A limited liability company is an unincorporated business organization that combines the best aspects of both corporations and partnerships. For this reason, it is sometimes referred to as a ‘hybrid’ entity. Its common characteristics include an informal management/decision-making process, limited liability for all owners (a.k.a. ‘members’), temporary or perpetual existence, charging order protection, and unparalleled flexibility in choosing its tax treatment. Although the LLC has been around for over 100 years in other countries (such as the German equivalent to the LLC, the Gesellschaft mit beschrnkter Haftung or ‘GmbH’), LLCs have only been in the US for about 30 years, starting with Wyoming’s passage of its Limited Liability Company Act in 1977. They were not widely used in the U.S. until the IRS provided guidance on LLC tax treatment in 1988, and thereafter issuing the ‘check-the-box’ regulations in 1996 (where an LLC may simply ‘check-the-box’ to elect C corporation treatment via IRS form 8832 or even S corporation tax status if it also files IRS form 2553.)
An LLC is generally the entity of choice for the small to medium sized business, and even some large businesses, although it must be noted that some states (such as Alabama, Florida, California, Kentucky, New Jersey, New York, Pennsylvania, Tennessee, and Texas) levy a franchise or other similar tax on LLCs. Some of these states’ franchise taxes are very small, however in other states the tax is significant, and such tax may sometimes be avoided by instead forming a limited partnership.
The LLC vs. the Corporation
The advantages of an LLC over a corporation are as follows:
- No need for annual meetings, minutes, resolutions, or other corporate formalities when making decisions on behalf of the company. In layman’s terms, this means it’s much less of a hassle to run the company!
- There are generally less ways to pierce the veil of an LLC than with a corporation.
- Almost all states levy a franchise tax on corporations, whereas the majority of states don’t levy franchise taxes on LLCs.
- Like limited partnerships, LLCs benefit from charging order protection, while corporations do not.
- LLCs may be taxed as a disregarded entity, partnership, C corporation, or S corporation, while a corporation may only be taxed as a C or S corporation.
- In general, an LLC or limited partnership is usually preferable to a corporation, unless the company plans on having a public offering.
The disadvantages of an LLC over a corporation are:
- Only C corporations can have a public offering (be traded on the stock market.)
The LLC vs. the Limited Partnership
Operationally, an LLC behaves much like a limited partnership, however it has the following advantages:
- The manager of a limited partnership (called a general partner) has no limited liability. All LLC members, whether they manage the company or only passive investors (a.k.a. ‘limited members’), have limited liability.
- A limited partnership may only be taxed as a … partnership :o) (If there is only one underlying taxpayer, however, it will be taxed as a disregarded entity. See IRS Rev. Rul. 2004-77 for more on this.) An LLC may be taxed as a disregarded entity, partnership, C corporation, or S corporation.
- You can form an LLC with only one member. Limited partnerships need at least two partners.
The disadvantages of an LLC over a limited partnership are:
- In a few states, you can avoid a state franchise tax by forming a limited partnership instead of an LLC.
- There is more case law regarding limited partnerships than there is regarding LLCs, which allows us to predict more accurately how a court will treat a limited partnership in various situations. However, several landmark cases regarding LLCs since 2003 have made this almost a non-issue.
It should also be noted that, like limited partnerships (a.k.a. ‘family limited partnerships’), LLCs can also be used in estate planning to reduce estate taxes via valuation discount techniques.
Relevant Case Law: