EXECUTIVE SUMMARY AND INTRODUCTION: For much of
U.S. business history, the only choices of legal entity for a business
were generally: "To incorporate, or not to incorporate." However,
since a bold legal innovation by the state of Wyoming in 1977, all 50
states and the District of Columbia have now adopted limited liability
company (LLC) laws. LLCs offer a very attractive alternative that every
small business, including the smallest home-based business, should
now consider, since an LLC can provide the liability protection of a
corporation but offers the pass-through tax treatment of a partnership
or sole proprietorship, under the federal income tax laws and under the
tax laws of most states. LLCs can also generally be operated in a less
formal manner than a corporation, although separate accounting records
and bank accounts must be maintained.
In addition to LLCs, every state has also created a somewhat similar
but often even simpler new type of business entity, the limited liability
partnership, or LLP, which can provide partners of a general partnership
with liability protection by simply electing under state law to be an LLP.
Several states now also allow a limited partnership to make an LLP election,
becoming a limited liability limited partnership, or LLLP, which operates
much like a traditional limited partnership, but offers liability protection
to the general partners as well as to the limited partners.
This web page, excerpted from the authoritative books,
Starting and Operating a Business in California, Starting and
Operating a Business in Texas, and other state editions in
our Kindle e-book series, by Michael D.
Jenkins, Esq., will guide you through the pros and cons and ground
rules for operating your business in the form of an LLC or LLP,
including some of the specifics of various state laws dealing with
LLCs and LLPs. This web site provides a small sample of the comprehensive
tax, legal, and practical business advice found in the "Starting and
Operating a Business in ...(State)" e-books, all of which are written
for non-lawyers in plain English.
EVERYTHING YOU EVER WANTED TO KNOW (AND PROBABLY MORE)
ABOUT LIMITED LIABILITY COMPANIES AND LIMITED LIABILITY PARTNERSHIPS
By: Michael D. Jenkins, Esq., J.D., CPA (Retired). Mr. Jenkins is a graduate
of the Harvard Law School, and has practiced as a senior tax attorney with the major
law firm of Cooley, Godward, et al, in San Francisco (now the Cooley, LLP law firm
of over 800 lawyers), as a CPA and Tax Supervisor with the "Big 4" firm of Peat,
Marwick (now known as "KPMG") in Los Angeles, and as a tax partner in a large regional
CPA firm in the San Francisco Bay Area, Kimbell, McKenna & Von Kaschnitz.
From 1980 to 1999, he was the author and principal editor of the 1.2 million-selling
state-specific book series, "Starting and Operating a Business in.... (state)," which
were co-authored in most states by attorneys in those states or by the staff of the
CPA firm of Ernst & Young. (He revised and re-published the series in 2000 as a single
national print edition, "Starting and Operating a Business in the U.S.," with a CD-ROM
included that contained state chapters for all 50 states and the District of Columbia.)
All of the above print versions of those books are now out of print --
However, updated 2018, 2019, 2020, or 2021 versions of these books for most states
and the District of Columbia are now published in electronic book format by the
author. Editions for 32 states and D.C. are currently available
-- see the Kindle ordering page, to order the
Kindle e-book edition for your state.
LIMITED LIABILITY COMPANIES -- A RELATIVELY NEW TYPE OF LEGAL ENTITY:
The age-old choice of entity in starting a business has
long been a threefold one: sole proprietorship, partnership,
or corporation (plus such oddities as the "Massachusetts
business trust," an entity which the state of Massachusetts
recently did away with). But now, not only do most states
allow you to change your partnership into a "limited liability
partnership," but there is also a relatively new kind of
business entity which has arrived on the scene and finally
accepted and "blessed" by the IRS: the "limited liability company."
What, you may wonder, is this LLC entity?
- Is it a corporation? No, not exactly.
- Is it a partnership? Yes, sort of.
- Is it a sole proprietorship? No, not quite.
(Though it is sometimes treated as one for tax purposes.)
- Is it recognized in all states? Yes, since Hawaii's
law went into effect on April 1, 1997. (But its use is
prohibited for many kinds of state-licensed businesses or
professions in California.)
BACKGROUND OF LLCs:
Starting with the pioneering state of Wyoming in 1977, and
ending with the action of the Hawaii legislature in 1996, every
state has, during those twenty years, passed laws creating a
new type of legal entity called a "limited liability company"
(or LLC). These entities, which resemble (and are usually taxed
as) partnerships, offer the advantages of limited liability,
like corporations. While it has long been possible for
partnerships to offer limited liability to their LIMITED
partners, a limited partnership always had to have at least
one GENERAL partner, who was fully liable for the debts of
the business. That is not the case, with LLCs, in which all
"members" (owners) have limited liability, to the same extent
as shareholders of corporations.
