Definition: A form of business organization with the liability-shield
advantages of a corporation and the flexibility and tax
pass-through advantages of a partnership
Many states allow a business form called the limited liability
company (LLC). The LLC arose from business owners' desire to adopt
a business structure permitting them to operate like a traditional
partnership. Their goal was to distribute income to the partners
(who reported it on their individual income tax returns) but also
to protect themselves from personal liability for the business's
debts, as with the corporate business form. In general, unless the
business owner establishes a separate corporation, the owner and
partners (if any) assume complete liability for all debts of the
business. Under the LLC rules, however, an individual isn't
responsible for the firm's debt, provided he or she didn't secure
them personally, as with a second mortgage, a personal credit card
or by putting personal assets on the line.
The LLC offers a number of advantages over subchapter S
corporations. For example, while S corporations can issue only one
class of the company stock, LLCs can offer several different
classes with different rights. In addition, S corporations are
limited to a maximum of 75 individual shareholders (who must be
U.S. residents), whereas an unlimited number of individuals,
corporations, and partnerships may participate in an LLC.
The LLC also carries significant tax advantages over the limited
partnership. For instance, unless the partner in a limited
partnership assumes an active role, his or her losses are
considered passive losses and cannot be used as tax deductions to
offset active income. But if the partner takes an active role in
the firm's management, he or she becomes liable for the firm's
debt. It's a catch-22 situation. The owners of an LLC, on the other
hand, do not assume liability for the business' debt, and any
losses the LLC incurs can be used as tax deductions against active
income.
However, in exchange for these two considerable benefits, the
owners of LLCs must meet the "transferability restriction test,"
which means the ownership interests in the LLC are not transferable
without restriction. This restriction makes the LLC structure
unworkable for major corporations. For corporations to attract
large sums of capital, their corporate stock must be easily
transferable in the stock exchanges. However, this restriction
isn't as problematic for smaller companies, where stock ownership
transfers take place relatively infrequently.
Since the LLC is a relatively new legal form for businesses,
federal and state governments are still looking at ways to tighten
regulations concerning them. Unfortunately, some investment
promoters use LLCs to evade securities laws. That's why it's
imperative to consult with your attorney and CPA before deciding
which corporate structure makes sense for your business.