Introduction

     Traditionally, there were only two types of business organizations: corporations and partnerships.  Corporations protect officers, directors and shareholders from personal liability, but have certain tax consequences, which may be undesirable.  Partnerships, on the contrary, offer certain tax benefits, but partners are responsible for the debts and obligations of the partnership.  Today there are various hybrids of these two basic models.  The “Limited Liability Company” is an alternative which combines the liability protection of a corporation, while giving members the freedom to tailor their own ownership and management relationships, but bestowing status as a partnership for tax purposes. 

Limited Liability Companies

     A limited liability company is formed under state laws, which authorize the creation of the company and govern the company’s operations.  The members of the limited liability company are all parties to a contract, sometimes called the operating agreement, which sets forth the rights and duties of the members.  Some states allow the members to structure the agreement in whatever fashion they desire.  Other states are more restrictive and limit the ability of members to structure the agreement in a manner that may affect eligibility for special federal tax treatment.

     The state laws are written to give the company a legal existence separate from its members and shield those members from personal liability for the obligations of the company.  In this way, the limited liability company resembles a corporation.  The company, as a separate entity is liable to its members for any loss incurred in carrying out company business, but the individual members are not.  In other words, if the company does not have enough funds to cover the loss incurred by one of its members, that member may not look to the others for compensation.  However, each member remains personally liable for damages resulting from their own wrongful acts.   

     Even though they provide the protection from liability usually afforded by virtue of incorporation, the state laws are also designed to allow limited liability companies to take advantage of the tax benefits conferred by the federal governments on partnerships.  Unlike corporations, partnerships are not seen as an entity separate from the partners.  Thus, the partnership does not pay a separate business tax.   By contrast, a corporation, as a separate entity, pays income tax on its earnings.  Then, if the corporation chooses to distribute its after tax income to the shareholders in the form of dividends, the shareholders must pay tax on that income.  Thus, those sums are taxed both at the corporate level and at the shareholder level.  This is commonly referred to as “double taxation.”  In a partnership, only the partners pay taxes.  Losses also pass through the partnership to the partners.  When the partnership loses money, the partners can deduct that loss from their own income taxes.  This is the way in which limited liability companies are taxed if they maintain the characteristics of a partnership.

     The state laws that create limited liability companies design them to resemble partnerships, not corporations, so that they may achieve partnership tax status.  Corporations have four essential elements: limited liability, continuity of life, free transferability of ownership interests, and centralized management.  The more of these attributes the limited liability lacks, the greater the likelihood the limited liability company will be treated as a partnership for tax purposes.  Because limited liability companies are meant to limit the liability of their members, states attempt to limit the remaining three characteristics.

     To avoid the corporate characteristics of continuity of life, free transferability of ownership and centralized management, state laws usually adopt the parameters of partnership structure.  Thus, like a partnership, the general rule is that the limited liability company does not continue to exist if one of the members dissociates from the company for any reason.  Also, like a partnership, ownership interests in limited liability companies are reflected by membership interests, rather than by shares, as commonly seen in corporations.  Members of the limited liability company may assign their economic rights, such as the right to receive distributions, but the transferees may not participate in the management of the company.   A member must have the consent of the other members to transfer their entire interest, which includes the important right to manage the company.  Lastly, most states allow for management by the members (a few states provide for management by managers).  Some states have enacted “bullet proof statutes” that limit the characteristics of a limited liability company in such a way that it will necessarily be treated as a partnership for tax purposes.  Other states have “flexible statutes” which allow the members of the limited liability company greater freedom in structuring their own organization. 

Conclusion

     One of the most important business and income tax planning decisions facing a business planner is the choice of organizational form.  This decision is seldom given the consideration it deserves even though the wrong choice can lead to unnecessarily high taxes.  New hybrid models, such as the Limited Liability Company, expand the business organizational options, but make choosing among them more complicated.  An experienced business attorney can help you decide whether a Limited Liability Company is right for you or whether a different organizational structure makes sense considering your specific business needs.  Your chosen attorney can also assist you in the actual formation and planning of your business.

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