LLC Basics This hybrid entity brings together some of the best features of partnerships and corporations, and is a great choice for entrepreneurs who want to move beyond the sole proprietorship.

Probably the single greatest disadvantage of the corporate form is the burdensome range of formalities that corporate managers must observe. A modern corporation's heavy administrative burden is a remnant of the more traditional and formal legal system under which corporate law was cultivated. The LLC changed all that.

Limited liability companies (LLCs) have been around since 1977, but their popularity among small-business owners is a relatively recent phenomenon. The LLC offers the liability protection benefits of the corporation without the corporation's burdensome formalities. This simplicity has made the LLC an instantly popular business form for smaller companies.

LLCs are the favorite choice for small businesses with one to three owners working who don't plan to grow the business significantly and don't expect to raise significant amounts of cash. But as the number of owners grows, the corporation often becomes a more attractive choice as a business form.

An LLC is a hybrid entity, bringing together some of the best features of partnerships and corporations. LLCs were created to provide business owners with the liability protection that corporations enjoy without the double taxation. Earnings and losses pass through to the owners and are included on their personal tax returns.

Sound similar to an S corporation? It is, except an LLC offers small-business owners even more attractions than an S corporation. For example, there is no limitation on the number of shareholders an LLC can have, unlike an S corporation, which has a limit of 75. In addition, any member or owner of the LLC is allowed a full participatory role in the business's operation; in a limited partnership, on the other hand, partners are not permitted any say in the operation.

Unlike corporations (and like partnerships), LLCs do not have perpetual life. Some state statutes stipulate that the company must dissolve after 30 or 40 years. Technically, the company dissolves when a member dies, quits or retires.

More Pros and Cons

Here are more advantages of the LLC form of business organization:

• 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.

• Managing members' 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.

• The members' 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.

Some of the disadvantages of an LLC include:

• Each member's pro-rata share of profits represents taxable income--whether or not a member's share of profits 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 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.

• Some states do not allow the organization of LLCs for certain professional vocations.
• For companies that wish to pursue venture capital, accumulate a large number of shareholders, and/or eventually pursue an initial public offering, the LLC is not an appropriate alternative to a corporation.

Setting It Up

To set up an LLC, you must file articles of organization with the secretary of state in the state where you intend to do business. Some states also require you to file an operating agreement, which is similar to a partnership agreement.

Before deciding upon an LLC, remember to check with your lawyer or accountant about the advantages of the LLC in your particular state. Ask up front what it would cost to form a corporation versus the cost of forming an LLC. You may be surprised to learn that in some states an LLC could be established by filing a simple, one-page document, which lays out the Articles of Organization of your LLC, with the secretary of state.

You can form an LLC for any lawful business as long as the nature of the business is not banking, insurance, and certain professional service operations, such as doctor, lawyers or accountants. By simply filing articles of organization with the respective state agency, an LLC takes on a separate identity. Similar to a corporation, but without the tax problems of the corporation, it will be taxed like a partnership.

Also, you'll need two people (members) to meet the state requirement in many states and to meet the basic federal tax law requirements to obtain the flow-through tax provisions that are one of the advantages of an LLC.

The cost of setting up an LLC is roughly equivalent to setting up a corporation. The secretary of state's fees for filing articles of organization and for filing annual reports are often the same for both LLCs and corporations. Entrepreneurs who wish to seek help in organizing an LLC through an LLC formation service or through an attorney will find the fees to be roughly the same.

Even after you settle on a business structure, remember that the circumstances that make one type of business organization favorable are always subject to changes in the laws. It makes sense to reassess your form of business from time to time to make sure you are using the one that provides the most benefits.

Outgrowing Your Business Structure

What should the owners of an LLC do if their company grows in size such that an LLC is no longer the appropriate business form? The answer is simple: it is possible to convert an LLC into a corporation. Thus, some small companies begin life as LLCs, outgrow the LLC form, and then the LLC's owners transfer the assets of the LLC to a newly formed corporation with the same owners as the LLC.

As one might imagine, it is also possible to convert a corporation into an LLC, or nearly any business form into any other. It is also possible to reorganize a business in another state by transferring the assets of a business into a newly chartered entity. Converting business forms does require some sophisticated legal and tax analysis and should not be attempted without the services of a qualified attorney and accountant.

This article was excerpted from the books Start Your Own Business and Entrepreneur Magazine's Ultimate Book on Forming Corporations, LLC's, Sole Proprietorships and Partnerships, and the article "Pros and Cons of the LLC Model" by David Meier.