Your LLC Companion 

1. Overview of the LLC

• Top Ten Questions About LLCs
• The Benefits of LLCs
• Which Businesses Benefit as LLCs?
• Comparing LLCs and Other  Business Forms
• Business Entity Comparison Tables

2. Basic LLC Legalities

• Number of Members
• Paperwork Required to Set Up an LLC
• Responsibility for Managing an LLC
• Member and Manager Liability to Insiders and Outsiders
• Are LLC Membership Interests Considered Securities?

3. Tax Aspects of Forming an LLC

• Pass-Through Taxation
• Pass-Through Tax Deduction
• How LLCs Report and Pay Federal Income Taxes
• LLCs and Self‑Employment Taxes
• State Law and the Tax Treatment of LLCs
• Other LLC Formation Tax Considerations

4. How to Prepare and File LLC Articles of Organization

• Go to Your State’s LLC Filing Office Online
• Choose a Name for Your LLC
• Check Your State’s Procedures for Filing Articles
• Prepare Your LLC Articles of Organization
• Finalize and File Your Articles of Organization
• What to Do After Filing Your Articles of Organization

5. Prepare an LLC Operating Agreement for Your Member-Managed LLC

• Customizing Your LLC Operating Agreement
• How to Prepare a Member‑Managed LLC Operating Agreement
• Distribute Copies of Your Operating Agreement

6. Prepare an LLC Operating Agreement for Managers

• Choosing a Manager-Managed LLC
• How to Prepare an LLC Management Operating Agreement
• Distribute Copies of Your Operating Agreement

7. After Forming Your LLC

• If You Converted an Existing Business to an LLC
• Basic Tax Forms and Formalities
• Ongoing LLC Legal Paperwork and Procedures
• Other Ongoing LLC Formalities

 8. Lawyers, Tax Specialists, and Legal Research

• Finding the Right Tax Adviser
• How to Find the Right Lawyer
• How to Do Your Own Legal Research

Appendixes

A: How to Locate State LLC Offices and Laws Online

• How to Locate State LLC Offices Online
• How to Locate Your State’s LLC Act Online

B: LLC Forms

• LLC Reservation of Name Letter
• Articles of Organization
• LLC Articles Filing Letter
• Operating Agreement for a Member-Managed Limited Liability Company
• Limited Liability Company Management Operating Agreement
• Minutes of Meeting
• Certification of Authority

C: How to Use the Downloadable Forms on Nolo’s Website

• Using the Minutes Forms and Resolutions
• List of Forms Provided on Nolo’s Website

Index

Chapter 1
Overview of the LLC

In this chapter, we’ll cover the nuts and bolts of the limited liability company, or LLC: the most common questions, the primary benefits, which businesses should choose LLC status, and what other types of business entities there are. We’ll delve into the specific legal and tax characteristics of LLCs in the next two chapters.

Top Ten Questions About LLCs

1. What Is an LLC?

An LLC is a business structure that gives its owners corporate-style limited liability, while at the same time allowing partnership-style taxation:

• Like owners of a corporation, 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, the assets of the business itself are at risk but usually not the personal assets of the LLC owners, such as their houses or cars.
• Like owners of partnerships or sole proprietorships, LLC owners report their share of the business profits or losses on their personal income tax returns. The LLC itself is not a separate taxable entity.

Because of these attributes, the LLC fits somewhere between the partnership and the corporation (or, for one-owner businesses, between the sole proprietorship and the one-person corporation).

2. How Many People Do I Need to Form an LLC?

You can form an LLC with just one owner. For reasons we’ll explain later, LLCs are appropriate for businesses with no more than 35 owners and investors.

3. Who Should Form an LLC?

Consider forming an LLC if you are concerned about personal exposure to lawsuits arising from your business. For example, an LLC will shield your personal assets from:

• suppliers’ claims for unpaid bills, and
• slip-and-fall lawsuits that your commercial liability insurance policy may not adequately cover (for businesses that deal directly with the public).