The new limited liability company entities have, in effect,
done away with the need to have unlimited liability for ANY
of the owners of what is, in essence, a partnership form of
business organization. The same is true for businesses owned
by a single person, whether that person is an individual or
another legal entity, such as a corporation, partnership, or
another LLC. An individual who is a sole proprietor may now
easily and simply obtain limited liability by operating the
business as a single-member LLC, for minimal costs in most
states.
LIMITED LIABILITY PARTNERSHIPS:
In addition, all 50 states and D.C. have now adopted a
similar type of entity, the limited liability partnership
(LLP) or registered limited liability partnership (RLLP).
The LLP (or an RLLP) is simply a garden variety partnership
that registers with the state and pays a specified fee, in
order to become an LLP or RLLP and to have limited liability
conferred upon the partnership, which is generally quite
similar to an LLC, except that it may be operated like a
regular partnership, for the most part.
However, LLPs are mostly used for professional firms, and
in some states (New York and California and, until recently,
Nevada) only professional firms may set up LLPs. For those
professionals, the LLP offers only somewhat limited protection
from liability, in that a professional who is a partner in an
LLP remains personally liable for his or her own malpractice or
gross negligence, or such misdeeds committed by employees of
the LLP who operate under that partner's direction. (The same
is generally true of professional corporations or professional
LLCs.) But in most states, other, non-professional businesses
may also operate as LLPs, and generally obtain more liability
protection than professional LLPs. For more on limited liability
partnerships, see our LLP
BASICS WEB PAGE.
I.R.S. CHECK-THE-BOX-REGULATIONS OPENED THE DOOR WIDE
FOR LIMITED LIABILITY COMPANIES:
It was not until 1988 that the Internal Revenue Service
finally ruled that LLCs created under the LLC law of Wyoming
could qualify for tax treatment as a partnership, rather than
as a corporation, even though they offered limited liability
protection to the owners, much like a corporation. However,
the IRS initially laid down a strict set of highly technical
rules that LLCs had to follow, if they were to avoid being
subject to corporate income taxes, such as requiring LLCs to
have a limited term of existence, such as 20 years.
This tended to discourage the use of LLCs by all but the most
adventuresome businesses, for a number of years. Because of the
complex tax requirements of the IRS rules, many lawyers, other
than a few tax lawyers, were reluctant to attempt to set up LLCs
for their small business clients. In addition, the IRS took the
position that a single-owner LLC would be taxed as a corporation
in all instances.
However, in 1997, the IRS opened the floodgates when it
issued a new set of regulations that basically allowed any
LLC to choose whether it wished to be taxed as a partnership
or a corporation, simply by filing an IRS form and "checking
the box" as to what kind of taxable entity it wanted to be.
The new "check-the-box" tax regulations also allowed
one-owner LLCs, for the first time, to escape corporate tax
treatment and instead could be ignored as separate taxable
entities for tax purposes, the same as a sole proprietorship.
The tax regulations provide that any newly formed "eligible
entity" (which excludes corporations and, in most cases,
banks) will be treated by default as a partnership, unless
the owners or members of the eligible entity elect corporate
tax treatment, by filing Form 8832. A noncorporate
entity with only one owner, such as a one-person LLC, will
be treated as not being an entity that is separate from its
owner -- that is, its existence will be ignored -- unless
the owner elects corporate tax treatment. Thus, a sole
proprietorship that becomes an LLC will continue to be
treated as a sole proprietorship (for most purposes) by the
IRS, and an LLC set up by a corporation will be treated as
just another branch or division of the corporation, and not
treated as a separate legal entity.
The IRS will also continue to honor the noncorporate tax
status of any entity that was reporting as a noncorporate
entity (such as an LLC reporting as a partnership) before
1997, generally.
An existing eligible entity, if previously treated as a
corporation before 1997, is now able to elect noncorporate
status by simply filing Form 8832 with the
appropriate IRS service center, specifying the date the election
is to become effective, provided the date is not more than 75
days after, or 12 months prior to, the date of filing. If
no date is specified on the form, the election becomes
effective on the date filed. A copy of this form must be
attached to the tax return of the person or entity filing
the form for the first year in which the election is in
effect.
WARNING:
Such a change from corporate to noncorporate status would
be the equivalent of a corporate liquidation, with potential
capital gains or other taxable income resulting at both the
corporate and owner level at the time of such changeover.
Don't make such a change without first consulting a competent
tax advisor, as the tax consequences can be very severe in
certain situations!
This new set of IRS regulations was a truly revolutionary
change in the very old and long-established ground rules
for choosing a legal entity.
Under the "check-the-box" regulations, there is very
little reason for any business with more than one owner
to operate in "naked" form, without limited liability,
as a partnership. Also, since the 1997 "check-the-box" IRS
regulations went into effect, the states which still required
an LLC to have at least two members have all since amended
their LLC laws to permit formation of one-member LLCs.
