Should You Form an LLC?

Whether you’re just starting or you have an existing company, you may be considering forming an LLC. Here’s what you need to consider before you do:

  1. Corporate Gymnastics.  LLCs are a flexible form of business entity with fewer mandatory rules than apply to LLCs than to corporations or partnerships.  However, this flexibility means that all of the details governing each LLC must be spelled out in long, complicated Operating Agreements.
  2. Limited Liability.  Like corporations and (some) partnerships, LLCs offer their members limited liability.  Each member of an LLC may lose his or her investment in the company, but the member’s other property should not be subject to the LLC’s liabilities.  Of course, creditors know this too, so members are often required to personally guarantee loans and other obligations of the LLC.
  3. The Rule Book.  An LLC and its members are governed by the Operating Agreement.  The Operating Agreement should cover such topics as management of the LLC, capital contributions from the members, distributions of net profits, and ultimate liquidation of the company. 
  4. Upper Management.  An LLC can either be managed by its members or managed by one or more managers who might or might not be members.  Even where an LLC is manager-managed, there are usually some decisions that must be made by the members (such as a sale of the LLC).  LLCs do not usually have traditional corporate officers (like president, treasurer), but they can.
  5. Ante Up.  The investments members make in the LLC are called capital contributions.  Capital contributions can be cash or anything of value.  A key term of the Operating Agreement is whether existing members can be required to make additional capital contributions.
  6. Pride of Ownership.  Unlike corporations, in which ownership is evidenced by stock, ownership in LLCs may be denominated and evidenced in many different ways.  A member might simply own a percentage interest recorded only on the LLC’s books, or a member might own membership units or shares that are represented by certificates. 
  7. Returns on Investment.  Net profits of the LLC are generally paid to some or all of the members in the form of distributions.  When and how distributions are made should be addressed in the Operating Agreement.  Members can divvy up the profits in almost any way imaginable.
  8. Pick Your Poison.  By default, LLCs (those with more than one member) are treated like partnerships for income tax purposes, but they can instead elect to be treated like corporations (even S corporations).  LLCs with only one owner are completely ignored for income tax purposes, meaning that they are lumped together with their owners.
  9. Taxing Calculations.  The taxation of partnerships, and therefore most LLCs, is very complicated.  The LLCs do not pay taxes themselves (in most cases), but they do have to file tax returns.  Net income passes through to the LLC’s members in the form of allocations to member capital accounts, which must comply with very detailed tax rules.  Bottom line: have a good CPA.
  10. Charge!  When a corporate shareholder is sued, it’s possible that a judgment creditor could end up controlling the shareholder’s stock, including the right to vote.  In an LLC, the judgment creditor of a member is only entitled to a charging order, which is the right to receive distributions when and if paid.  The judgment creditor of an LLC member cannot participate in the management of the LLC.

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