Not all businesses can operate as LLCs, however. Those in the banking, trust, and insurance industries, for example, are typically prohibited from forming LLCs. Some states (including California) prohibit special licensed professionals, such as accountants, doctors, lawyers, and some other state-licensed practitioners, from forming LLCs. Many of these professionals may benefit from forming a limited liability partnership or a professional corporation.

4. How Do I Form an LLC?

In most states, the only legal requirement to form an LLC is that you file articles of organization with your state’s LLC filing office, which is usually part of the Secretary of State’s office.(Several states refer to this organizational document as a “certificate of organization” or a “certificate of formation.”) A few states require an additional step: Prior to or immediately after filing your articles of organization, you must publish your intention to form an LLC, or a notice that you have formed an LLC, in a local newspaper. We’ll explain how to prepare and file articles of organization in Chapter 4.

5. Do I Need a Lawyer to Form an LLC?

You usually don’t need a lawyer if you’ve decided the LLC is the right entity for your business. In most states, the information required for the articles of organization is simple—it typically includes the name of the LLC, the location of its principal office, the names and addresses of the LLC’s owners and/or managers, and the name and address of the LLC’s registered agent (a person or company that agrees to accept legal papers on behalf of the LLC).

The process itself is simple, too. Most states have fill-in-the-blanks forms and instructions that can be downloaded. Many states even let you prepare and file articles online at the state filing website, which means you can create your LLC in a matter of minutes. LLC filing offices increasingly allow owners to send them email questions, too.

We alert you to situations throughout this book when a lawyer’s advice will be useful and include a discussion in Chapter 8 on how to find and work cost effectively with an experienced business lawyer.

6. Does My LLC Need an Operating Agreement?

Although most states’ LLC laws don’t require a written operating agreement, don’t even consider starting an LLC without one. An operating agreement is necessary because it:

• sets out rules that govern how profits and losses will be split up, how major business decisions will be made, and the procedures for handling the departure and addition of members
• keeps your LLC from being governed by the default rules in your state’s LLC laws, which might not be to your benefit, and
• helps ensure that courts will respect your personal liability protection, because it shows that you have been conscientious about organizing your LLC.

In Chapters 5 and 6, you’ll learn how to create an operating agreement.

7. How Do LLCs Pay Taxes?

Like partnerships and sole proprietorships, an LLC is not a separate entity from its owners for income tax purposes. This means that the LLC itself does not pay income taxes. Instead, the LLC owners use their personal tax returns to pay tax on their allocated share of profits (or deduct their share of business losses).

LLC owners can elect to have their LLC taxed like a corporation. This may reduce taxes for established LLC owners who will regularly need to keep a significant amount of profit in the company.

These tax consequences will be discussed in detail in Chapter 3, and Chapter 8 explains how to find the right tax adviser for your business.

8. What Are the Differences Between a Limited Liability Company and a General Partnership?

The main difference between an LLC and a general (standard) partnership is that LLC owners are not personally liable for the company’s debts and liabilities. Partners, on the other hand, do not have this limited liability protection. Also, owners of limited liability companies must file formal articles of organization with their state’s LLC filing office, pay a filing fee, and comply with other state filing requirements before they open for business. Partnerships don’t need to file any formal paperwork and don’t have to pay special fees (limited partnerships do, but here we’re talking about a general partnership (the standard type of partnership)).

LLCs and partnerships are almost identical when it comes to taxation, however. In both types of businesses, the owners report business income or losses on their personal tax returns. In fact, co-owned LLCs and partnerships file the same informational tax return with the IRS (Form 1065, U.S. Return of Partnership Income) and distribute the same schedules to the business’s owners (Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc. which lists each owner’s share of income).

9. Can I Convert My Existing Business to an LLC?

Converting a partnership or a sole proprietorship to an LLC is an easy way for partners and sole proprietors to protect their personal assets without changing the way their business income is taxed. Some states have a simple form for converting a partnership to an LLC (often called a “certificate of conversion”), as described in Chapter 4. Partners and sole proprietors in states that don’t use a conversion form must file regular articles of organization to create an LLC.