(You may disregard statements in both major professional
all-state tax services that say that Massachusetts still requires
an LLC to have more than one member. That requirement ended
on January 1, 2003, and in 2008 tax legislation Massachusetts
made it clear that it will follow the federal classification
of legal entities, including "disregarded entities" -- i.e.
single-member LLCs. The major publishers' all-state tax publications
were still badly out of date in this regard the last time we
checked.)
THE INS AND OUTS OF OPERATING YOUR BUSINESS AS AN LLC:
Now that all of the states allow one-member LLCs, it makes
good business sense for almost any sole proprietor to become
an LLC, since the IRS will ignore the existence of the LLC
and continue to treat its income as being earned by a sole
proprietorship. In short, you will gain the benefits of limited
liability for your sole proprietorship without any increase in
your federal tax compliance chores or any changes in your tax
liability, except that, starting in 2009, federal tax regulations
require all disregarded entities to be employers for purposes of
federal payroll taxes. This means that you will need to apply for
a separate tax identification number for a single-member LLC if
the business has any employees and file payroll tax returns under
the name and taxpayer I.D. of the LLC.
In contrast, if you incorporate your business to gain limited
liability, you become subject to a whole host of federal and state
income tax and, in many states, franchise tax burdens, plus much
more complicated tax compliance requirements. Of course, there
are still situations when certain corporate tax advantages may
outweigh such disadvantages. For example, S corporation status is
often preferable to an being an LLC for professional firms, since
profits not paid out by an S corporation as salary will not be
subject to self-employment tax, generally. Furthermore, not all
states allow professionals to operate in LLC form, but all states
allow professional corporations. (Professional LLCs, like professional
corporations, do not protect the owners from their own malpractice
liability in any state.)
Multiple LLCs
It is also becoming standard practice for any form
of business, including sole proprietorships, partnerships
or corporations, to create separate LLCs for any new business
ventures, such as new stores for a retail chain, so that
the failure of such a new store or other venture will not
devastate the entire company. This could be accomplished
in the past by setting up multiple corporations for each
such business segment, but the heavy accounting, legal, and
tax return compliance costs of setting up and maintaining
multiple corporations has generally made that strategy
prohibitively expensive for all but quite large businesses.
Under the new set of ground rules, the main business
entity can now set up a series of subsidiary LLCs that
create "fire walls" between different segments of the
business, but which can be totally ignored for federal tax
filing purposes -- the main business will still file one
partnership or corporate tax return (or file one Form 1040
with one or more Schedule C's, in the case of an individual
owner), combining the results of all the separate "sole
proprietorship" LLCs on the single tax return. No multiple
tax returns, no horrendously complex consolidated corporate tax
returns and intercompany accounting will be required for such
arrangements -- a very clean, very simple, and very effective
way to reduce your liability exposure to creditors!
However, be aware that it will still be necessary to keep
separate accounting records and bank accounts for these LLCs,
as each will be a separate legal entity. Otherwise, creditors
might be able to "pierce the veil" of limited liability if the
LLC's assets are commingled with yours or with assets of another
entity, or if you do not otherwise consistently treat the LLC as
a separate business entity. Also, most states require some kind
of annual report to be filed, along with filing fees, by all LLCs
doing business in the state, so that each LLC will require some
additional paperwork, besides keeping separate accounting records
and bank accounts.
Note, however, that some state laws have recently provided for
"series LLCs," which allow you to set up a single LLC and create
separate "divisions" (or "series"), each of which is a separate
legal entity, in terms of liability exposure, as discussed
below.
State Taxes on LLCs
Some states, such as Tennessee, do subject LLCs to their
corporate income taxes, and some states with only a franchise tax
(on capital or gross receipts), such as Texas or Wyoming, impose
the franchise tax on LLCs as well as on corporations. Others, like
New Hampshire and the District of Columbia, impose an income or
franchise tax on the taxable income of all businesses, including
unincorporated ones. California imposes an "LLC fee" each year on
LLCs, based on their gross receipts, if California gross receipts
exceed $250,000, plus an $800 minimum franchise tax, which is
imposed regardless of size or profits.
Not all state tax laws initially conformed to the IRS "check-the-box"
regulations, so it was possible that a one-owner LLC could be treated
as a corporation under such states' income tax laws, until conforming
legislation was enacted. Also, a few states' LLC laws did not recognize,
or permit the formation of, single-owner LLCs, at the time the IRS
regulations were promulgated.
Now, however, all 50 states and D.C. permit one-owner LLCs, though some
states still tax LLCs like corporations.
In 2008, the IRS issued several Private Letter Rulings
(200816002, 200816003, and 200816004) to the effect that an S
corporation will not lose its "S" status if it has a shareholder
that is a single-member LLC, provided that the LLC is a "disregarded
entity" for tax purposes (meaning that it has not elected corporate
tax treatment) and is owned by an individual.
