LIMITED LIABILITY COMPANY
Self-employment has its benefits.
Self-employed business owners who want to reduce their personal liability for company debts and legal problems but don't want the more complex structure of a corporation have an alternative: The limited liability company or LLC. This type of business structure has been used in the U.S. for about 30 years, and is now permitted in all 50 states.
Reasons for Choosing an LLC
As an owner (or "member") of a limited liability company you're only partially on the hook for unpaid debts or court judgments against your business: Your losses are limited to your investment in the company. The same is true if you form a corporation, but when you opt for that business structure you lose a lot of the management flexibility you enjoyed as a sole proprietor (or you and your partners enjoyed in your partnership).
With an LLC, however, you hold on to that flexibility: You can have an unlimited number of members, or just one. A member can be an individual, a partnership or even a corporation. Members can run the LLC themselves or hire an outside manager. You can even choose how you want the business to be taxed: Either as a partnership or a corporation (or, if you're a single-owner LLC, as a sole proprietorship). And LLCs don't issue stock, so profits are divvied up any way the members choose, and there's no need for shareholders' meetings.
Even with all these advantages, there may be situations where you'll opt to incorporate instead. For example, you may want to be able to issue stock, so you can reward key employees by giving them stock options. And in many states, LLCs can't be formed by certain types of businesses, including banks and insurance firms.
How LLCs Are Formed
Like corporations, LLCs are governed by state law. You'll need to draft articles of organization in the state where your company is headquartered, file them with the appropriate state office (usually the secretary of state or department of commerce) and pay a filing fee. Most states make the process easy. They usually have a pre-printed form where you just fill in the blanks to provide your company's information, or they have a sample form to follow in creating your own document. As soon as your articles are processed and approved by the state, you can begin operating your business as an LLC.
For LLCs with more than one member, you'll also need to draw up an operating agreement. Items in this document should include: The rights and responsibilities of the LLC members; what percentage of the business each member owns; how the business will be managed; how members will make decisions on major issues; what the procedures are for adding new members; and what tax treatment the LLC chooses.
Tax Treatment of an LLC
The IRS assumes that LLCs with more than one member are partnerships for tax purposes. That means the company itself pays no tax, but taxable profits and deductible losses are passed through to the members. So at tax time the LLC files Form 1065, Partnership Return of Income, to give IRS a record of distributions to members. The members, in turn, report their share of the LLC's profit or loss on their individual returns.
If you choose to have your LLC file taxes as a corporation, you must tell IRS by filing Form 8832, Entity Classification Election. At tax time you'll use Form 1120, Corporation Income Tax Return or the short form, 1120-A. If you're a single-member LLC, you'll file as a sole proprietorship, using Schedule C.
A big issue for LLC members is whether they owe self-employment tax on their share of the company's earnings. In general, members who are actively engaged in the business must pay this tax, which for 2007 is 15.3% on the first $97,500 of net earnings from self-employment and 2.9% on earnings above that amount. There is a special rule for LLC members who are the equivalent of limited partners and don't take an active role in the business: They don't pay self-employment tax on profits the company passes through to them, only on compensation they receive for any services they provide to the LLC.
But the law isn't clear on how inactive an LLC member has to be to qualify for this special rule. IRS tried to clear things up a few years ago by proposing rules that would require self-employment tax to be paid on profits distributed to any member who is personally liable for the LLC's debts, participates in the business for more than 500 hours annually, or has authority to sign contracts on behalf of the company. And even if none of those characteristics applied, the proposed rules would require you to pay the tax if you're a member of an LLC in health, law, accounting, engineering, architecture or consulting. Although the rules haven't been made final, IRS has said anyone who follows them won't be challenged by the Service on this issue.
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