Nearly everyone has a general idea what “Inc.” means at the end of a company name, but what about “LLC”?
You can be sure that a company whose name ends with an “Inc.” or “Corp.” is a corporation. As a corporation, the company is regarded by the federal and state governments as an entity separate from its owners, almost like a person. If the corporation goes bankrupt or issued, the owners are generally liable only for the amount that they have invested. They are said to have limited liability.
The same can be said of an “LLC”, whose letters stand for Limited Liability Company. Just like a corporation, a limited liability company’s owners have a high degree of protection from financial loss beyond what they have invested in the company. They have limited personal liability. Any lawsuit or bankruptcy proceeding involving the company is regarded by the courts as concerning only the company, not the individual owners unless the court believes the owner has committed fraud or other illegal act or has failed to establish a clear division of the company from his or her personal finances.
This degree of liability protection is in stark contrast to a company structured as sole ownership or partnership. In these cases, the owners’ financial investment carries a greater downside risk because there are no distinctions drawn between company assets and personal assets, including savings accounts and other investments. Everything is fair game for potential creditors.
Another similarity between corporations and LLCs is that both are creatures of state law. The rules which define an LLC are established by state legislation, so there are variations from state to state. This article discusses only those characteristics of LLCs that are generally true throughout the United States (it is strongly recommended that you seek qualified professional advice if you are considering structuring your business as an LLC.) LLCs, like corporations, can be formed in a state other than the one in which it does business.
Delaware and Nevada are popular states for filing the “articles of organization” (the most common document that establishes an LLC) because both states offer franchise tax and income tax advantages. However, most LLCs that do business in a single state are formed in that state to avoid complications. In most states, the articles are filed with a division of the Secretary of State’s office (the same as for corporations).
So far, there is no discernable difference between a corporation and an LLC, so what distinguishes one from the other? The answer lies mainly in the way management is organized, the way ownership is distributed and the way the business is taxed.
Of these, the last is the most telling. Taxation is undoubtedly why most LLCs are formed. Instead of being taxed, like most corporations, as a separate entity, an LLC is taxed like a partnership or sole proprietor business. The LLC files an annual tax return, but its tax liabilities are passed through to its members (an LLC’s member is the equivalent of a corporation’s stockholder.) The members then pay taxes according to their individual tax rates. This avoids the corporation’s pitfall of “double taxation” where the corporation’s profits are taxed as corporate profits and again as a shareholder’s income when they receive the profits as dividends.
This defining feature was not established when LLCs were first introduced to the United States in 1977 when Wyoming passed legislation that gave LLCs their legal framework. In the next decade, only Florida joined Wyoming in offering LLCs as an option for businesses. In 1988, the Internal Revenue Service finally ruled that qualified LLCs’ profits will be treated the same as a private business’s, not a corporation’s. Now, business owners can form an LLC anywhere in the U.S. In 1997 the rules were changed to allow an LLC to be taxed as a corporation if it chooses.
Of corporations, only subchapter S corporations share this pass-through income tax feature; however, they differ greatly in the rules they must follow regarding ownership and management.
An active member of an LLC cannot be paid wages. Any money paid to that member is regarded as a withdrawal of profits from the company and is subject to self-employment taxes. Inactive members, who have been given a membership share because of money invested or other considerations, do not have this problem.
Money that is distributed to them is treated as unearned income. An S corporation has a self-employment tax advantage because an active owner can also be an employee. The corporation pays its share of the payroll taxes on wages, the active shareholder pays his or her share of the payroll taxes, and any dividend distribution of profits is not subject to self-employment taxes.
Because an LLC is designed to pass through any profits to its members each year, those profits are taxable, whether or not they are actually distributed.
An LLC’s active members can take advantage of tax breaks on fringe benefits, such as health plans, but inactive members cannot.
The rules for how an LLC’s management can be organized are less stringent than for a corporation. Most LLCs are managed by one or more of their members, though it is possible to hire outside managers to run the business. An LLC must file an annual report but is not required to hold an annual meeting. The details of the LLC’s management structure are defined in its articles of the organization when it is formed.
Finally, in the last area of difference between an LLC and a corporation, an LLC’s ownership is distributed in a way uniquely its own. A corporation’s ownership is determined by how many shares of its stock a person owns, and dividends are distributed on a “per share” basis. An LLC, on the other hand, can set a special allocation of distribution of profits for a member that is different than that member’s ownership share. This must be specified in its operating agreement.
An LLC’s members cannot transfer their ownership as easily as a corporation’s stockholders. Instead of simply selling shares of stock, an LLC member must obtain the approval of the other members.
This lack of a free transferability of interest was one of two major distinguishing features that swayed the Internal Revenue Service to rule that LLCs could be taxed as a personal business rather than a corporation. The other big difference was a corporation’s “continuity of life.” An LLC can be set up in one of two ways to satisfy this criterion of the IRS.
It can set a date at which time the LLC is automatically dissolved, or it can specify that the LLC is to dissolve upon the incapacitation or retirement of one of its members. In both these instances, the dissolution of the LLC need not be final, for the remaining members can vote to continue the business.
To put a nutshell around all these diverse details, it can be said that an LLC is a hybrid of a corporation and a partnership/sole ownership business, with the limited liability and some, though not all, of the extra reporting requirements of the former, and the pass-through income tax benefits and flexibility of management of the latter.