Limited Liability Company

What is an LLC?

A limited liability company, commonly called an "LLC," is a business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation.

Like owners of partnerships or sole proprietorships, LLC owners report business profits or losses on their personal income tax returns; the LLC itself is not a separate taxable entity. Like owners of a corporation, however, all LLC owners are protected from personal liability for business debts and claims -- a feature known as "limited liability." This means that if the business owes money or faces a lawsuit, only the assets of the business itself are at risk. Creditors usually can't reach the personal assets of the LLC owners, such as a house or car. (Both LLC owners and corporate shareholders can lose this protection by acting illegally, unethically, or irresponsibly.)

For these reasons, many people say the LLC combines the best features of the partnership and corporate business structures.

Who should form an LLC?

You should consider forming an LLC if you are concerned about personal exposure to lawsuits or debts arising from your business. For example, if you decide to open a store-front business that deals directly with the public, you may worry that your commercial liability insurance won't fully protect your personal assets from potential slip-and-fall lawsuits or claims by your suppliers for unpaid bills. Running your business as an LLC may help you sleep better, because it gives you personal protection against these and other potential claims against your business.

Not all businesses can operate as LLCs, however. Businesses in the banking, trust, and insurance industry, for example, are typically prohibited from forming LLCs. In addition, some states, prohibit professionals such as architects, accountants, doctors, and licensed healthcare workers from forming LLCs.

Does my LLC need an operating agreement?

Here's why an operating agreement is necessary:

It helps to ensure that courts will respect your personal liability protection by showing that you have been conscientious about organizing your LLC as a legitimate business.

It sets out rules that govern how profits will be split up, how major business decisions will be made, and the procedures for handling the departure and addition of members.

It helps to avert misunderstandings among the owners over finances and management.

It allows you to create your own operating rules rather than being governed by the default rules in your state's LLC laws, which might not be to your benefit.

Corporations

What is a corporation?

What sets the corporation apart from all other types of businesses is that a corporation is an independent legal entity, separate from the people who own, control, and manage it. In other words, corporation and tax laws view the corporation as a legal "person" that can enter into contracts, incur debts, and pay taxes apart from its owners. Other important characteristics also result from the corporation's separate existence: A corporation does not dissolve when its owners (shareholders) change or die, and the owners of a corporation have limited liability -- that is, they are not personally responsible for the corporation's debts.

Who should form a corporation?

Because of the expense and formalities involved in setting up a corporation and issuing stock (shares in the corporation), you should form a corporation only if you have good reason to do so. If you merely want to limit your personal liability for business debts, forming a limited liability company (LLC) is probably smarter, because LLCs cost less to form and are easier to run. But here are some situations in which incorporating your business instead of forming an LLC might make sense:

Your business needs the ability to issue stock or stock options to attract key employees or outside investment capital.

Your business is so profitable that you can save significant income tax dollars by keeping some profits in the corporation each year.

You own a family business and you want to begin making gifts of ownership to your family as part of your financial or estate plan or to plan for the next generation of owners. You can easily make gifts of shares in your corporation without necessarily giving up management control and, if it's done correctly, without paying gift tax.

Others insist that you incorporate your business. For example, if you are an independent contractor, companies you want to work for may ask you to incorporate before they will sign contracts for your services. These companies don't want the IRS or another government agency to reclassify you as an employee, which is very unlikely if you are incorporated.

How are corporations different from partnerships, sole proprietorships, and LLCs?

Unlike corporations, partnerships and sole proprietorships do not provide limited personal liability for business debts. This means that creditors of those businesses can go after the owners' personal assets to collect what's due. However, organizing and operating a partnership or sole proprietorship is much easier than forming a corporation, because no formal paperwork is required.

A limited liability company (LLC), on the other hand, does offer limited personal liability, like a corporation. And while formal paperwork is required to form an LLC, running an LLC is less complicated than running a corporation. LLC owners do not have to hold regular ownership and management meetings or follow other corporate formalities, for example.

Corporations also differ from other business structures in the way they are taxed. The corporation itself must pay corporate income taxes on its profits -- whatever is left over after paying salaries, bonuses, and other deductible expenses. In contrast, partnerships, sole proprietorships, and LLCs are not taxed on business profits; instead, the profits "pass through" the business to the owners, who report business income or losses on their personal tax returns.