Nolo's Quick LLC
All You Need to Know About Limited Liability Companies
Nolo's Quick LLC
All You Need to Know About Limited Liability Companies
Anthony Mancuso, Attorney
February 2015, 8th Edition
Get LLC answers and learn the basics of limited liability companies
If you run your own business, you’ve probably heard about limited liability companies. Business owners who operate LLCs aren’t personally liable for business debts, so their personal assets are generally not at risk. But is forming an LLC right for you?
Nolo's Quick LLC provides essential information for business owners in every state. In plain English, it explains the advantages and drawbacks of forming an LLC – including limiting your personal liability. Find out about:
- the unique legal features of LLCs, including limited personal liability for owners
- who should – and shouldn’t – form an LLC
- how to choose among an LLC, corporation, partnership or other business form
- choosing between a member-run or a manager-run LLC
- how LLCs are taxed
- how to manage multiple-owner LLCs
- the ongoing legal and tax paperwork that’s required
Practical, concise and easy to read, this edition of Nolo's Quick LLC provides the latest facts, figures and updated tax information you'll need to know about this structure for your small business.
TABLE OF CONTENTS
- Should You Consider Forming an LLC?
- How to Use This Book
- What This Book Doesn't Do
- Legal and Tax Experts
- Other Nolo LLC Resources
1. An Overview of LLCs
- Basic LLC Features
- Exceptions to Owners' Limited Liability
- Basics of Forming an LLC
2. The LLC vs. Other Business Structures
- Other Business Structures
- What Is a Sole Proprietorship?
- What Is a General Partnership?
- What Is a Limited Partnership?
- What Is a C Corporation?
- What Is an S Corporation?
- What Is an RLLP?
- The Series LLC
- Do-Good LLCs and Corporations - The Latest in Limited Liability Entities
- Deciding Between an LLC and Another Business Type
- Business Structures Comparison Table
3. Members' Capital and Profits Interests
- LLC Capital Interests
- Tax Considerations of Start-Up Capital
- Converting an Existing Business to an LLC
- Profit and Loss Interests
- Special Allocations of Profits and Losses
4. Taxation of LLC Profits
- Pass-Through Tax Treatment
- How LLCs Report and Pay Federal Income Taxes
- Electing Corporate Tax Treatment
- LLC Owners and Self-Employment Taxes
- An LLC Can Elect to Be Treated as an S Corporation
5. LLC Management
- Member Versus Manager Management
- Legal Authority of LLC Members and Managers
- Member and Manager Meetings
- Member and Manager Voting Rights
6. Starting and Running Your LLC: The Paperwork
- Paperwork Required to Form an LLC
- Ongoing LLC Paperwork
- Securities Filings
7. Getting Legal and Tax Help for Your LLC
- Getting Legal Help for Your LLC
- Getting Tax Help
A. State Information
- Business Entity Filing Office
- Tax Office
- Securities Office
B. Sample Operating Agreement
- A. Preliminary Provisions
- B. Membership Provisions
- C. Tax and Financial Provisions
- D. Capital Provisions
- E. Membership Withdrawal and Transfer Provisions
- F. Dissolution Provisions
- G. General Provisions
- H. Signatures of Members and Spouses of Members
C. Checklist for Forming an LLC
Should You Consider Forming an LLC?.......................................... 3
How to Use This Book..................................................................... 9
What This Book Doesn’t Do........................................................... 10
Legal and Tax Experts................................................................... 10
Other Nolo LLC Resources............................................................ 11
In the business world, limited liability companies are seen as the latest hot thing. The limited liability company (LLC) is a relatively new business ownership structure that combines the best features of the corporation and the partnership. It gives small business owners corporate-style protection from personal liability while retaining the pass-through income tax treatment enjoyed by sole proprietorships (the legal term for one-person businesses) and partnerships.
