Which Business Structure is Right for Your Company? Part Three: LLCs
One of the most fundamental and important questions new business owners must ask themselves is how the business will be structured. While numerous options for legal structures are available for entrepreneurs to choose between, what may be optimal for one entity could prove disastrous for another. At the end of the day, the formal structure which is best for your venture depends heavily upon your business’ unique objectives. In the past, our three-part blog series “Which Business Structure is Right for Your Company?” has gone over the merits and drawbacks of corporations and partnerships. In the third and final installment, our business attorneys evaluate the pros and cons of registering your business as a Limited Liability Company, or LLC.
What is an LLC?
The acronym LLC stands for Limited Liability Company.
While the corporation has existed as a legally recognized business entity for centuries (in fact, the first corporation was established in Sweden in 1347), the LLC as a commercial structure is a modern invention. Many people are surprised to learn that the first LLC was established in Wyoming as late as 1977, making the LLC less than 40 years old.
While the roots of the LLC may not boast the same historical reach as those of the corporation, the LLC has become an extremely popular business structure during the few decades it has been in existence. For many business owners, the LLC represents the best of both worlds. This is because the LLC borrows the most advantageous features from corporations and partnerships to create a single, sturdy hybrid incorporating the flexibility and tax benefits of partnerships with the limited liability of corporations.
LLCs as Pass-Through Tax Entities
Regardless of size or industry, all businesses have one goal in common: protecting and maximizing their profitability. Avoiding unnecessary taxation can help achieve this objective.
To use a common example, new business owners sometimes hesitate to select the C-Corporation as a legal structure due to a taxation practice called “double taxation.” In double taxation, company profits are initially taxed to the actual corporation, at which point the company’s shareholders are taxed for a second round on the individual level. In order to avoid this financially unattractive arrangement, some business owners prefer to set up a “pass-through” arrangement like an LLC instead.
A pass-through arrangement is precisely what it sounds like. Instead of being taxed first to the company and then a second time to the shareholders, LLC tax liability “passes through” the company, and is taxed directly to the shareholders. This means that the company itself does not pay taxes. Instead, the LLC’s shareholders must report losses and profits on their personal tax returns, similar to members in a partnership. While LLCs do not pay taxes, they are required to file Form 1065, which is a five-page document detailing profit/loss information to the IRS.
In another similarity with the partnership, LLC members (i.e. owners) are also required to pay self-employment tax. However, part of the self-employment tax may be deducted as a business expense.
All of this information boils down to one critical point: LLCs are taxed less heavily than C-Corporations. For entrepreneurs, that’s good news.
LLCs Offer Protection Against Liability
Corporations offer extensive liability protection, but sometimes suffer from extensive taxation. By comparison, general partnerships are taxed less heavily, but leave their members vulnerable to unmitigated personal liability in the event of a lawsuit, bad investment, or general debt. LLCs are taxed lightly like a partnership, but offer personal liability protection like a corporation.
Imagine a scenario in which a general partnership incurs a debt, as happens frequently in the business world. Perhaps the partnership simply lost money on a poor investment, or breached a contract and is being sued for damages. Unfortunately for the partners, they can now be legally held personally liable for satisfying the company’s financial obligations. In order to pay off the company creditors, the partners themselves can be forced to relinquish their personal assets, such as their vehicle or the money in their bank account. Needless to say, this arrangement involves a certain threshold of risk.
The Limited Liability Company lives up to its namesake by eliminating this personal liability risk. In a nutshell, business creditors cannot legally collect a debt from an LLC member, regardless of the debts the LLC may have incurred as a business. While the LLC itself may be “on the hook” for a payment, its individual owners are not. This is one of the most significant differences between an LLC and a general partnership, and one of the most common reasons entrepreneurs choose the LLC over the partnership as a structure.
However, it is important to mention that there are several exceptions to the limited liability protection which the LLC structure normally offers. Should any of the following scenarios occur, the LLC members can be held personally liable for a business debt:
- A member causes personal injury to another person (i.e. personal injury liability).
- A member commits fraud or conducts other illegal activity, which results in damages to the company and/or another person.
- A member does not deposit taxes which have been withheld from an employee’s pay.
Regardless of the structure you ultimately choose for your entity, creating a company is a legally and financially complex matter. At Maselli Warren, our business attorneys have been helping the men and women of New Jersey make the right decisions for 25 years. If you have a question about what’s best for your business, call our law offices today at (800) 891-2657, or contact us online.