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Title: Is the Limited Liability Company the Right Entity for Your

Author: Germaine A. Hoston, Ph.D.

Should you operate your business as a corporation? Or is there
another, simpler alternative? You've probably noticed that in
the past decade there are more and more businesses with their
names followed by the letters "LLC" instead of "Inc.". "LLC"
stands for Limited Liability Company, is the newest type of
legal entity that exists in the United States, and for many
entrepreneurs it is the ideal marriage between the tax
advantages of the limited partnership and the limited liability
feature of the corporation. Now available in all 50
states---even to non-U.S. citizens--most likely the LLC should
have a key place in your business structure.

When it comes to legal entities for conducting business, limited
liability companies are the newest kid on the block in the
United States. The state of Wyoming was the first to pass
legislation, in 1977, to establish this new entity. By 1999 all
fifty states in the United States had enacted legislation to
allow the formation of this exciting new legal entity.

But why is the LLC so attractive, so irresistible to
legislators? And why have so many entrepreneurs opted for the
LLC instead of a "C" corporation, or even an "S" corporation?
And most important, how do you decide if it's right for you?

Perhaps the most important reason is for the popularity of the
LLC that the it satisfies the demands of both accountants and
attorneys. Accountants tend to prefer the Limited Partnership
("LP") because they are concerned about the dangers of "double
taxation" if their clients use a corporation: If your
corporation pays dividends, the corporation pays taxes on its
profits, and its shareholders pay taxes again on those same
profits when they are taxed on the dividends they receive. By
contrast, attorneys usually prefer the greater asset protection
offered by the limited liability that the corporation has to
offer to all its owners.

Let's begin with an understanding of what the limited liability
company is. Basically it is a partnership among its owners, who
are called "members". The LLC is like a limited partnership (and
an S-corporation), because it is a "pass-through entity"--each
partner's or member's share of the net gain or loss for the year
"flows through" to the individual tax-payer's 1040 individual
tax return. There is no separate tax to which the LLC itself is
subject. On the other hand, the LLC is also like a corporation,
because unlike the limited partnership--which requires a general
partner, who is responsible for all results of all decisions and
actions of the partners--all its owners benefit from limited

People choose to form LLCs basically for the same reasons that
they would elect to set up an S-corporation or a limited
partnership. The LLC, like the S-corporation, is attractive if
you have earned income that puts you in a high tax bracket, and
you would like to be able to offset that income with the losses
that you can normally expect to incur in your first years in a
business. When I formed my first business entity twenty years
ago, my husband and I selected the S-corporation. We both had
salary income that placed us in a high tax bracket, and we knew
that our new consulting business would incur significant capital
expenses in the first few years. After all, we would have to
purchase new equipment such as a fax machine, a laser printer,
personal computers, and the replaceable supplies to operate
them. We were also aware that it would take some time to build a
clientele, so our income from the business would take a few
years to take off. The S-corporation allowed us to carry the
losses we incurred onto our individual 1040 tax returns. The
losses were deducted from our gross personal salary income, and
we paid dramatically lower taxes.

If you can get this advantage from an S-corporation, why would
you bother with an LLC? The LLC has a number of advantages over
the S-corporation:

1. First, the LLC does not have the limitations that the
S-corporation has on who can be a member of the LLC. Only
individuals, estates, some trusts, and other S-corporations can
be members of an S-corporation. Individuals (shareholders) must
be either U.S. citizens or residents. By contrast, the LLC is
not subject to these limitations. Thus, it is an ideal entity
that you can combine with other entities in your business
structure. For example, you can have a corporation or other
legal entity be a member of an LLC.

2. The LLC has much greater flexibility for allocation of
rights, profits, and assets than the S-corporation. The
S-corporation can have only one class of stock: In other words
each share of stock has the same rights as every other share.
This means that the allocation of profits and assets is
extremely rigid. If Parties A and B are equal shareholders in a
corporation, and the corporation decides to distribute its
profits of $10,000, then A and B must each receive $5,000. This
might not necessarily be equitable if one partner was much more
active and produced a much greater share of the profits than the
other. The LLC allows for A to receive, say, $8,000 if its
business activities generated 80% of the profit, leaving B with
the remaining 20%, or $2,000. This can be very attractive in a
partnership in which there is a significant difference in the
amount of capital and ongoing business activity that the
partners are contributing to the business.

