What you’ll learn to do: discuss the advantages and disadvantages of hybrid forms of business ownership
The concept of “limited liability” has given rise to hybrid forms of business ownership such as LLCs and LLPs. In this section you’ll learn what these forms are and the pros and cons of each.
- Define limited liability company (LLC) as a form of business
- Discuss the advantages and disadvantages of LLCs
- Define limited liability partnerships (LLP) as a form of business
- Discuss the advantages and disadvantages of LLPs
Limited Liability Company (LLC)
A limited liability company (LLC) is a hybrid business structure allowed by state statute. LLCs are attractive to small business owners because they provide the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. Each state may use different regulations, and you should check with your state if you are interested in starting a limited liability company.
Owners of an LLC are called members. Most states do not restrict ownership, and so members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single-member” LLCs, those having only one owner.
Unlike shareholders in a corporation, LLCs are not taxed as a separate business entity. Instead, all profits and losses are “passed through” the business to each member of the LLC. LLC members report profits and losses on their personal federal tax returns, just like the owners of a partnership would.
Forming an LLC
While each state has slight variations on forming an LLC, they all adhere to some general principles:
Choose a Business Name. There are three rules that your LLC name needs to follow: (1) it must be different from an existing LLC in your state, (2) it must indicate that it’s an LLC (such as “LLC” or Limited Company”) and (3) it must not include words restricted by your state (such as “bank” and “insurance”). Your business name is automatically registered with your state when you register your business, so you do not have to go through a separate process.
File the Articles of Organization. The “articles of organization” is a simple document that legitimizes your LLC and includes information like your business name, address, and the names of its members. For most states, you file with the Secretary of State. However, other states may require that you file with a different office such as the State Corporation Commission, Department of Commerce and Consumer Affairs, Department of Consumer and Regulatory Affairs, or the Division of Corporations & Commercial Code.
Create an Operating Agreement. Most states do not require operating agreements. However, an operating agreement is highly recommended for multimember LLCs because it structures your LLC’s finances and organization, and provides rules and regulations for smooth operation. The operating agreement usually includes percentage of interests, allocation of profits and losses, member’s rights and responsibilities, and other provisions.
Obtain Licenses and Permits. Once your business is registered, you must obtain business licenses and permits. Regulations vary by industry, state, and locality.
Announce Your Business. Some states, including Arizona and New York, require the extra step of publishing a statement in your local newspaper about your LLC formation.
In the eyes of the federal government, an LLC is not a separate tax entity, so the business itself is not taxed. Instead, all federal income taxes are passed on to the LLC’s members and are paid through their personal income tax. While the federal government does not tax income on an LLC, some states do, so check with your state’s income tax agency.
Since the federal government does not recognize LLC as a business entity for taxation purposes, all LLCs must file as a corporation, partnership, or sole proprietorship tax return. Certain LLCs are automatically classified and taxed as a corporation by federal tax law.
Advantages of an LLC
- Limited Liability. Members are protected from personal liability for business decisions or actions of the LLC. This means that if the LLC incurs debt or is sued, members’ personal assets are usually exempt. This is similar to the liability protections afforded to shareholders of a corporation. Keep in mind that limited liability means “limited” liability—members are not necessarily shielded from wrongful acts, including those of their employees.
- Less Record Keeping. An LLC’s operational ease is one of its greatest advantages. Compared to an S Corporation, there is less registration paperwork and there are smaller start-up costs. However, it is very important to keep proper and separate business financial records. If it appears that the LLC is co-mingling personal and business funds, it can be legally reclassified and end up assuming additional liability.
- Sharing of Profits. There are fewer restrictions on profit sharing within an LLC, as members distribute profits as they see fit. Members might contribute different proportions of capital and sweat equity. Consequently, it’s up to the members themselves to decide who has earned what percentage of the profits or losses.
Disadvantages of an LLC
- Possible Limited Life. When an LLC is formed, the members must decide on the duration of the LLC. If an LLC is formed in a state where perpetual life is not permitted, then the death or disassociation of a member will dissolve the LLC, and the members must fulfill all remaining legal and business obligations to close the business. For this reason, it is important for individuals seeking to use this form of ownership verify the requirements for an LLC in the state in which they intend to operate.