10. Do I Need to Know About Securities Laws to Set Up an LLC?

If you’ll be the sole owner of your LLC, which you will manage and operate, and you don’t plan to take investments from outsiders, your ownership interest in the LLC should not be considered a “security” and you don’t have to concern yourself with these laws. For co-owned LLCs, however, the answer to this question is a bit more involved.

If all of the owners of your LLC will actively manage the LLC, their ownership interests in the company will usually not be treated as securities. However, when someone invests in your business expecting to make money from the efforts of others, that person’s investment is generally considered a security under federal and state law.

If your LLC’s ownership interests are considered securities, you must get an exemption from the state and federal securities laws before the initial owners of your LLC invest their money. Fortunately, smaller LLCs, even those that plan to sell memberships to passive investors, usually qualify for securities law exemptions.

We’ll explain this further in Chapter 2.

The Benefits of LLCs

The LLC stands as a unique alternative to five traditional legal and tax ways of doing business: sole proprietorships, general partnerships, limited partnerships, C corporations (also called “regular” corporations), and S corporations. While these business entities offer some of the same benefits as LLCs, none offer all of the same benefits. The combination of structural and tax benefits unique to LLCs includes:

• limited liability status
• taxation of business profits at individual rates
• flexible management structure, and
• flexible distribution of profits and losses.

Limited Liability Status

The legal characteristic most interesting to business owners is undoubtedly the limited liability status of LLC owners. With the exception of corporate entities, the LLC is the only form of legal entity that lets all of its owners off the hook for business debts and other legal liabilities, such as court judgments and legal settlements obtained against the business. Another way of saying this is that an investor in an LLC normally has at risk only his or her share of capital paid into the business.

 

Business Profits and Losses Taxed at Individuals’ Income Tax Rates

The LLC is recognized by the IRS as a “pass-through” tax entity. That is, the profits or losses of the LLC pass through the business and are reflected and taxed on the individual tax returns of the owners, rather than being reported and taxed at a separate business level. (Other pass-through entities include general and limited partnerships, sole proprietorships, and S corporations—those that have elected S corporation tax status with the IRS.) We’ll discuss We’ll discuss pass-through taxation further in Chapter 3.

Flexible Management Structure

LLC owners are referred to as “members.” A member may be an individual or a separate legal entity, such as a partnership or corporation. Members invest in the LLC and receive percentage ownership interests in return. These ownership interests are used to divide up the assets of the LLC when it is sold or liquidated and are typically used for other purposes as well—for example, to split up profits and losses of the LLC or to divide up members’ voting rights.

LLCs are run by their members unless they elect to be managed by a management group, which may consist of some members and/or nonmembers. Small LLCs are normally member-managed—after all, most small business owners want and need to have an active hand in the management of the business. However, this isn’t always true. Especially with a growing business or one that makes passive investments, such as in real estate, investors may not want a day-to-day role. Fortunately, an LLC can easily adopt a management-run structure in situations such as these:

• The members want the LLC to be managed by some, but not all, members.
• The members decide to employ outside management help.
• The members choose to cater to an outsider who wishes to invest in or lend capital to the LLC in exchange for a vote in management.

 

Flexible Distribution of Profits and Losses

An LLC allows business owners to split profits and losses any way they wish (this flexibility is afforded partnerships as well). You are not restricted to dividing up profits proportionate to the members’ capital contributions (the standard legal rule for corporations).

By contrast, rules governing the distribution of corporate profits and losses are fairly restrictive. A C corporation cannot allocate profits and losses to shareholders at all—shareholders get a financial return from the corporation by receiving dividends or a share of the corporation’s assets when it is sold or liquidated.

In an S corporation (covered in detail below), profits and losses generally must follow shareholdings. For example, an S corporation shareholder holding 10% of the shares ordinarily must be allocated a 10% share of yearly profits and losses.