The upshot of these major law changes has not been to make
S corporations, sole proprietorships, and general partnerships
less attractive choices as ways to structure ownership of a
small business. Almost every small business is now able to
gain limited liability protection by adopting either the
LLC or LLP form, without need of incorporating or paying
corporate-level federal income taxes, although LLPs provide
less liability protection than corporations or LLCs in some
states that have not updated their LLP laws.
While single-member LLCs generally are accorded very favorable
and flexible tax treatment, it was not always entirely clear whether
an LLC is a "single-member LLC" LLC or not, in a community property
state like California, where the "single owner" is a married person,
which means the owner's spouse may also have an ownership interest,
as community property, in the LLC. Fortunately, the federal Internal
Revenue Service has taken a very lenient position in Rev. Proc.
2002-69, stating that the IRS will accept whatever choice the
couple make, either to disregard the LLC as an entity (treating it
as a "single-member LLC") or to treat it as a partnership between
the husband and wife. Presumably, the couple's choice of federal
tax treatment will also generally apply for state tax purposes,
since most states with income taxes follow the federal tax treatment
of LLCs, generally. (The nine community property states are
Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas,
Washington and, since 1986, Wisconsin.)
However, where the LLC is owned by a husband and wife as joint
tenants, or tenants in common, or as tenants by the entirety, it
is unclear whether the IRS treatment would be as lenient as for
community property owners, since the IRS has not yet issued any
published rulings on whether an LLC can be a disregarded entity
if held in one of the various forms of tenancy by a married
couple, rather than being held as community property. Thus,
it is also unclear, where an LLC is owned by a husband and
wife as co-tenants, whether a state would treat the LLC as
a single-member LLC or as a partnership.
Where a husband and wife directly own a business, a 2007
federal law change now allows them to elect to either treat
it as a partnership or as a "Qualified Joint Venture" where
each spouse reports his / her share of the business earnings
on separate Schedule C's on Form 1040.)
The Congressional committee reports regarding the 2007 law change do
not mention the treatment of an LLC owned solely by a husband and wife.
However, on its website, the I.R.S. states, regarding the "qualified joint
venture" election, that the business must be owned and operated by the
spouses directly, and must not be owned in the name of a state law entity,
such as an LLC or a limited partnership. Thus, an LLC owned by a
married couple must file as a partnership, except in community property
states, according to the I.R.S.
Since your lawyer no longer needs to be a rocket scientist or a tax
genius to properly set up an LLC that qualifies for noncorporate tax
treatment, the legal costs of forming an LLC have come down quite a bit
in recent years, due to the explosive growth in the number of businesses
or professional practices operating as LLCs. For example, there are
several organizations (not law firms), such as Northwest Registered Agent
LLC, that will set up an LLC (or corporation) for you in
any state for as little as $100.
Some Types of Businesses or Professions Cannot Operate in LLC Form
Not all states allow professional LLCs, and California prohibits
most businesses that require a state license of any kind from
operating as an LLC, so not every kind of business in every state
can be operated in the form of an LLC.
Converting An Existing Business to an LLC
Note that in Rev. Rul. 95-37, the IRS has ruled
favorably that an existing partnership may generally be
converted, tax-free, to an LLC (if the LLC qualifies for
partnership tax treatment). In fact, such a conversion can
be done without terminating the partnership's taxable year
(the LLC is simply treated as a continuation partnership) and
without need to obtain a new Federal Employer Identification
Number.
In many states, a simpler approach may be to merely
register the partnership as an LLP, where state law permits,
and where the liability protection that is offered by an LLP
is comparable to that of an LLC. (In our state editions of the
"Starting and Operating a
Business in ... (state)" e-books, we analyze the liability
protection offered by the LLP laws in the state. Some states
offer much less protection to partners in an LLP than for
members of an LLC, although most states have updated their
LLP laws to provide protection on a par with LLCs.)
Federal Self-Employment Tax on LLC Members
Be aware that, if an LLC is treated as a partnership,
the members may be subject to self-employment tax on their
earnings from the partnership. However, proposed IRS 1997
tax regulations (which have never been finally adopted)
would have generally treated members of an LLC like limited
partners in a limited partnership, so that certain members of
an LLC would not be subject to self-employment tax on their
distributive share of earnings from the LLC. However, under
those proposed, but never adopted, regulations, a member of
an LLC that elected to be taxed as a partnership (or a partner
in a limited partnership) would be treated as earning
self-employment income if any of the three following
conditions applied to the member:
- He or she has personal liability as a partner
of the partnership for debts or claims against it
(this would generally only apply to a general
partner in a limited partnership, not an LLC);
- The member has authority to contract on the LLC
or partnership's behalf under the law of the state
in which the LLC or partnership is organized; or
- The member participates in the entity's trade
or business for more than 500 hours during the tax
year. [Prop. Regs. Sec. 1.1402(a)-2(h)(2), proposed
in 1997 but never adopted or revised since]
Even if a member of an LLC participates more than 500 hours
a year in the LLC's business, his or her distributive share
of the profits may not be subject to self-employment tax,
although any "guaranteed payments" received from the
LLC for services would be. Thus, part of a member's income
from an LLC could be subject to self-employment tax, while
part is not, under the (never finalized) Proposed Regulations.
