Limited Liability Company (LLC)-- Quick Fact Sheet presented by

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1 Limited Liability Company (LLC)-- Quick Fact Sheet presented by --NationalLawDocs.com Questions: Give us a call. (800) What is an LLC? Stands for Limited Liability Company. Simply stated, it acts as a light corporation : a separate legal entity similar to a corporation that insulates members from personal liability for company debt, but operates more informally. In fact, it was created by state legislatures purposely for small companies that like to conduct business without a lot of paperwork. History. It all started in 1977 when Wyoming attempted to entice business owners to move to the State by this new entity. In the free and open environment of this frontier State, the idea was simple: conduct business informally without a lot of paperwork, insulate the members from personal liability, and have them taxed as sole proprietors or partners without double taxation. But as usual, the roadblock was the IRS. It was not until 1988 that the Internal Revenue Service finally ruled Wyoming LLC s could qualify for tax treatment as a partnership, rather than as a corporation. So much for the Federal government invigorating the economy! But then the IRS laid down a set of highly technical rules that had to be followed to the letter if they were to avoid being subject to corporate double income taxes (taxed once at the corporation level and again on distribution to the shareholders). This put a damper on the use of LLCs by all but the most adventuresome entrepreneurs for years. People were just reluctant to jump into the vat of uncertainty. In addition, the IRS took the position that a one-owner LLC would be taxed as a corporation. Finally in 1997 our friends at the IRS gained a glint of sanity and issued a new set of regulations that allowed any LLC to choose whether it would be taxed as a sole proprietorship, partnership or a corporation by filing out IRS form LLC s then spread like wildfire. Now every state (Hawaii was the last in 1996) allows an LLC. Limited Liability. If properly operated, it shields a single and multiple member enterprise from personal liability as to company debt. For example, all general partners could have their personal assets

2 seized if there is a judgment against the partnership. Traditionally, the only way to prevent this was to set up a limited partnership. The limited partners, because decisions were made by general partners, would risk only their investment. But with an LLC, sole proprietors and partners can enjoy the benefits of insulated liability. Operates Informally. In essence, an LLC acts like an informal partnership. By statute, every state allows you to operate without the typical corporate formalities of formal noticed meetings, minutes, and resolutions. Committees and sub-committees are not required. Nor is there a requirement of a board of directors. Additionally, you need not designate officers in the sense of a president, vice-president, secretary, or treasure. Record keeping is kept to a minimum. But remember, with a properly drafted Shareholder s Agreement or bylaws, even an S corporation can act more informally and can even dispense with formal meetings. How Does the IRS Treat it? The IRS considers the LLC itself a pass through entity. This means the LLC as a separate entity does not pay tax, instead net profits are reported and taxed at the individual level by the members. Thus, there is no double taxation. By default, the tax status depends upon how many members: 1. Single Member LLC. Considered a sole proprietorship. Profits and losses end up being handled by the individual on his or her 1040 in Schedule C. 2. Multiple Member LLC. Considered a partnership. Profits and losses are reported like any other partnership on form 1065 after the members receive a K-1. But what if you are in a community property state in which each spouse has an ownership interest in the business (the nine community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and, since 1986, Wisconsin.)? If Frank is the sole owner of his Laundromat, does he become a partnership because his wife has an interest? And does that mean he has to be taxed as a partnership? Fortunately, the IRS has ruled in Rev. Proc that it will accept whatever choice the couples make, either to disregard the LLC as an entity (treating it as a "single-member LLC") or to treat it as a partnership. But if the property is held in joint tenancy, who knows. A member or members can also elect on IRS Form 8832 to be treated as an S corporation for tax purposes. Many experts recommend this as the best of all worlds. The company operates informally as an LLC with limited liability, but the same time income passes through to the individual members without double taxation.