- Self-Employment Taxes. Members of an LLC are considered self-employed and must pay the self-employment tax contributions towards Medicare and Social Security. The entire net income of the LLC is subject to this tax.
Limited Liability Partnership (LLP)
A limited liability partnership (LLP) is a partnership in which some or all partners (depending on the jurisdiction) have limited liabilities. It therefore exhibits elements of partnerships and corporations. In an LLP, one partner is not responsible or liable for another partner’s misconduct or negligence.
In an LLP, some partners have a form of limited liability similar to that of the shareholders of a corporation. Some states require one partner to be a “general partner” with unlimited liability, meaning he/she is ultimately responsible for the debts of the business and for any lawsuits such as personal injury or breach of contract. Unlike corporate shareholders, the partners have the right to manage the business directly. In contrast, corporate shareholders have to elect a board of directors under the laws of various state charters. The board organizes itself (also under the laws of the various state charters) and hires corporate officers who, as “corporate” individuals, then have the legal responsibility to manage the corporation in the corporation’s best interest. An LLP also has a different level of tax liability compared with that of a corporation.
As in a partnership or limited liability company (LLC), the profits of an LLP are allocated among the partners for tax purposes, avoiding the problem of “double taxation” often found in corporations.
Forming an LLP
Verify Eligibility Status. In the United States, each individual state has its own law governing the formation of LLPs. Although found in many business fields, the LLP is an especially popular form of organization among professionals such as lawyers, accountants, and architects. In California, New York, Oregon, and Nevada, LLPs can only be formed for such professional uses.
Choose a Business Name. When selecting a name for the LLP, generally the name (1) must be different from an existing LLP in your state, and (2) most states require the inclusion of “Limited Liability Partnership,” “LLP,” or another related abbreviation at the end of your business name.
Draft a Limited Liability Partnership Agreement. Although not required in every state, this agreement is strongly recommended. A limited liability partnership agreement should define each partner’s role and responsibilities. It should clearly define the partners’ assets and liability limitations. The agreement should also outline capital contributions, distribution of profits and losses, buyout agreements, expulsion or addition of partners, etc.
File a Certificate of Limited Liability Partnership. The drafting of an LLP agreement is optional; however all LLPs must file a certificate of limited liability partnership (sometimes called a certificate of registration as a limited liability partnership). The certificate of limited liability partnership is more general than the limited liability partnership agreement, as it does not detail responsibilities, capital contributions, buyouts, etc. The certificate requires the listing of your business’s name and address, the names and contact information of the partners, and information on the registered agent of the LLP.
Obtain Licenses and Permits. Once your business is registered, you must obtain business licenses and permits. Regulations vary by industry, state and locality.
Announce Your Business. Some states, including Arizona and New York, require the extra step of publishing a statement in your local newspaper about your LLP formation.
The tax treatment for LLPs is similar to general partnerships, as discussed earlier. Profits and losses are passed through to the partners so the partners reflect them on their individual tax return.
Advantages of an LLP
- Single Taxation. The credits and deductions of the company are passed through to partners to file on their individual tax returns. Credits and deductions are divided by the percentage of individual interest each partner has in the company.
- Limited Liability. The LLP structure protects individual limited partners from personal liability for negligent acts of other partners or employees not under their direct control. In addition, individual partners are not personally responsible for company debts or other obligations.
- Flexibility. LLPs provide the partners flexibility in business ownership. Partners have the ability to decide how they will individually contribute to business operations, both financially and physically. Management duties can be divided equally or unequally based on the experience of each partner. Partners who have a financial interest in the company can elect not to have any authority over business decisions but still maintain ownership rights based on their percentage interest in the company.
Disadvantages of an LLP
- Duration. The business life of a LLP is unstable because the partnership can be dissolved by agreement of the partners or upon the death or withdrawal of a partner. A limited liability partnership agreement can prevent dissolution if a partner dies or withdraws.
- Limitation of Formation: Unlike general partnerships, limited liability partnerships are not recognized as legal business structures in every state. Some states limit the creation of a limited liability partnership to professionals such as doctors or lawyers.
- Partner Control. If an LLP is formed without a limited liability partnership agreement, individual partners are not obligated to consult with other participants in certain business agreements. The fact that a partner can make business decisions without consulting the other partners can be problematic, to say the least.