As a sole proprietor, you've enjoyed watching your business take off. Your customer base is building, orders are steady, and your overhead is under control. But with this growth, you now realize you can't handle everything yourself. You need to attract investors, take on a few associates, and protect your personal assets from your firm's liabilities.
You've reached a turning point: it's time to run your company in a more formal manner. But should you set up the business as a corporation or partnership? The answer may be neither. As an alternative, consider a limited liability company (LLC) -- a form of business organization popular among small business owners that combines some advantages of a corporation and a partnership.
Compare the LLC
Why the need for an LLC? LLCs can offer a competitive advantage over corporations and partnerships in three areas: taxes, liability protection, and flexibility. Although the LLC statutes vary among the states, it's possible to generalize about how LLCs measure up against other business arrangements.
If the LLC is structured properly, it will be taxed like a partnership for federal income tax purposes. That means no tax at the company level. Like partnerships, LLCs distribute income and losses directly to owners who then report these items on their personal income tax returns. Being taxed like a partnership also avoids the double taxation problem faced by shareholders in a corporation. Corporate earnings can be taxed twice -- first as income to the corporation, and again as a dividend income to the individual shareholder. This combination of two levels of tax can mean a much higher tax cost than the single tax available through ownership of an LLC.
In general or limited partnerships, general partners can be held personally liable for the partnership's debts and obligations, as well as other partners' mistakes -- a big deterrent to many would-be entrepreneurs and prospective investors. Additionally, in certain situations, limited partners who become actively involved in running a partnership can be reclassified as general partners and lose their limited liability protection. But LLC owners, like corporate shareholders, are shielded from personal liability beyond the value of their investment. Their personal assets are generally not subject to the claims of business creditors. LLCs avoid the threshold problem in forming a limited partnership -- finding a general partner willing to be exposed to the business's liabilities.
The various state laws authorizing the use of LLCs generally permit their use in almost any type of business. LLC organizers have broad discretion in deciding who will manage the company. Often, LLCs are managed by a small group of the company's owners. And, while LLCs share some subchapter S corporation advantages -- such as limited liability and taxation only on the individual level -- they have far fewer restrictions. For instance, only individuals, estates and certain trusts may be S corporation shareholders, and the maximum number of shareholders is limited to 75. In contrast, LLCs have no such limits.
Forming an LLC
Forming an LLC typically involves filing articles of organization with the state. This document is analogous to a corporation's articles of incorporation and contains basic information about the LLC. The fundamental governing document is the operating agreement which outlines the rules for operating the business and allows the owners to allocate ownership interests in any desired fashion. It is generally a flexible, private agreement that can be customized to meet your business needs.
If you are already doing business as a C corporation or S corporation, you may face a host of taxes, expenses and complications in converting to an LLC. Merging LLCs with other entities is also fraught with potential complications. Since LLCs are relatively new and untested, many legal issues have yet to be addressed by statute or by the courts. Additionally, failure to carefully follow the LLC guidelines established by the IRS could nullify the tax advantage -- which would subject an LLC to corporate or "double" taxation. And there are no guarantees that the earnings of businesses conducted as LLCs will not be subjected to some form of taxation in the future. A few revenue-hungry states have already expressed such an interest.
Is the LLC the entity of choice for you? That depends on a number of factors. Adopting or changing your form of business requires careful consideration of your business, tax and financial needs and the legal risks. An experienced, professional advisor can assist you in making that decision.
Advisor is a registered representative of Lincoln Financial Advisors, a broker/dealer, and offers investment advisory service through Sagemark Consulting, a division of Lincoln Financial Advisors Corp., a registered investment advisor. . This information should not be construed as legal or tax advice. You may want to consult a tax advisor regarding this information as it relates to your personal circumstances.