3 Do I File for an LLLC at the State or Federal Level? You form the LLC at the state level with your Secretary of State. Do All States Acknowledge It? Yes. Can Every Business Be a LLC? Just about. An S corporation excludes banks, thrifts, insurance companies (insurance agents and brokers are OK), and domestic international sales corporations (act as brokers who help an American company export their goods). Not so with an LLC. An S corporation also excludes the following shareholders: more than 100; nonresident aliens; corporations or partnerships as shareholders; and more than one class of stock (or otherwise have disproportionate distributions). There are no such prohibitions for an LLC How Many Members? Any number. For a while, there were some states that did not allow one member LLC s, but now all States allow such an entity. Before such legislation, it was the kiss of death: the one member LLC would be subject to double taxation at the LLC level (similar to a C corporation) and then at the individual level upon distributions. By contrast, an S corporation has a maximum of 100 shareholders. Members. Here are some features: a) Officers. One person may hold any position (manager, president, vice president, treasurer, or secretary). b) Residency. Members do not have to be residents (live in the state) of the state of incorporation. c) Names Listed? Most states do not require listing the names of officers in the articles of organization. d) Age Requirements? Anyone over age 18. What Kinds of Membership Certificates? Different classes of membership certificates are allowed. The most common would be voting certificates, similar to common stock in a corporation. There could also be certificates without voting rights and if the business goes under, including bankruptcy, they could receive first dibs on whatever assets are left, similar to preferred shares in a corporation.

4 No. of Authorized Shares/Certificates: In the Articles of Organization, some states require stating how many are initially authorized. Make sure you pick a large enough number so more can be issued in the future to other persons who may wish to join the organization or for investors (for example 10,000). That way you can issue 5,000 now so you have a reserve. Do We Pay Tax if Profits are Withheld? Yes. If the LLC makes a profit and there is still money left over in its bank account after paying salaries, expenses, and fringe benefits, that retained money is still considered income to the members who report and pay taxes on their But that rarely causes a problem. If there is money left over, it is usually spent on the business or distributed to members. Most people do not mind paying taxes on profits that are put to productive use or which can be used for personal expenses. And, in this economy, few businesses horde money in their business accounts unused. Notarized or certified paperwork? Not with the Secretary of State, but may be required for others. Some government agencies and other sources insist on receiving certified copies of your LLC papers, but if this occurs, you can always receive them for a fee from the Secretary of State s office later. In most cases, a bank will require certified copies of your Articles of Organization to open a business bank account. Annual Report and Fee. Once a year you are required to file an annual report with the current status of your LLC, including up-to-date names and addresses of the members. The fee is nominal, usually in the $25.00 range. Exception: Maryland charges a whopping $300.00! LLC Name: The common allowable names are: Limited Liability Company; LLC; Limited Company; Limited, Ltd., Company; and Co. Licensed Professionals. Most states limit the setting up of an LLC by professionals, including a doctor, lawyer, chiropractor, accountant, architect, or engineer. Instead, they must be denominated as a Professional Limited Liability Company (PLLC). They can still insulate themselves from personal liability, except for malpractice claims. In California, such professionals cannot set up an LLC in any event. How Do We Address You? With a corporation, the players are easily identified: directors, shareholders, president, vicepresident, secretary, and treasurer. But it is open field with an LLC. The individuals can be

5 identified as: member, managing member, managing director, executive director, as well as the traditional rubrics of president, vice-president, secretary, and treasurer. You can even call yourself as a group the board of directors. Purpose stated in articles: Most states only require a general statement or any lawful business which may be conducted in this state. Registered agent: This is the person who resides in the state of incorporation and who can receive legal papers if you are sued or correspondence as to tax matters. There is a requirement of having such an agent. The agent must be an individual with a permanent residence address in the state or another business entity that is registered in the state. No post office boxes are allowed (except for rural routes). The corporation cannot be its own registered agent. On the other hand you can designate any of the individual shareholders, officers, or directors if they have a permanent residence in the state. Initial capital cash requirements: None in most states. EIN: As of January 1, 2009, the IRS requires that the LLC itself secure a Tax ID number. Converting a Partnership to an LLC. Very easy, even per the IRS. Under Rev. Rul , the IRS found that an existing partnership may generally be converted, tax-free, to an LLC (if the LLC qualifies for partnership tax treatment). In fact, such a conversion can be done without terminating the partnership's taxable year. Self-Employment Tax: Most of us realize that self-employed persons are not off the hook with payroll taxes. They currently pay 15.3% for Social Security and Medicare yearly. At least with an S corporation the rule was relatively clear. If you received a wage, salary, or guaranteed payment of any kind, you had to pay the tax. If you were simply getting a profit distribution or dividend payment, it wasn t owed. But the rules as to an LLC are in a different world--murky at best. We highly recommend you talk to your accountant or tax adviser. But let us give you a general summary. Proposed IRS regulations (Prop. Regs. Sec (a)-2(h)(2), proposed in 1997 but never adopted or revised since) would treat members of an LLC that were passive, did not spend much time with the company, were not actively involved in decision-making, and did not sign

