09/ 21/ 2007
by Beth Gaudio, NFIB Legal Foundation
Choosing a legal business entity is one of the most important decisions a small-business owner will have to make. The ability to easily form a business in a way that shields personal assets while reducing the tax burden is an important, evolving area of law. A limited liability company (LLC) provides many small-business owners with the flexibility and personal asset protection they need to focus on what they do best-- providing their employees with rewarding jobs and their customers with the highest quality products and services.
A choice of entities
Historically, states created LLCs in response to pressure from professional groups to provide partners who were not actively involved in the business with limited liability for partnership debts and actions. To address these needs, state statutes provide that an LLC is a separate legal entity that affords owners with liability protection. Variations of the LLC include limited liability partnerships (LLPs), limited liability limited partnerships (LLLPS) and professional limited liability partnerships (PLLPs). The various forms of limited liability partnerships are mostly used by professionals like attorneys and accountants. Every state and the District of Columbia now have an LLC and an LLP or RLLP statute on the books.
Tax treatment of an LLC
By forming an LLC, a business owner safeguards personal assets and adopts a more advantageous tax form. In fact, an LLC provides owners with several options regarding how they want the entity to be taxed. If the LLC has two or more members, the entity can choose to be taxed as a partnership or a corporation. An LLC that elects corporate treatment can also elect S corporation treatment if it qualifies. If no election is made, the IRS will tax the entity as a partnership. If the LLC has only one owner or member, the entity can choose to be taxed as a disregarded entity (a sole proprietorship) or a corporation. If there is only one member and no election is made, the IRS will treat the LLC as a disregarded entity for tax purposes.
Formation and operation
To form an LLC, the owners or members must register with the state and file Articles of Organization. Except in rare circumstances, such as situations where an LLC is formed to skirt the law, owners (known as members) are not responsible for the LLC's liabilities. Unlike limited partners in a limited partnership, LLC members do not lose their limited liability by actively participating in management. As a separate legal entity, an LLC can own property, incur debts, enter into contracts and be a party to civil actions.
Other options?
While LLCs have increased in popularity, other business forms such as sole proprietorships, partnerships and corporations remain viable alternatives and offer similar protections. The chart below highlights some of the differences between LLCs, LLPs, partnerships and corporations.
Comparison of LLC to other entities
| Limited Liability Co. | Limited Partnership | General Partnership | LLP | Corporation | |
| File documents with state | Yes | Yes | No | Yes | Yes |
| Governing instrument | Articles of organization & operating agreement | Partnership agreement | Partnership agreement | Partnership agreement | Articles of incorporation & by-laws |
| Owner title | Member | Partner | Partner | Partner | Shareholder |
| Entity name | Name indicates limited liability | Name indicates limited liability | No requirement | Name indicates limited liability | Name indicates limited liability |
| Number of owners | No upper limit. Some states require at least two members. | At least two partners | At least two partners | At least two partners | No upper or lower limit for C Corps. S Corps limited to 75 shareholders. |
| Type of owners | No restrictions | No restrictions | No restrictions | States may limit type of owner | No restrictions for C Corps. Significant restrictions on shareholders of an S Corp. |
| Type of interest | No restrictions | No restrictions | No restrictions | No restrictions | No restriction for C Corps. Single class of stock for S Corps. |
| Liability for entity debts | No member is liable | General partners are liable | All partners are liable | Malpractice liability limited to self and those supervised | No shareholders are liable. Liable for contractual debts in most states. |
| Participation in management | All members may participate; Agreement can limit to selected managers | General partners manage, limited partners don't | All partners may manage; can limit by agreement | All partners may manage; can limit by agreement | Managed by officers and directors. |
| Transfer-ability of interest | Significant restrictions placed on transfer | Significant restrictions placed on transfer | Significant restrictions placed on transfer | Significant restrictions placed on transfer | No restrictions |
| Dissolution events | All or a majority of remaining members must agree to continue in case of a dissolution event | All or a majority of remaining general partners must agree to continue in case of a dissolution event | All or a majority of remaining partners must agree to continue in case of a dissolution event | All or a majority of remaining partners must agree to continue in case of a dissolution event | No effect |
Source: Internal Revenue Service (2007)