Protection from personal liability—often referred to as “limited liability”—means that creditors of the business cannot normally go after the owners’ personal assets to pay LLC debts and claims arising from lawsuits; pass-through tax treatment means that business profits are reported and taxed on the individual income tax returns of the business owners. I’ll discuss limited liability and pass-through taxation in much more depth in Chapter 1.
All 50 states and the District of Columbia now allow people to form this unique type of legal and tax entity, and most make it easy, convenient, and even relatively economical for small business owners to create and register an LLC. For these reasons, more and more entrepreneurs are choosing to organize their businesses as LLCs. And there have been three recent developments that have added fuel to the LLC fire:
Tough economic times have made it more important than ever for business owners to limit their liability for business debts, either by forming an LLC in the first place or by converting an existing sole proprietorship or partnership to an LLC. If an LLC falls behind on its bills, creditors know that their only legal remedy is against the business, not against the owner personally. This gives creditors a strong incentive to work with the owner to settle outstanding accounts. Even if the worst-case scenario comes to pass and the business fails, at least the owner won’t be personally liable for its debts.
All states now permit single-owner LLCs. This means that a person who has done business in the past as a sole proprietor (or is just starting out) can now protect his or her personal assets from business debts and claims by filing some simple paperwork and forming an LLC.
The IRS now allows LLCs (including single-owner LLCs) to choose between pass-through taxation and corporate tax treatment. Although most LLC owners will decide to stick with pass-through tax status (paying tax on their individual income tax returns), they can also elect to be taxed as a corporation, splitting business income between the business and their own personal income tax returns, which can lower overall business income taxes. As you’ll see in Chapter 4, income splitting can make sense for LLCs that make more than the owners want to take out of the business or that need to retain substantial profits on a regular basis.
For me, the most convincing evidence that the LLC has indeed caught on as a popular small business legal entity is the fact that, almost every day, I notice more small businesses with the telltale “LLC” tag at the end of their business names. If you doubt this, just enter any big office building and look at the directory of tenants: You’re bound to notice a good sprinkling of LLC business names along with the traditional “Inc.” and “Corp.” designators.
Should You Consider Forming an LLC?
Forming a new business as an LLC is an easy, quick, and relatively inexpensive way for new business owners to operate a business with limited liability while paying taxes on their individual income tax returns. Likewise, converting an existing sole proprietorship or partnership to an LLC is an easy way for sole proprietors and partners to protect their personal assets without changing the income tax treatment of their business.
But this doesn’t address the larger question: Does it make sense for you to form your new business as an LLC or to convert your existing business into an LLC? Unless you have already incorporated or you run a microbusiness that has little chance of incurring debts or liabilities, my answer is simple: Yes, you probably should form an LLC. Here’s why: Forming an LLC is very easy—you just fill in a standard form provided by most state LLC filing offices and file it, usually for a modest filing fee. And in exchange for your small efforts, you will receive a big legal benefit—your personal assets will be protected from business debts and claims, without making your taxes more complicated.
A few examples help to illustrate when it does and doesn’t make sense to form an LLC:
Example 1: Sam sets up a music store to sell guitars, keyboards, and musical accessories. Because members of the public will enter his retail space, Sam has some potential legal exposure (slip-and-fall lawsuits, for example). In addition, he knows that it’s easy to become enmeshed in contract disputes with suppliers and customers (for example, buyer’s remorse can often set in shortly after the purchase of a pricey guitar or synthesizer). Even though Sam will carry a reasonable amount of commercial liability insurance and do his best to keep his customers satisfied, he decides that it makes sense to file LLC articles of organization with his state for a $125 fee, so he can take advantage of the extra personal security that limited liability protection affords. Sam’s state, like many others, also charges a $50 annual report fee each year, but aside from this small expense and the few minutes it takes to complete the simple one-page annual filing form, there are very few added costs or burdens associated with doing business as an LLC. And Sam knows that by forming an LLC instead of operating as a sole proprietor, he won’t get a different tax status, as he would if he elected to form a corporation (the other legal entity that provides owners with limited personal liability for business debts).