6 on contracts (almost like a limited partner) as not subject to these taxes. These regulations said that a member is subject to the tax if any one of the following conditions applied: 1. A member has personal liability as a partner for partnership debts. This only applies if the member personally signs on the contract. By definition, the LLC shields a member from personal liability, or 2. The member has authority to enter into contracts. By definition, each member does (different from a manager-managed LLC in which you appoint a manager to enter into the contracts), or 3. The member works for more than 500 hours during the tax year. Even if a member works more than 500 hours a year, his or her distributive share of the profits may not be subject to self-employment tax. This is not a salary or wage and not subject to self-employment tax. You can see that service partnerships (lawyers, doctors, architects, dentists, chiropractors, engineers, consultants, etc.) would normally not qualify for treatment as a "limited partner" for purposes of the above exemption from self-employment tax. The current status of the regulations are uncertain. This as been exacerbated after the IRS came under heavy criticism and Congress ordered them not to finalize or implement before July, 1, The IRS has yet to set forth any new regulations and has never implemented the Proposed Regulations. As a result, some tax practitioners surmise that a member is not subject to self-employment tax if the member is not a manager or has 10% or less ownership, unless they receive a guaranteed payment (like a salary). However, to date no court case has directly considered the question of whether LLC members are subject to self-employment tax. So, be careful. Watch out for statements that this IRS 1997 regulation is the current law. It has not yet been formally adopted. Separate Properties Separate LLC s. Because LLC s are so easy to setup and run, some real estate professionals with multiple properties set up an LLC for each separate parcel. This prevents cross-liability, in other words if you liable for acts or omissions on one property, the plaintiff will seek to go against the income from other parcels as well. Example: John is a real estate broker and property manager. He started small twenty years ago and through hard work owns four separate units, including a four-plex, two small apartment buildings, and an office building. The dentist tenant in the office building has sued him for breach of covenant and contract (loss of profits and business interruption) when the office became unusable for a six month period when the slab fractured, rupturing the flooring and requiring substantial renovation and delay. If each property is owned by its own LLC,

7 any judgment would not be able to reach the income stream from the other units. Separate Stores-Separate LLC s. This is where it gets interesting. Assume you have a chain of small retail shops and want to make sure the failure of one store will not impact the entire company. It is becoming standard practice to create separate LLCs for each outlet. This could be accomplished previously by forming multiple corporations, but the heavy accounting, legal, and tax return compliance costs made it prohibitive. But now you can have subsidiary LLCs that create "fire walls" between different segments of the business. And, they can be ignored for federal tax filing purposes -- the main business will still file one partnership or corporate tax return (or one Form 1040 with a Schedule C's for individual ownership), combining the income of all stores on the single tax return. No multiple tax returns, no difficult consolidated corporate tax returns and intercompany accounting. Example: Ted and Alice have three dry cleaning outlets in Georgia. They are run under a single general partnership. They are concerned about a government agency investigating and finding them liable for possible toxic discharge. Or, what if one outlet goes bankrupt--it would involve all three. They have recently converted to green solvents but are still concerned about past operations. One day their attorney told them that a lawsuit against one outlet (the oldest) would make the overall partnership as well as the individual partners, jointly and severally liable. After thinking about it, they decided to set up three separate LLC s to prevent this eventuality. They had already kept separate books as required by their accountant so the conversion changed little if anything. Now they feel even more insulated. But remember, it will still be necessary to maintain separate accounting records and bank accounts for these LLCs, as each is considered a separate legal entity. Otherwise, an attorney may seek to "pierce the veil" of limited liability if the LLC's assets are commingled with the assets of another entity--not treating the LLC as a separate island unto itself. But this is rarely a problem since separate books are typically kept in any event. How else can you trace the profitability (or lack thereof) of the various stores and make business decisions? The Series LLC. In the sample of Ted and Alice above, what would be even better than having the three separate LLC s? Having one LLC that encompasses all three entities. Can this be done? It can, and it s called Series LLC. But it is very tricky and unproven at this time by most states. Entrepreneurs have already discovered the insulation of liability benefits of having separate LLC s by a single set of owners. But, in many states, such as California, using multiple LLCs means incurring multiple taxes and fees (initial and annual).