However, in service partnerships engaged in activities
such as legal or medical services, accounting, architecture,
engineering, actuarial or consulting services, anyone who
provides more than a minimal amount of such services would
not qualify for treatment as a "limited partner" for
purposes of the above exemption from self-employment tax
on his or her income from a limited partnership or LLC.
Unfortunately, the status of the tax law regarding the
application of the self-employment tax to members of an LLC
is still very much up in the air, since the IRS came under
heavy criticism for the Proposed Regulations, which Congress
ordered the IRS not to finalize or implement before July, 1,
1998. The IRS has not to this date set forth any new Proposed
Regulations or other pronouncements on this controversial
subject, and has never implemented the Proposed Regulations.
As a general rule, many tax practitioners today believe
that an LLC member is not subject to self-employment tax on
his or her income if the member is not a manager of the LLC
and that, generally, 10% or less owners of an LLC are not
subject to self-employment tax unless they receive a guaranteed
payment (like a salary) from the LLC for services rendered,
and not just a percentage share of the LLC's profits. However,
there is no clear answer to this question at present, and the
IRS may not necessarily agree if you treat your share of income
from an LLC as exempt from self-employment tax.
One court case in 2000 that considered whether some LLC members
could be treated like general partners, despite the fact that
all members of an LLC have limited liability, concluded that
members who actively participate in the business were similar
to general partners, and thus their income or loss from the LLC
was not "passive income or loss" under the passive activity
tax rules. Steven A. Gregg, et ux. v. United States,
87 AFTR 2d Par. 2001-311, U.S. District Court, District of Oregon
(November 29, 2000). The IRS had argued in this case that all
the members were similar to limited partners, due to their limited
liability, and that their losses were thus "passive losses" that
could not be deducted against other income.
While the IRS lost the Gregg case, regarding passive activity
tax losses, they might now try to use that court decision to argue that
some or all LLC members are also like general partners for purposes of
the self-employment tax. In one recent federal District Court case in
New Mexico, Riether v. United States, 919 F Supp. 2d 1140
(D. N.M. 2012), members of an LLC had issued themselves W-2s for much
of their income, treating themselves as employees of the LLC, and
treating the rest of their income (reported on a K-1) as "unearned
income," not subject to self-employment tax.
The court held that they were not employees and that ALL of their
income from the LLC was subject to self-employment tax. The District
Court opinion noted that members of an LLC are not automatically
treated as limited partners (who would be exempt from
self-employment tax). The District Court rendered a summary judgment
in favor of the IRS, stating that "Plaintiffs are not members of a
limited partnership, nor do they resemble limited partners, which
are those who 'lack management powers but enjoy immunity for debts
of the partnership,'" citing the U.S. Tax Court decision in
Renkemeyer, 136 T.C. 137 (2011).
More recently (2017), in Castigliola, T.C. Memo 2017-62, the Tax
Court followed the Renkemeyer decision, holding that three Mississippi
attorneys who were the members of a professional (law) LLC were not the
equivalent of limited partners and thus were subject to self-employment tax
on their distributive shares of income of the LLC. The three attorneys had previously
been the three partners in a law partnership before it was converted to an LLC.
The court reasoned that a limited partnership must have at least one general partner,
and since all of the members of the LLC had the same rights and responsibilities,
their positions were analogous to those of general partners in a limited partnership.
CAUTION:
It is probably safe to assume that, in the case of
an LLC which is not a service business in one of the
professions, performing arts, or consulting, and which
has a management agreement that creates two classes of
members -- managers and passive investors -- the
managing members will be subject to self-employment
tax and the passive members will very likely not
be subject to self-employment tax on their share of the
LLC's profits.
Otherwise, in most cases, the courts seem to be
leaning recently in the direction of treating all LLC or LLP
members as general partners, so there may not be many other
situations where members will be able to escape self-employment
tax any longer on their share of LLC profits, unless the
profits are from sources not subject to self-employment tax,
such as real estate rentals or interest income.
Whether or not income from an LLC (or LLP) should be
reported as self-employment income is a decision that should
only be made after consultation with a competent tax professional,
as this is a highly technical tax question and an area where
experts (and the IRS) can and do disagree as to what the
proper tax treatment should be. This issue is likely to
continue to be litigated until, if ever, Congress decides
to resolve the controversy.