Example 2: Stella and Vera have operated a pet grooming business from rented quarters in a strip mall for several years. Their partnership has been successful, and they’ve managed to increase their profits every year. Of course, there have been small problems with the occasional fussy pet owner—and they were sued once in small claims court for a poodle dye-job that went slightly awry—but no big lawsuits or other major legal hassles. However, as profits have grown, so too have the owners’ worries about their business. They are a lot busier than they used to be, and have had to hire several employees. They know that although their employees are well trained, expensive mistakes can happen, especially when new people come on board. Stella and Vera have also begun to worry about employee lawsuits. If the owners have to fire someone, will the employee go quietly or hire a lawyer and make their lives miserable for a while?
Because of these concerns, Stella and Vera decide to turn their partnership into an LLC. They do this by filing a one-page “Conversion of Partnership to an LLC” form, provided by their state. The filing fee is small, and they still file taxes as if they were a partnership (each owner continues to report and pay taxes on her share of business profits on her 1040 individual income tax return, and the business continues to file IRS Form 1065, an informational tax return for partnerships). Now both Stella and Vera rest a little easier at the end of each pet-grooming day, knowing that they won’t be personally liable for any legal problems they face in the future of their business. Of course, because the assets of their business remain at stake (as opposed to their personal assets), Stella and Vera will continue to choose and train their employees carefully.
Not all states provide a form for converting from a partnership to an LLC. In states that don’t provide a conversion form, partners file regular articles of organization to create their LLC. In some states, they also have to publish a notice in a local newspaper that they are terminating their partnership. I discuss these requirements in Chapter 6.
Example 3: Winston is a graphic artist, sitting 40 hours per week in his well-lit cubicle, churning out computer art for a software publishing firm. He yearns for the day when he can work for, and answer only to, himself in his own computer-graphics business. Rather than just quit his day job cold turkey, Winston starts his new business by working from home in the evenings and on weekends doing 3-D animation. Winston does most of his projects on a work-for-hire basis for Bill, a good friend of Winston’s and an entrepreneur who recently started a video game software company. Winston likes the fact that his animation work is fun, but he loves the fact that he can bill his services at an hourly rate that is twice what he makes at his day job.
Winston has heard about the advantages of forming an LLC, but he decides not to form one for his moonlighting business, at least for the time being. His reasons are:
He doesn’t feel that his sideline business exposes him to personal liability since he works at home, under the terms of a very basic work-for-hire agreement with Bill, who pays Winston’s invoices on time every time.
He is too busy with his regular job and his new business to concentrate on the legal end of his business.
Winston’s decision is a sensible one. Even though converting a sole proprietorship to an LLC isn’t difficult, Winston doesn’t need to take this step yet. If Winston continues to operate as a sole proprietor (as most freelancers do), he doesn’t need to keep his personal funds and business funds separate. If Winston were to form an LLC, he would need to keep his personal funds separate from his business funds (to be sure that a court will respect the separate legal existence of his LLC, and its limited liability protection). And, if he decides to stop moonlighting, all he has to do is stop working. Forming an LLC, no matter how easy, will make Winston’s business life more formal, and if he goes on to something else, he will have to officially dissolve his LLC. This is a little more trouble than just doing business as a sole proprietorship.
Example 4: Bill, Winston’s only client, has just started his own video game software venture, as mentioned in the above example. Bill knows that forming an LLC is a modern legal strategy, and he is definitely a cutting-edge kind of guy. His plans are big—he hopes to hire a crew of talented programmers from the local college, then turn them loose to create the latest in 3-D video game software. He can’t pay his software team much to start, but he thinks he can convince them of the profit-making potential of the enterprise, particularly if one of the company’s software offerings gets licensed by one of the big video game companies. He’s sure his company has a good chance of success, but he also wants to limit his personal liability in case something goes wrong (for instance, if his company folds while owing money to creditors).