8 Now, some progressive states such as Delaware (Delaware Code, Title 6, Subtitle II, Sec ) have amended their laws to permit these series LLCs. Other states have followed suit, including Illinois, Iowa, Nevada, Oklahoma, and Utah. A series LLC is a single LLC that divides itself into a "series" of separate divisions, each of which must keep a separate set of books, but with each operates as separate business, with its own limited liability like a tree with several branches. For example, if the business of one declares bankruptcy, the other divisions are not liable for its claims. Making it even better, only one LLC exists, hence creating only one set of taxes and tax filings. Each "series" can also have different members, managers, and ownership percentages with corresponding different distributions of income. However, attorneys are divided as to whether other states would respect such a legal framework. And, it is uncertain if IRS will allow the LLC to file a single partnership tax return as opposed to separate ones. California has already jumped in and found such entities treated as multiple LLCs, so that each will be subject to the California $800 minimum franchise tax. So be careful. The last thing you want to do is be a test case in your State. States That Have Additional Requirements for an LLC. California treats an LLC similar to a corporation: "LLC fees" are based on gross receipts of the business, as well as a $800 annual minimum tax. Tennessee taxes the income of an LLC in the same manner as a corporation. New Jersey has annual fees based on the number of members (owners) of the LLC. New York City has annual fees based on gross income. Ohio is phasing out its corporate franchise tax and calling it a "Commercial Activities Tax," (gross receipts tax that applies equally to all types of legal entities). Kentucky has a "limited liability entity" tax on LLCs, based on gross receipts, but a business with less that $3 million of gross receipts pays only a flat $175 tax. Texas imposes a franchise tax (similar to a modified gross receipts tax) on LLCs. Wyoming has a franchise tax (on capital or gross receipts). New Hampshire, Michigan and the District of Columbia tax the income of all business entities in more or less the same manner, regardless of the legal form of the operation, whether LLC, corporation, partnership, etc.

9 New Kid in Town Limited Liability Partnership. Similar to the LLC, all 50 states and D.C. recognize what is called a limited liability partnership (LLP) or registered limited liability partnership (RLLP). It is nothing more than a common general partnership which registers with the secretary of state and pays a fee. It is entitled to the benefit of limited liability similar to a LLC or S corporation. It also acts informally in every sense of the word acts like an unregistered general partnership. LLPs are typically used for professional firms (doctors, lawyers, engineers, architects, chiropractors, etc.), and in some states (New York and California) only professional firms may set them up. It offers limited protection from liability, in that a professional who is a partner in an LLP remains personally liable for his or her own malpractice or gross negligence. FUTURE PAPERS TO FILE Annual reports to file? Yes. Every year you must file an annual report which gives an update of your LLC information. The fees are modest (average is $25). There are some rather substantial penalties for late filing, including the suspension of your charter and penalty fees for reinstatement. When are other filings needed? Normally, you are not required to file additional paperwork, but there are exceptions as to material changes to the LLC, such as (along with modest fees): Change of name of registered or statutory agent (the person who is named for service of process, for example when you are sued, this person is served the papers). Change of address of the registered or statutory agent. Change of company registered address (when you change your main office or principal place of business). This is usually not required because the Operating Agreement gives the members the right to change the address without amending the articles of organization. All you do is put the new address in the annual filing statement. Foreign corporation registrations (typically when you have opened an office in another state you register with that Secretary of State as a foreign LLC).

10 Amending the Articles of Organization. Since the Articles state very little about your LLC, it is rare to file amendments. Usually, the man reasons are: change of LLC name, business address, increase or decrease in the number of members, and increase or decrease in the number of authorized share certificates, if so stated in the Articles (for example, adding more shares when additional members come aboard, redemption, etc.). Correcting misstatements in the Articles. Dissolving the LLC. Consolidations or mergers. Changing status from one entity to another (for example from a limited partnership to a corporation). Reinstatement after forfeiture due to nonpayment of LLC tax or fees. There are standard secretary of state forms for all these purposes on their websites. Good luck. National Law Docs.