One thing is clear, however. An I.R.S. study for
the years 2008-2010 concluded that self-employment tax was
being under-reported by about $65 billion for that period,
much of it due to LLCs taking the position that income of
LLC members was not subject to self-employment tax. As a
result, following the recent string of I.R.S. court
victories in cases like Renkemeyer and Castigliola,
the I.R.S. has gone on the warpath on this issue, designating it as a
compliance campaign issue in an announcement on March 18, 2018.
Accordingly, the I.R.S. has made it clear that it will now litigate reported
exclusions of self-employment taxes on distributive earnings of LLC
members who are in a position of management control or who provide
significant services to an LLC.
LLC members, beware!
Also, beware of much of the information on this question
you will find on the Internet, much of which assumes that the
IRS Proposed Regulations (of which Congress disapproved, but
did not order the IRS to rescind, in the 1997 tax act) are the
law. Sophisticated tax practitioners would beg to differ.
Some States Now Allow "Series" LLCs
Individual entrepreneurs, corporations, or other entities have
learned to utilize multiple LLCs, by putting separate business
ventures in separate LLCs, which allows the owner to isolate the
risks of each venture to the capital invested in that LLC. However,
in many states, such as California, using multiple LLCs means
incurring multiple taxes or other fees or administrative costs,
particularly where the various LLCs have somewhat different
members. The following example is how multiple LLCs are being
used to insulate separate businesses from liability, in most
states (not utilizing a "series LLC"):
EXAMPLE:
ABC Restaurants, a restaurant chain, typically might set up a
number of LLCs, one for each restaurant, perhaps with local
partners in each city who own part of the LLC that operates the
ABC Restaurant in that city. The bankruptcy of one of the LLCs
will not affect the parent company or other owners of any of
the other restaurants. This may work well to limit liability
from the failure of any one or more restaurants, but will result
in multiple annual fees and costs of annual reporting for each
of the LLCs, which may be substantial if there are a large
number of restaurants, each operated as a separate LLC.
Now, some states, notably Delaware, [Delaware Code, Title 6,
Subtitle II, Sec. 18-215] have amended their LLC laws to allow
"series LLCs." Several other states have enacted similar LLC
provisions, including Illinois, Iowa, Kansas, Nevada, Oklahoma,
Tennessee, Texas, and Utah, as well as the District of Columbia.
A series LLC is a single LLC that divides itself into a
"series" of separate divisions, each of which must keep a
separate set of books, but with each such division or series
operating a separate business, with its own separate limited
liability, so that if the business of one series goes bankrupt,
the other series or divisions of the LLC are not liable for
its losses. In effect, each such "series" of an LLC is like
a separate legal entity, with regard to legal liability, but
only one LLC exists, thus creating only one set of taxes, tax
filings, etc.
Each "series" can even have different members, managers,
and ownership percentages and can make distributions to
its members while other members of the LLC receive none.
Thus, in the restaurant chain example above, in a state
that allows "series LLCs," a single "series" LLC could
be substituted for a large number of separate LLCs, with
each restaurant segregated into a separate unit ("series")
or subdivision of the single large series LLC. Doing so
would provide the same liability protections, but filing
fees and tax returns would only be required for the one
LLC entity, resulting in considerable cost savings.
However, legal experts are divided, so far, as to whether
other states will respect such series LLCs established
under the laws of, for instance, Delaware. Also, it is not
yet clear whether the IRS will allow such an LLC to file a
single partnership tax return, or will treat each separate
series as a separate partnership, with tax returns required
for each. California almost immediately decided that Delaware
"series" LLCs that do business in California would be treated
as multiple LLCs, so that each will be subject to the
California $800 minimum franchise tax. (Ouch!)
Thus, while this new legal development offers significant
potential benefits, you may take significant risks if you
are one of the pioneers who sets up a series LLC before the
tax and legal treatment of such entities has been sorted out
by the courts, IRS, and state legislatures.
PROS AND CONS OF LIMITED LIABILITY COMPANIES:
Major benefits of LLCs over the traditional business
entities that were available up till now (corporations,
partnerships and sole proprietorships) include the following:
- Unlike partners in a general partnership or the general
partners in a limited partnership, the owners of an LLC
have limited liability; and, unlike limited partners in
a limited partnership, they do not lose their limited
liability if they actively participate in management.
- Under the IRS "check-the-box" regulations,
a business that is currently a sole proprietorship is
also able to change to LLC form and thus obtain limited
liability, with no tax consequences or added tax
compliance requirements of any kind (except, on or after
January 1, 2009, to get a separate tax I.D. number for
payroll tax reporting), as the IRS will now, in effect,
ignore the existence of the one-owner LLC for income tax
purposes. Most, but not all, states follow the federal
treatment of such "disregarded entities."