Bill considers forming an LLC, but decides to form a corporation instead. The corporation will give him the same limited liability protection an LLC affords, but it offers Bill some special advantages that suit his business plan better. With a corporation, Bill can attract employees by offering them stock options—which, despite the fluctuations in the stock market, are considered desirable by employees in companies that have the potential to go public or be acquired for big bucks. Also, after reading Chapter 2 of this book, Bill understands that forming a corporation is often the best approach for attracting outside investors. This is important to Bill, who plans to do a lot of networking to find a venture capital firm to help fund the growth of his business. With a corporation, Bill can offer investors stock ownership and a seat on the board of directors.
Even though a corporation requires much more work to maintain—you will have to hold annual and special directors’ and shareholders’ meetings, plus keep a more complicated set of accounting records for the business and prepare a separate income tax return—incorporating makes sense for Bill. While an LLC insulates the personal assets of owners of a small, privately held business venture, sometimes it’s not a good vehicle for outside investors like venture capitalists. Let’s take a look at the reasons.
An LLC can be set up with a management structure that has the same centralized features as a board-managed corporation—for example, the LLC can select a management team consisting of owners who are active in the business and possibly an outside investor (see Chapters 1 and 5 for a discussion of LLC management). But precisely because LLCs are more flexible and informal business entities, they can be less disciplined and less responsive to the interests of outside investors. LLCs don’t provide as many management protections and controls as corporations, such as shareholder inspection rights and annual disclosure requirements, which makes it more difficult for investors to hold management accountable.
In addition, it’s more difficult to set up different classes of ownership in an LLC to cater to the special concerns of investors. In contrast, in a corporation, the founders can adopt an off-the-shelf capitalization structure of nonpreferred and preferred shares—which are usually immediately attractive to venture capital investors. And forget about taking an LLC public with an IPO (initial public offering of stock)—if this is your short-term dream, you’ll no doubt want to incorporate to take advantage of the long-established statutory procedures for attracting and maintaining a large group of investors (shareholders).
Most small businesses don’t want to incorporate. Because a corporation limits its owners’ personal liability for business debts, and because, unlike LLCs, corporations have been around for centuries, people often ask if it makes more sense to incorporate. The answer is most often “No” unless, as discussed just above, there is a really good reason to incorporate, such as wanting to sell stock to investors or distribute stock options to employees. For most other small businesses—those that are owned by just a few people and have no plans to go public—forming an LLC is usually the best approach, because corporations are considerably harder to maintain. For example, state corporate statutes have specific rules for holding meetings of directors and shareholders, issuing stock, distributing profits, and much more. Also, unlike an LLC, a corporation is a separate tax entity that calculates profits according to a lot of special corporate tax rules and then reports and pays taxes on these profits separately from its owners. While LLCs have the option to elect this added income tax complexity, they can wait until the owners decide that it makes tax sense to do so. (I discuss electing corporate tax treatment in Chapter 4.)
Don’t worry if you still don’t know whether an LLC is right for you. By reading the rest of this book, you’ll understand better the features of an LLC and how they can work for you. Also, in Appendix C, I’ve provided a checklist for forming an LLC, which includes a list of questions to help you decide whether it makes sense to run your business as an LLC.
Some types of businesses cannot form an LLC. Banking, trust, or insurance businesses are prohibited from forming LLCs in many states. In addition, some states also prohibit certain professionals (or anyone holding a vocational license) from forming an LLC, or at least subject them to special rules when forming one. If you fall into one of these categories, take a minute to skip ahead to Chapter 1 to see whether you’ll be eligible to form an LLC.
How to Use This Book
In this book, I provide basic legal and tax information about LLCs. My purpose is to help you understand exactly where LLCs fit into the larger picture of business ownership structures and to help you decide whether it makes sense for you to form an LLC to conduct your business.