3. The LLC is not subject to the same corporate formalities that
are required of the S or C corporation. While the LLC must still
maintain appropriate LLC records and bookkeeping, it is not
required to be managed by a board of directors and maintain
minutes of regular board of directors meetings.

4. Unlike the S-corporation, liquidation of an LLC is generally
not a taxable event. As your personal and business financial
situation change over time, you may determine that it is no
longer in your interest to maintain a "pass through" entity for
your business. Once your business begins to turn a regular
profit after the relatively high costs of the first year or two,
you may decide that a C-corporation that is taxed at a maximum
of 25% (unless it is a personal service corporation) would be
more advantageous to you. If you have been operating as an
S-corporation and you liquidate it by selling the liquidated
assets to the shareholder(s) at their fair market value, the
liquidation will be a taxable event. This does not apply to the
LLC. This is one of the factors that makes the LLC particularly
attractive for holding real estate.

 5. The concept of the charging order makes the LLC especially
effective for asset protection. This makes it a particularly
attractive entity for holding real estate. The corporation
should not be used to hold real estate, because if the
corporation is sued, the court might award shares in the
corporation in the judgment. Control of the corporation
translates into control of the property, and you effectively
lose control over your real estate holdings. By contrast, the
charging order, used with Limited Liability Companies as with
Limited Partnerships, gives the plaintiff only the right to
receive income distributions from the interest of the party or
parties against whom the suit was brought. The charging order
grants no voting rights or management powers. Thus, the existing
managers or members could vote simply not to distribute income,
thus leaving the plaintiff with no recourse; yet the plaintiff
will have to pay taxes on the income allocated to her, even
though the funds were not distributed(!). This offers a strong
incentive for the plaintiff to negotiate for a settlement.

Clearly, the LLC is a powerful tool for protecting your assets
against financial predators. If you use it for real estate
holdings, you can maximize this protection by holding each piece
of real estate in a separate LLC. Thus, if one LLC comes under
attack from financial predators, the operations affecting only a
single property will be affected.

 Disadvantages of the Limited Liability Company

Needless to say, there are some disadvantages with the
LLC--otherwise there would not be remain so many other
attractive options for structuring your business. Why might the
LLC not be the best option for you?

1. Increased taxes for LLC members in high tax brackets. Once
your LLC is making a profit, its income passes through the
individual members, who are taxed directly on that income,
whether it is actually taken out of the LLC or not. Thus,
members who are in a high tax bracket might pay higher taxes
than they would if they used a C-corporation, which is subject
to lower marginal tax rates. Proper planning of disbursements
for expenses and other aspects of the business could overcome
this disadvantage.

2. Higher initial filing fees for LLCs in some states. Some
states may levy heavier tax obligations on LLCs in their initial
years. Our home state of California requires that an LLC pay a
minimum $800 tax in its first year, while corporations are
exempt in their first year--whether the business has any
earnings or not! It can still be worthwhile for you to start an
LLC: If you have high start up costs, tax savings in the
thousands of dollars will outweigh these higher filing fees.

3. Unlike corporations, LLCs do not have continuity of life,
that is they are limited usually to a specific period of time
(say, 50 years) depending on the state. If an LLC member dies,
the remaining members may vote to continue the LLC business. LLC
interests can be gifted to other family members; and the LLC can
have a trust or family limited partnership as a member, thus
providing for effective estate planning.

4. The LLC is a relatively untested entity. There is the large
body of case law on corporations but on LLCs. We may also expect
to see changes in the laws governing LLCs as the implications of
this new entity become more apparent to legislators.

Space does not permit coverage of all the advantages and
disadvantages of LLCs, but clearly the LLC can be a powerful
tool for operating your business, protecting your assets, and
planning your estate. It is easy and inexpensive to set up on
your own, if you use one or more of the items on our <a
Structuring Resources page</a>.

Copyright 2006 Azur Pacific Associates 

About the author:
Germaine A. Hoston, Ph.D. is President and Treasurer of Azur
Pacific Associates, a consulting and translation firm and
distributor of the Secret Millionaire Asset Security System and
Eventis wealth-building courses. Get a free gift when you sign
up for her free wealth structuring eNewsletter for entrepreneurs