There are a few wrinkles in the flexibility afforded to LLCs. Because LLCs are treated like partnerships for tax purposes, LLCs must comply with technical partnership tax rules:

• Tax laws require special (disproportionate) allocations of LLC profits or losses to have “substantial economic effect.” In Chapter 3, we’ll discuss exactly what that means and how to help make sure your LLC complies with the requirement. For now, simply understand that the purpose of the rule is to ensure that the members have corresponding economic benefits and risks for profits and losses allocated to them.
• Members contributing services to the LLC may be subject to income taxes on the value of their services. Again, we’ll discuss the tax effects of a member’s future personal services to the LLC in Chapter 3.

Which Businesses Benefit as LLCs?

Here is an overview of the types of persons and businesses for which the LLC form makes the most and least sense. These guidelines aren’t set in stone—certainly you may find that your business breaks the mold.

Businesses That Benefit From the LLC Structure

LLCs generally work best for:

• Actively run businesses with a limited number of owners. The logistics of making collective business decisions are manageable with a maximum of around 35 owners.
• Small new businesses. New businesses generally wish to pass early-year losses along to owners to deduct against their other income (usually salary earned working for another company or income earned from investments).
• Anyone thinking of forming an S corporation. Like LLCs, S corporations provide limited liability protection to all owners and allow profits and losses to be taxed at individual shareholder rates. However, as we’ll discuss in “S Corporations,” below, these benefits come at a pretty high price: S corporations are significantly restrictive and a business can inadvertently lose its eligibility—for example, when a disqualified shareholder inherits or buys stock—resulting, perhaps, in a big tax bill.
• Existing partnerships. Only the LLC provides partnership-style pass-through tax treatment of business income while insulating all owners (not just limited partners as in a limited partnership) from personal liability for business debts.
• Businesses planning to hold property that will appreciate, such as real property. C corporations and their shareholders are subject to a double tax on appreciation when assets are sold or liquidated—taxation occurs at both the corporate and individual level. S corporations that were originally organized as C corporations may also be subject to double tax on gains from appreciated assets, as well as a penalty tax on passive income (money from rents, royalties, interest, or dividends) if it gets too high. Because the LLC is a true pass-through tax entity, it allows a business that holds appreciating assets to avoid double taxation.

Businesses That Normally Should Not Form an LLC Using This Book

The LLC is not normally suitable for:

• Existing S or C corporations. While it may be possible to convert an existing corporation to an LLC without hefty tax or legal costs, you’ll need the help of a lawyer and a tax adviser to make sure you don’t get stung.
• Highly profitable LLCs in certain states. Some states have a graduated LLC license fee schedule, meaning the more profitable the LLC, the higher the tax. In California, for example, LLCs with high gross incomes are subject to paying an annual fee of perhaps several thousand dollars. Check your state tax website (see Appendix A) or ask your tax adviser to find out whether you face this unpleasant prospect in your state. Of course, in states with an LLC fee or tax, chances are good that the state also has enacted fees that apply to other pass-through tax entities (limited partnerships and S corporations). In these states, you may decide that forming a general partnership, which isn’t taxed separately, is the least expensive way to go—but you won’t qualify for limited liability for business debts.

 

Comparing LLCs and Other Business Forms

Anyone considering an LLC will want to compare this business form to the three traditional ways of doing business:

• sole proprietorships
• partnerships, and
• C corporations.

In addition, to fully understand the pros and cons of LLC status, you’ll need to compare the LLC to two variants on these traditional business forms that come closest to resembling the legal and tax characteristics of the LLC:

• limited partnerships, and
• S corporations.

This section provides general information on the characteristics of each type of legal entity, focusing on the main reasons why businesspeople adopt one form over another. Our aim is to explain most of the information you’ll need to decide whether the LLC is right for you. However, please realize that we can’t cover every nuance of tax and business organization law as it applies to your business. Furthermore, coming to terms with pass-through taxation is challenging, even for tax specialists. You may need to check with a tax adviser to make sure the LLC makes sense to you from a tax standpoint, and to learn about any of the special tax areas (some of which are covered in Chapter 3) that may have special relevance to your business. (For a quick overview of the different legal and tax characteristics of the various entities, see the business entity comparison chart, at the end of this chapter.)

