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Limited Liability Company - LLC

General Description of an LLC

Limited Liability Company

LLC's have become the most popular business form for new entities, and many existing entities have converted to this form. They exist in some form in every state. They embody limited liability features of corporations and pass-through characteristics of partnerships and S-corps, but are more flexible than S-corps.

For business law purposes, LLC members may be either passive investors or active investor-managers. Unlike with limited partnerships, active management won't affect limitation of liability. For federal tax purposes, LLCs are treated as partnerships (unless they elect otherwise).

Note: Since LLC rules vary from state to state, a characteristic, power or rule in the state where an LLC was created may not apply in some other state where it does business.

Note: Some states do, and some states do not, authorize LLCs with only one member.

Tip: Where one becomes the sole surviving LLC member in a state that doesn't allow single member LLCs, consider quickly incorporating (to regain limited liability) and electing S-corp status (to retain pass through treatment).

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LLC's vs. S-Corporations

LLC's and S-Corps share the same business advantage-limitation of liability. S-corps are a bit better understood by the business community because LLC's are new and vary from state to state.

The tax advantages of LLC's, as compared to S-corps, are the tax advantages of partnerships. All the points below where LLC's outscore S-Corps arise because LLC's can choose partnership tax status.

LLC's can to some degree allocate tax attributes, like income or certain kinds of income, depreciation deductions, etc., disproportionately among members to suit their individual tax situations (unlike S-corps limited by the effect of the single-class-of-stock rule).
S-Corp owners can deduct startup or operating losses up to their investment plus any debt that the S-corp owes them. LLC members can do the same but can deduct further, up to their share of the debt the LLC owes others.
Adding co-owners after the entity is formed is easier with LLC's. An outsider's transfer of appreciated property for an LLC membership interest is tax-free. A comparable transfer to an S-Corp is taxable unless the new co-owner owns more than 80 percent of the S-Corp after the transfer.
Complex tax adjustments ("basis adjustments") can be made by the LLC when LLC interests change hands or LLC property is distributed. These adjustments, unavailable with S-corps, can have the effect of reducing amounts taxable to certain LLC members.
Distribution of appreciated LLC property to LLC members is not taxable to the LLC. Comparable S-Corp distributions to stockholders are taxable to the S-Corp.

Tip: Depending on circumstances, S-corp status can be preferable to LLC status when the owners leave the business. The LLC is not taxed when appreciated property is distributed to its members, which is a standard form of business liquidation. But the members would be taxed on distributions exceeding the "basis" (broadly, the amount they invested) of their interests. S-corp owners, on the other hand, can arrange a tax-free exit, via a corporate reorganization in which they transfer their S-corp stock for stock in a corporate acquirer. (Later sale of stock in the acquirer would be taxable.)

Depending on state law, S-corps, and LLCs may be taxed at the entity level in states where they do business.

LLCs vs. Partnerships

LLC's, with their limited liability for all members, have the edge on general and limited partnerships from a business standpoint. While the federal tax treatment of partners and the LLC's members is basically the same, there are occasional special tax rules for limited partners (especially self-employment tax rules).

Note: It is not clear whether these special tax rules extend to non-manager LLC members.

Note: LLCs are more likely than partnerships to be subject to a state tax.

LLCs vs. Proprietorships

LLCs, with their limited liability, are preferable, where available, for sole proprietors from a business standpoint. Where the sole proprietor so elects, the LLC is ignored and the proprietor is taxed directly under federal tax rules as if no separate entity existed.

Note: Some states do-and some do not-ignore the LLC entity for state tax purposes.