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In this four-part series, we'll examine the different ways to structure your small business, comparing the various advantages and disadvantages of each

Part II - Limited Liability Company and Limited Liability Partnerships

 


by Reed Richardson

Started more than 30 years ago as a hybrid between corporations and traditional partnerships, limited liability companies have proven to be an increasingly popular strategy for small business owners and are now legal in all 50 states. The flexibility and financial benefits offered by an LLC structure have quickly made it a common choice for business owners of all sizes, supplanting even the once favored S-Corporation business model. (In 2007, after hedge fund investors bought out automaker Chrysler, they re-organized the new private company as an LLC.)

For the most part, LLCs and LLPs are very similar organizational structures. They both offer the limited liability protections common to incorporated businesses, but with the ability to pass through profits to the company's individual owners. Where they differ centers on operational control and tax status. LLCs, though equally owned by their members, are typically run on a day-by-day basis by a single president or a few hands-on managers, whereas with LLPs, the business's many partners usually have a more substantive role to play in running the business. As a result, most traditional retail and B-to-B companies tend to organize as LLCs, while most legal, accounting, and consulting firms-professional practices that have a higher number of partners and a more flattened-out organizational hierarchy-tend to favor LLPs. Also, an LLC can be taxed in various ways-as a sole proprietorship, general partnership, or corporation-but an LLP must, necessarily, be taxed as a partnership.

 

Here are some of the advantages of the LLC/LLP approach:

Operations - If your small business will have 35 or fewer partners, a fairly simple one-page article or certificate of organization, filed with your state's business authority, is all that is usually required to establish and maintain an LLC or LLP. (To find your individual state's filing requirements, try your state's Secretary of State website. To compare sample LLC and LLP certificates of organization from the state of Washington, go here: http://secstate.wa.gov/_assets/corps/LLC.pdf and here: http://secstate.wa.gov/_assets/corps/LLP.pdf .)

When it comes to spelling out how your LLC or LLP will run on a day-to-day basis, drawing up a fairly straightforward "operating agreement" is standard practice. This document, which typically runs from three to ten pages, sets up the rules for governing the company as well as the rights and responsibilities of each partner, or "member" as they're called in LLCs. These partners or members are free to make decisions and run the business however they see fit. They can even change the operating agreement whenever they want, provided they get unanimous approval. In addition, if some members of an LLC want to function more like silent partners, the group can choose to elect a manager or managers-who may or not be members of the LLC-to run the day-to-day affairs of the business. To create another layer of ownership and additional liability protection, LLCs can also have separate corporations as members. (To view a blank operating agreement, check out this online sample for LLCs in the state of California: http://docstoc.com/docs/294675/Sample-LLC-Operating-Agreement .)

Tax - The LLC or LLP operating agreement also spells out how the business's profits will be allocated. Just as in a sole proprietorship or general partnership, LLCs and LLPs allow for tax simplicity as they permit the multiple owners of the company to directly share in the profits and, as a result, file only once through their individual returns. In addition, they have the flexibility to choose not to "pass through" company profits to their personal tax returns or to have the business taxed as a separate entity. Also of note, because of the similar way profits are treated, the IRS allows sole proprietors and general partnerships to convert to an LLC or LLP without changing the company's reporting requirements or paying any additional taxes. (For a comparison of the tax implications of the different business entities, go here: http://irs.gov.)

Personal Liability - Here is where the LLCs and LLPs differ from sole proprietorships and general partnerships. Members of a limited liability business, while they enjoy the same tax privileges of a general partnership, get the same limited personal liability protections that are afforded to shareholders of a corporation. This means that members typically do not have any more exposure to loss than what they have directly invested in the business because any legal judgment against an LLC is limited to that company's assets. However, some states do have a requirement that at least one partner in an LLP have personal liability for the company, so be sure to check your local regulations.

 

While LLCs and LLPs can appear to combine the freedom of sole proprietorships/general partnerships with the safety of a corporation, they do have some quirks that are worth considering before you choose the LLC/LLP for your small business's structure.

Operations - Since LLCs and LLPs are relatively new legal entities, their regulations can still vary greatly from state to state, making organizational structure a bit more difficult for companies with a regional or national presence. For example, because some states restrict the types of businesses that can form as LLCs, most law firms and accounting practices with a nationwide presence choose to organize as LLPs since there are no states that restrict forming limited partnerships. Also, it's worth pointing out that several state laws automatically stipulate LLC expiration dates (typically 30 years after formation), which could complicate a situation in which a business owner intends to hand a company down to the next generation of his or her family. In addition, many states require unanimous approval by all other members before one member can sell or transfer their stake in the company. This also means that if a member dies, in many cases the LLC's operating agreement is immediately rendered invalid and a new document must be drawn up.

Tax - Just as with sole proprietorships, the earnings of LLC members and LLP partners are generally subject to self-employment taxes. In fact, the IRS does not recognize LLCs or LLPs as classification for tax purposes, so your business must still follow the tax filing procedures for a sole proprietorship, partnership, or corporation. Also, be aware that if your LLC sells or exchanges more than half of the company's capital within a 12-month period, the IRS will assume the company is dissolving the partnership and summarily terminate the LLC for federal tax purposes. And while LLPs and LLCs are mostly treated the same as general partnerships and sole proprietorships tax-wise, some states do not exempt the former group from state income taxes or "franchise taxes" so, again, it's best to check your state's Secretary of State website for more information. (To find a state-by-state list of requirements for starting a LLC or LLP, with links to individual state government websites, go here: http://limitedliabilitycompanycenter.com/states.html.)

Be sure to come back next week for Part III in our business organization series, which deals with the pros and cons of the S-Corp structure.

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