Sole Proprietorship

The simplest way of being in business for yourself is as a sole proprietor. This is just a fancy way of saying that you are the owner of a one-person business. There’s little red tape and cost—other than the usual business licenses, sales tax permits, and local and state regulations that any business must face. As a practical matter, most one-person businesses start out as sole proprietorships just to keep things simple.

 

Sole Proprietorship Is Limited to One Person

If your sole proprietorship grows, you’ll need to move to a more complicated type of business structure. Once you decide to own and split profits with another person (other than your spouse), by definition, you have at least a partnership on your hands.

Sole Proprietor Is Personally Liable for Business Debts

Unfortunately, although a sole proprietorship is simple, it can also be a risky way to operate, especially if the work you do might result in large debts or liabilities from lawsuits. The sole proprietor is personally liable for all debts and claims against a business. For example, if someone slips and falls in a sole proprietor’s business and sues, the owner is on the line for paying any court award (if commercial liability insurance doesn’t cover it). Similarly, if the business fails to pay suppliers, banks, or other businesses’ bills, the owner is personally liable for the unpaid debts. The owner’s personal assets, such as a home, car, and bank accounts, are fair game for repayment of these amounts.

Sole Proprietor’s Taxes

Sole proprietors report business profits or losses on IRS Schedule C, Profit or Loss From Business (Sole Proprietorship), included with a Form 1040 individual federal tax return. Profits are taxed at the owner’s individual income tax rates.

Because the owner is self-employed, he or she must pay an increased amount of self-employment (FICA) tax based upon these profits—about twice as much as an incorporated business or corporate employee would personally pay. This increased FICA tax doesn’t necessarily mean that sole proprietorships are more expensive tax-wise than other business forms. For instance, if you are both a corporate shareholder and employee, as is the case for the owner/employees of most small corporations, you end up paying a similar amount of total FICA taxes.

 

Sole Proprietorships Compared to LLCs

The LLC requires more paperwork to get started and is more complicated than a sole proprietorship from a legal and tax perspective. Although LLC owners, like sole proprietors, report business profits on their individual tax returns, a co-owned LLC itself is treated as a partnership and must prepare its own annual informational tax return. The payoff for the LLC of this added complexity is that owners are not personally liable for business claims or debts (unless personally guaranteed, as with a personally guaranteed bank loan).

General Partnerships

A “partnership” is a business in which two or more owners agree to share profits. If you go into business with at least one other person and you don’t file formal papers with the state to set up an LLC, a corporation, or a limited partnership, the law says you have formed a “general partnership.” A general partnership can be started with a handshake (a simple verbal agreement or understanding) or a formal partnership agreement.

Number of Partners in a General Partnership

General partnerships may be formed by two or more people; there is no such thing as a one-person partnership. Legally, there is no upper limit on the number of partners who may be admitted into a partnership, but general partnerships with many owners may have problems reaching a consensus on business decisions and may be subject to divisive disputes between contending management factions.

General Partnership Liability

Each owner of a general partnership is individually liable for the debts and claims of the business. In other words, if the partnership owes money, a creditor may go after any member of the partnership for the entire debt, regardless of that member’s ownership percentage (although one partner can sue other partners to force them to repay their shares of the debt).

In addition, each partner may bind the partnership to contracts or enter a business deal that binds the partnership, as long as the contract or deal is within the scope of business undertaken by the partnership. In legal jargon, this authority is expressed by saying that each partner is an “agent” of the partnership.

The personal liability for partnership debts, coupled with the agency authority of each partner, makes the general partnership riskier than limited liability businesses (corporations, LLCs, and limited partnerships).