Because many busy people won’t have time to read this book from cover to cover, I do my best to provide this information in a well-organized, easy-to-access format. First, I suggest you read Chapter 1 to get a good overview of how LLCs work. Then, to find the exact material you’re interested in, look at the chapter subheadings in the table of contents. (These are repeated at the start of each chapter.) Each time you pick up the book to read a different section, your “LLC IQ” will increase and, within a short time, you’ll know enough to decide if the LLC business structure might be a good fit for you and your business.
Another reason why I take this practical approach is philosophical. A major attraction of the LLC is that you can form one simply, quickly, and with a lot of flexibility. It follows that a book that provides an overview of LLCs should fit this same model. The idea is to use it quickly to get the information you need and then get back to business. And, let’s be honest—if you are going to spend leisure time curled up with a book, I’m sure you can think of several with better plotlines and character development.
What This Book Doesn’t Do
You can’t form an LLC using this book alone. Its goal is to provide a good overview of the subject, no more. So if you already know a good deal about LLC legalities and tax issues, including how LLCs are formed and operated, you may want to get right to the task of forming one. If so, my other Nolo books and products can help you do the job. See “Other Nolo LLC Resources,” below, for more information.
Legal and Tax Experts
This book provides basic legal and tax information. As in any other specialized field, LLC legal and tax information constantly changes. If you decide you want to form an LLC, you will benefit by discussing your specific situation with a small business lawyer and/or a small business tax adviser. Not only can professional advisers make sure you have the most current information on forming an LLC in your state, but they can also serve as great sounding boards to check your legal, tax, and practical conclusions. In Chapter 7, I provide several recommendations on how to find knowledgeable and helpful legal and tax advisers.
Other Nolo LLC Resources
Below is a list of Nolo resources that can help you actually form and operate an LLC. Of course, these are not the only helpful products on the market—they’re just the ones I know best (after all, I wrote or created most of them!). All are available at Nolo’s website (www.nolo.com).
LLC or Corporation? How to Choose the Right Form for Your Business, by Anthony Mancuso. This companion to Nolo’s Quick LLC explains in detail the technical legal and tax differences between LLCs and corporations. It also provides more detailed information on the legal and tax consequences of converting a business to (or from) an LLC or a corporation.
Form Your Own Limited Liability Company, by Anthony Mancuso. This book contains forms and instructions for preparing articles of organization (the main organizational document for LLCs) and an operating agreement (similar to corporate bylaws) to form an LLC in your state. It also provides legal and tax background information.
Nolo’s online LLC formation service. To create your LLC right now, use Nolo’s online service, which helps you form your LLC directly on the Internet. Once you pick a package and complete a comprehensive interview online, Nolo will create a customized LLC operating agreement for your LLC and file your articles of organization with the state filing office (your LLC will come into existence the day the articles are filed). To form your LLC online or get more information, go to www.nolo.com/products/online-llc-tccllcus.html.
Your Limited Liability Company: An Operating Manual, by Anthony Mancuso. This post-start-up book provides guidance and information on how to best operate your LLC on an ongoing basis. It provides ready-to-use minutes forms and instructions for holding formal LLC meetings. It also advises you on how to formally approve legal, tax, and other important business decisions that arise in the course of operating an LLC, and includes resolution forms to record these decisions.
Business Buyout Agreements: Plan Now for Retirement, Death, Divorce or Owner Disagreements, by Anthony Mancuso and Bethany K. Laurence. This book shows you how to adopt comprehensive provisions to handle the purchase and sale of ownership interests in an LLC when an owner withdraws, dies, becomes disabled, or wishes to sell his or her interest to an outsider. Comes with an easy-to-use agreement—you simply check the appropriate options, then fill in the blanks.
Tax Savvy for Small Business, by Frederick W. Daily and Jeffrey
A. Quinn. This book gives LLC owners information about federal taxes and explains how to make the best tax decisions for your business, maximize profits, and stay out of trouble with the IRS.