- Like a regular corporation (a C corporation), an LLC
provides limited liability to its owners, but taxable
income or losses of the business will generally pass
through to the owners (but any such losses may not
always necessarily be deductible, due to the "at-risk"
and "passive loss" limitations of the tax law).
- An LLC is more like an S corporation, in that it
provides for a pass-through of taxable income or losses,
as well as limited liability, but can qualify in many
situations where an S corporation cannot, since an S
corporation cannot:
- have more than 100 shareholders;
- have nonresident alien shareholders;
- have corporations or partnerships as
shareholders;
- be a financial institution, insurance company,
or a special corporation such as a DISC or a
"possessions corporation" (however, LLCs generally
cannot be one of those types of entities, either);
- have more than one class of stock (or otherwise
have disproportionate distributions); or
- have too much of certain kinds of "net passive
income" (under certain circumstances).
- Also, LLC owners may be able to claim tax losses
in excess of their "at-risk" investment, such as on
certain leveraged real estate investments, which would not
ordinarily be possible in the case of an S corporation
or even a limited partnership.
- LLCs are (generally) simpler entities to maintain
than corporations. An LLC is required to file its
"articles of organization," which are similar
to articles of incorporation, but the operational
similarities tend to end there. It is also a good
idea for an LLC to have a written operating agreement,
which spells out how the company is to be operated,
much like a partnership agreement. However, from
that point on, the LLC is governed by its operating
agreement, and there is generally no need for any
of the tedious corporate formalities such as minutes
of meetings, resolutions and annual meetings of the
shareholders ("members" in the case of an LLC).
This operating flexibility, in addition to freedom from
corporate level income tax (except in the few states
that impose state income taxes on them) makes the LLC
a highly advantageous form of doing business for the
closely-held or family-owned business.
However, the federal and state tax treatment of LLCs
is not uniformly favorable, as there are some disadvantages.
Perhaps unintentionally, a partnership tax law provision
that was added in the Revenue Reconciliation Act of 1993
may adversely impact professional service firms that are
organized as LLCs, rather than as true partnerships. Under
the 1993 tax law amendments, certain payments made by
partnerships to outgoing partners (for "goodwill" or
"unrealized receivables") are not deductible to the partnership,
except when made to a general partner in a service
partnership, such as a law or medical partnership.
Since LLCs with multiple owners, if properly organized, are
treated as partnerships for income tax purposes, this 1993 law
applies equally to professional service firms that are either
LLCs or partnerships.... With one important Catch-22: Since
an LLC has NO general partners (all of its partners have
limited liability, like limited partners), then NO payments
(for goodwill, etc.) by an LLC to buy out one of its members
can qualify as deductible under the 1993 tax law change.
This can be a serious tax disadvantage for a professional
service firm that operates as an LLC, rather than as a
partnership. (Furthermore, some states do not allow
professional service firms to operate in the LLC form.)
Professional firms will often find it preferable to
operate in the form of professional corporations, electing
S corporation status, rather than as LLCs, since all
the earnings of a professional LLC will generally be
subject to self-employment tax. If operating as an S
corporation, only the salaries paid will be subject to
FICA taxes (at the same rate as self-employment tax),
and any remaining profit that is earned by the S
corporation will be subject only to income tax, not
to self-employment or FICA taxes, provided that the
amount of salaries paid is not unreasonably low and
subject to treatment as a tax avoidance ruse by the IRS.
Another disadvantage of an LLC is that an LLC may need
to file with the IRS as a tax shelter if it has members who
are treated as limited partners or “limited entrepreneurs”
(persons who are not limited partners but who do not
actively participate in the LLC's management).
In addition, some states, which have corporate income
taxes or franchise taxes based on income, treat LLCs as
corporations for state income tax purposes. This can
result in double state taxation of income in New Hampshire
(although only in special cases after 2010), if you
distribute income, since the distributions may be treated
as taxable dividends to the recipients, after being taxed
once already at the LLC level; or, in states like Texas,
or Tennessee, which have no general personal income tax,
can result in at least one layer of state tax on income,
which would not otherwise be incurred with either a regular
general partnership or a sole proprietorship.
Also, some states impose other income-based taxes at
the entity level on LLCs, just as for corporations, such
as the Illinois Personal Property Replacement Tax. Other
business entity gross income or net income taxes such as
in Washington, D.C., New York City, New Hampshire,
Texas, Kentucky, Ohio, and Washington (state), apply
equally to LLCs and to some or all other unincorporated
businesses, as well as to corporations. However, the
Texas franchise tax and Kentucky Limited Liability Entity
(LLE) tax both mostly exempt small businesses with less than
certain substantial amounts of gross receipts -- $1.18
million for 2020 and 2021 reports for Texas, $3 million in
the case of Kentucky, except for a $175 minimum LLE tax.
New Mexico and Hawaii also impose gross receipts taxes that
are in place of sales taxes and those taxes apply equally
to all types of business entities.