General Partnership Taxes

A general partnership is not a separate taxable entity. Profits (and losses) pass through the business to the partners, who pay taxes on profits at their individual tax rates. Although the partnership does not pay its own taxes, it must file an information return each year—IRS Form 1065, U.S. Return of Partnership Income.

The partnership must give each partner a filled-in IRS Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc., which shows the proportionate share of profits or losses each person carries over to his or her individual 1040 tax return at the end of the year.

General Partnerships Compared to LLCs

General partnerships are less costly to start than LLCs because most states do not require a state filing (and fees) to form them. The major downside to running a general partnership over an LLC is the exposure to personal liability by each of the general partners. Although a general business insurance package (possibly supplemented by more specialized coverage for unusual risks) can mitigate possible effects, each partner is still personally responsible for all business debts and for any liabilities not covered by the business’s insurance policy. LLC owners, on the other hand, avoid this personal liability problem altogether.

General partnerships and LLCs come out about even on a couple of important issues:

• Partnership agreement or operating agreement. Even small partnerships and LLCs should start off with a good written partnership agreement or operating agreement. This, of course, takes time and if you don’t do the work yourself, is likely to cost $1,000 to $5,000 in legal fees, depending on the complexity of your business and the thickness of your lawyer’s rug. (We help you prepare an operating agreement in Chapters 5 and 6 of this book.)
• Taxes. General partnerships and LLCs can count on about the same amount of tax complexity, preparation time, and paperwork. Even though you’ll probably turn over most year-end tax work to a tax adviser (for either a co-owned LLC or partnership), understanding and following basic partnership tax procedures takes a fair amount of time and effort.

C Corporations

To establish a C corporation, you prepare and file formal articles of incorporation papers with a state agency (usually the secretary of state) and pay corporate filing fees and initial taxes. A corporation assumes an independent legal and tax life separate from its owners, with the result that it pays taxes at its own corporate tax rate and files its own income tax returns each year (IRS Form 1120, U.S. Corporation Income Tax Return).

Corporations are owned by shareholders and managed by a board of directors. Most management decisions are left to the directors, although a few must be ratified by the shareholders as well, such as the amendment of corporate articles of incorporation, sale of substantially all of the corporation’s assets, or the merger or dissolution of the corporation. Corporate officers are normally appointed by the board of directors to handle the day-to-day supervision of corporate business, and usually consist of a corporate president, vice president, secretary, and treasurer.

Number of Corporate Shareholders and Directors

In most states, one or more persons can form and operate a corporation. In a few states, the number of directors necessary for a multiowner corporation is related to the number of shareholders. For example, in these states, if there are two shareholders, two or more directors must be named; if three shareholders, then three or more directors are necessary.

Corporate Limited Liability

As we have mentioned, a corporation provides all its owners (“shareholders”) with the benefits of limited liability—before other limited liability entities (such as the LLC) were available, that was a major reason many businesses organized as corporations.

Corporation’s Separate Legal and Tax Existence

A corporation has a legal and tax existence separate from its owners. This leads to the following corporate characteristics:

• Separate taxes. A corporation files its own income tax return and pays its own income taxes.
• Tax benefits of employee fringe benefits. The corporate form allows owner-employees (shareholders who also work in the business) to deduct a number of corporate fringe benefits paid to employees (including themselves) from corporate income, such as the direct reimbursement of medical expenses. Also, corporations can provide tax-favored stock bonus, stock option, and other equity-sharing plans for employees.
• Legal formalities. Because a corporation has a separate legal existence, you must pay more attention to its legal care. This means owners must (figuratively) don directors’ and shareholders’ hats and hold and document annual meetings required under state law. Owners must keep minutes of meetings, prepare other formal documentation of important decisions made during the life of the corporation, and keep a paper trail of all financial dealings between the corporation and its shareholders. Owners also need to tend to other formalities, such as appointing officers required under corporate statutes. A corporation should issue stock to its shareholders and keep adequate capital on hand to handle foreseeable business debts and liabilities.

