Limited Partnership. He is both a general partner owning 1% and a limited partner owning 90% of the partnership. Each of his children own 4.5% of the company. The following protections can apply:

1.     If the father is sued, in most cases creditors cannot seize his partnership assets provided the partnership was set up before the creditor problems began.

2.     If one of the children divorces or is subject to creditor claims, the ex-spouse or creditor(s) generally cannot claim partnership assets.

FLPs can help lower taxes on family estates

Say a husband and wife, Mr. and Mrs. Smith, collectively have $200,000 worth of taxable income from various investments. They are in the maximum 32% tax bracket and owe approximately $64,000 in taxes per year on this income. 

But this year the Smiths decide they want to save money in taxes in order to set aside funds for their grandchildren's future education. So they set up an FLP and transfer all of their assets into the partnership. As general partners, they name a total of seven children and grandchildren as limited partners, granting them a combined ownership interest of $100,000. Under their partnership agreement, the children and grandchildren now owe taxes on $100,000 of the $200,000 in income generated by the partnership. But because each of the children is in a maximum tax bracket of 15 percent (in contrast to the parents' 32 percent tax bracket), the total taxes owed on the $100,000 of investment income is reduced from $32,000 to $15,000. This produces a savings of $17,000 in income taxes. 

But the best part is—the partnership agreement does not require that the $100,000 actually be distributed to the children. As general partners, the parents simply retain the entire amount and pay the taxes on their children's share of partnership income. Thus by transferring ownership interests to their children, they were able to reduce their annual tax burden by 17%. They then use their tax savings to set up a college fund for their grandchildren.

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