Even with the above drawbacks, LLCs seem to have many
advantages that almost guarantee a continued boom in their
popularity in coming years.
IMPORTANT NOTE RE LLC FORMATION:
If you want to set up an LLC in any state, or need Registered Agent
services in any state where your LLC does or will do business,
Northwest
Registered Agent LLC will handle the entire process of creating an LLC (or
corporation) for you for a flat fee of $100, which seems to be the minimum price
charged by any of the various companies that specialize in setting up LLCs. (Of
course, you will also have to pay the state any fees or taxes that are required
when forming an LLC -- but this particular firm does not "mark up" those costs
that they pay on your behalf, unlike some of the other incorporation/LLC firms.)
Northwest Registered Agent LLC has a simple one-page online
sign-up page for creating your LLC. Just
click
here to fill out their form, and for $100 plus applicable state fees or taxes, you
can have an LLC up and running in a few days.
State laws generally require an LLC to have a "registered agent" in
states in which the LLC does business. This company will also serve as your
registered agent in any state for (a very reasonable) $125 a year. For
information on the nature of the registered agent services that you will
need if doing business outside your home state and that Northwest
Registered Agent LLC provides,
click
here.
STATE NOTES ON LLC LAWS:
As noted above, every state in the U.S., has now adopted
a limited liability company (LLC) law, in some form. Thus, in
addition to the traditional choices of a sole proprietorship,
partnership, or corporation, a business may also choose, in
most states, to operate in the form of an LLC. In most states,
LLCs are very attractive entities for many small businesses,
in that they offer the same protection as a corporation from
creditors for debts of the business, while offering much of
the flexibility plus the flow-through tax treatment of a
partnership for federal tax purposes.
However, some states limit the types of businesses that
may operate as LLCs, or impose significant income taxes,
capital taxes, or fees on LLCs. For example, California
severely limits the types of businesses that may operate in
the form of an LLC, and imposes "LLC fees" on LLCs, based
on gross receipts of the business, as well as a $800 annual
minimum tax. Other states, such as Tennessee, tax the income
of an LLC in the same manner as a corporation, so that there
is no state tax advantage of using the LLC form in those states.
The states of New York and New Jersey impose hefty annual fees
on most LLCs, based on the number of members (owners) of the
LLC in New Jersey or on gross receipts in New York, up to a
maximum fee of $4,500 in New York or $250,000 in New Jersey.
Ohio phased out its corporate franchise tax in 2009 and
replaced it with a "Commercial Activities Tax," a gross receipts
tax that applies equally to all types of legal entities.
Similarly, Kentucky now imposes a "limited liability entity" tax
on LLCs and all other limited liability business entities, based
on gross receipts or gross profits, but small businesses with
less than $3 million of gross receipts pay only a flat $175 tax.
The Texas franchise tax (sort of a modified gross receipts tax)
applies to LLCs and other unincorporated limited liability entities
(LLPs and limited partnerships) as well as to corporations, although
it exempts small businesses with under $1,180,000 of gross receipts
for the years 2020 and 2021.
Still other states and cities, such as New Hampshire, the District
of Columbia and New York City, tax the income of all business
entities in more or less the same manner, regardless of the legal
form of the business, so that the LLC form provides no state (or
city) income or franchise tax advantages in some jurisdictions.
The following link is a sample from one of our state editions
that provides general information on LLC organizational requirements
and filing fees in the state of TEXAS.
OTHER STATES' LLC LAWS (NOT COVERED HERE):
The state-by-state summary of key provisions of LLC and LLP
laws for all 50 states and D.C., which was previously found on
this web page, has been removed from this web site. The LLC
and LLP laws of 32 states and D.C. (as well as other business
laws and taxes) are covered in our book series, Starting
and Operating a Business in the U.S., (by Michael D. Jenkins,
Esq.), now published in Kindle
e-book format, in place of the former print editions.
UPDATE NOTE:
Since 2011, when we converted out book series to Kindle editions of "Starting
and Operating a Business in New York," California, Texas, etc., the ebooks have
been available for all or most states. See our ordering
page for the Kindle edition for your state, which not only
can be read on a Kindle device, but also on PC's, iPads, iPhones
and other smart phones, and on numerous other devices, using the
free Kindle "apps" that you can download from Amazon.com.
However, 18 state editions are no longer being published since
2013, for the states of ID, IL, IN, IA, KS, KY, LA, MD, MS, MT, OH, OK,
OR, RI, TN, UT, VA, and WI, since Amazon.com, in its infinite wisdom,
somehow concluded in 2013 that the content of those editions was too
similar to the other editions, despite the drastic differences in state
laws in every state. Of course, the federal laws discussed in each edition
were the same, which was the apparent reason Amazon decided those 18
state editions violated the Kindle publishing guidelines. (Yes, a
mystery to us, too.)