Corporations Compared to LLCs

Corporations are similar to LLCs in the types of paperwork and fees necessary to get them started with the state. Both must prepare and file organizational papers with the secretary of state and pay filing fees. Both should adopt a set of operating rules that sets out the basic requirements for operating the business—corporations adopt bylaws; LLCs adopt operating agreements.

What sets the corporate form apart from LLCs is how they are taxed. Corporations are taxed separately from their owners at the federal corporate income tax rate (which is currently 21%). This can result in tax savings if money is left in a business for expansion or for other business needs. That’s because the federal corporate income tax rate applied to corporate income is often lower than the individual tax rates of business owners, which can go as high as 37%.

 

This corporate tax distinction can be eliminated if the LLC members wish. That is, LLC members can elect to have their LLC taxed as a corporation. We’ll discuss this option, and why some LLCs take it, in Chapter 3.

Even though an LLC may now elect corporate tax treatment, there may be other reasons to favor the corporate form over the LLC, such as the availability of corporate equity sharing plans. Also, a number of people—perhaps including persons you may wish to do business with—associate the corporate form with an added degree of formality and solidity. And, of course, the ability to go public (make a public offering of corporate shares) is a traditional feature of the corporate form that more successful small businesses may be able to capitalize on. (In our opinion, you should forget about going public with an LLC; the practical and tax restrictions on transferring membership interests rule out this possibility.)

There are several downsides to corporate life. We’ve already mentioned the complexity of complying with state law corporate procedures by holding annual and special directors’ and shareholders’ meetings. (Some states have tried to lessen the impact of these state-mandated formalities with the creation of the close corporation form—see “A Look at Close Corporations,” below.)

 

Limited Partnerships

A “limited partnership” is similar to a general partnership (discussed above), except that instead of being composed of general partners only, it has two types:

• Limited partners. One or more partners contribute capital to the business, but neither participates in its day-to-day operations nor has personal liability for business debts and claims.
• General partners. One or more partners manage business operations and have personal liability for business debts and claims.

To get this special type of partnership started, you must file papers (certificate of limited partnership) with the state and pay an initial filing fee.

Number of Partners

Limited partnerships may be formed by two or more people, with:

• at least one person acting as the general partner, who has management authority and personal liability, and
• at least one person in the role of limited partner.

Limited Liability Only for Limited Partners

Limited partners enjoy the same kind of limited liability for the debts and liabilities of the business as do the shareholders of a corporation and the members of an LLC. General partners of limited partnerships, on the other hand, have the same personal liability described above for general partnerships.

Limited Partnership Taxes

For tax purposes, limited partnerships normally are treated like general partnerships, with all owners having to report and pay taxes personally on their share of the profits each year. The limited partnership files an informational tax return only and is not subject to an entity-level federal income tax.

Limited Partnerships Compared to LLCs

There are two major differences between limited partnerships and LLCs. First, a limited partnership must have at least one general partner, who is personally liable for the debts and other liabilities of the business. This differs from LLCs, where all members are covered by the cloak of limited liability.

Second, limited partners are generally prohibited from managing the business. A limited partner who becomes active in the business of the limited partnership typically loses the limited partner status with its attendant limited liability protection. (There are exceptions to this ban under the newer Revised Uniform Limited Partnership Act, which has made the rounds through state legislatures and has been adopted, at least in part, in most states.) In contrast, LLC members are given a free hand in managing and running the business, either by themselves or in conjunction with outside managers.

This second restriction of the limited partnership makes it more of a gamble for investors, who must turn over management of the business to a general partner. Such an arrangement may work well for outsiders who want to invest cash or property in a business run by others, but it won’t work well for businesses that are funded and run primarily by their owners. Investors in actively run businesses who want limited liability status for all owners generally benefit by forming an LLC or a corporation: Both of these entities permit investors to help run the business while enjoying the personal protection of limited liability.

S Corporations

Now we come to our last comparison, and the one with the pickiest technical distinctions: the S corporation versus the LLC. Below, we address the main similarities and differences, but you should ask your tax adviser for further particulars if you want to understand the ins and outs of comparing these two business forms.

For starters, an S corporation follows the same state incorporation formalities as a C corporation. Typically, this means filing articles of incorporation and paying a state filing fee. An S corporation also must make a special one-page tax election under Subchapter S of the Internal Revenue Code to have the corporation taxed as a partnership (by filing IRS Form 2553, Election by a Small Business Corporation, with the IRS).

Number of S Corporation Owners

Generally, an S corporation may have no more than 100 shareholders (who must be individuals or certain types of trusts or estates). But spouses and other members of a shareholder’s family who own shares in an S corporation are counted as one shareholder.

Limited Liability of S Corporation Shareholders

All S corporation shareholders are granted personal protection from the debts and other liabilities of the business, just like C corporation shareholders and LLC members.

Tax Election of S Corporation

S corporations benefit from the same basic pass-through treatment afforded partnerships and LLCs, so profits and losses are reported on the individual tax returns of the S corporation’s shareholders. However, the S corporation must still prepare and file an S corporation annual income tax return each year, similar (from a time and energy standpoint) to the co-owned LLC preparing its own partnership informational tax return.

S Corporations Compared to LLCs

Like any other type of corporation, an S corporation requires some legal care and maintenance—more than is typically needed for an LLC. Regular and special meetings of directors and shareholders are held and recorded to transact important corporate business or decide key legal or tax formalities.

The main difference between S corporations and LLCs has to do with the requirements for electing S corporation tax treatment and some of the unique tax effects that result from this election. To be eligible to make an S corporation tax election with the IRS, the corporation and its shareholders must meet a number of special requirements. Here are a few of the S corporation tax requirements that can present a problem:

• Individual shareholders of an S corporation must be U.S. citizens or have U.S. residency status. If shares are sold, passed to (by will, divorce, or other means), or otherwise fall into the hands of a foreign national, the corporation loses its S corporation tax status.
• Shareholders must be individuals or certain types of qualified trusts or estates. Generally, S corporations can’t have partnerships or other corporations as shareholders. Under typical state statutes, LLCs may have both natural (individual) and artificial (corporate, LLC, partnership, trust, and estate) members.
• There can be no more than 100 shareholders in an S corporation.
• S corporations must have only one class of stock. Different voting rights are permitted, meaning that S corporations may have one class of voting shares and another consisting of nonvoting shares. But all shares must have the same rights to participate in dividends and the assets of the corporation when the business is sold or liquidated. Having only one class of stock limits the usefulness of the S corporation as an investment vehicle. Investors typically like to receive special classes of shares that have preferences regarding corporate dividends and participation in the liquidation assets of the corporation when it is sold or dissolved.
• An S corporation that loses its status cannot reelect it for five years. An S corporation can lose its S corporation tax status—perhaps inadvertently; for example, if some shares fall into the hands of a disqualified shareholder. Even if the corporation again becomes qualified, it must wait until five years have elapsed from the year of the disqualification.

Two special tax effects not suffered by other pass-through tax entities, such as LLCs and limited partnerships, often present problems for S corporation shareholders:

• S corporation shareholders can’t receive special allocations of profits and losses. Corporate profits and losses must be split up proportionately to the percentage of shares owned by each shareholder. This point may sound technical or theoretical, but even for smaller businesses it has practical—and sometimes negative—significance.

• S corporation entity-level debt can’t be passed along to shareholders. An S corporation generally can’t pass the potential tax benefits of borrowing money along to its shareholders. In other pass-through entities, such as partnerships and LLCs, business debt (money borrowed by the business) increases the tax basis of the owners (we’re simplifying here, but this is the effect of these special rules). This is good for a couple of reasons. First, the owners can deduct more losses from the business on their tax returns. Second, the higher the basis, the less gain—and the lower the taxes due—when owners sell their interests or the business itself is sold. This technical tax point is illustrated in the following example.

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