Form Your Own Limited Liability Company
Anthony Mancuso, Attorney
September 2013, 8th Edition
Make your business an LLC
Structuring your business as an LLC can bring important advantages: It lets you limit your personal liability for business debts and simplify your taxes. Here, you’ll find the key legal forms you need to create an LLC in your state, including:
• LLC articles of organization
• Operating agreement for member-managed LLC
• LLC management operating agreement
• LLC reservation of name letter
• Minutes of meeting form
Find all the instructions you need, including how to create an operating agreement that covers how profits and losses are divided and major business decisions are made. You’ll also learn how to choose a unique LLC name that meets state legal requirements and how to take care of ongoing legal and tax paperwork.
This new edition of Form Your Own Limited LIability Company has been carefully revised and updated to reflect the latest federal regulations, as well as the most current laws of all 50 states. Plus, all the forms you need are included.
You may also be interested in Nolo's Online LLC application, the easiest and fastest way to form your own LLC.
“Entrepreneurs can take advantage of the unique tax and legal benefits of the LLC for less than the cost of 10 minutes of their own lawyer’s time.”-Money Maker's Monthly
“In typical straightforward Nolo fashion, this book explains everything from choosing a name to maintaining the LLC’s legal and tax status.”-Orange County Register
- Articles of Organization
- Certification of Authority
- LLC Articles Filing Letter
- Minutes of Meeting
- Management Operating Agreement
- Operating Agreement for Member-Managed Limited Liability Company
- Reservation of LLC Name Letter
- IRS Form 8832: Entity Classification Election
Anthony Mancuso is a corporations and limited liability company expert. He graduated from Hastings College of Law in San Francisco, is a member of the California State Bar, writes books and software in the fields of corporate and LLC law, and studies advanced business taxation at Golden Gate University in San Francisco. He has also been a consultant for Silicon Valley EDA (Electronic Design Automation) companies, most recently working on a C++ open-source integrated circuit database project team. He is the author of several Nolo books on forming and operating corporations (both profit and nonprofit) and limited liability companies. His titles include Incorporate Your Business, How to Form a Nonprofit Corporation (national and California editions), Form Your Own Limited Liability Company, The Corporate Records Handbook, and LLC or Corporation? His books have shown over a quarter of a million businesses and organizations how to form a corporation or LLC. He also is a licensed helicopter pilot and has performed for years as a guitarist in many musical idioms.
Table of Contents
Your LLC Companion....................................................... 1
Overview of the LLC......................................................... 3
Top Ten Questions About LLCs............................................. 4
The Benefits of LLCs............................................................. 6
Which Businesses Benefit as LLCs?....................................... 9
Comparing LLCs and Other Business Forms......................... 10
Business Entity Comparison Tables...................................... 22
Basic LLC Legalities....................................................... 27
Number of Members........................................................... 28
Paperwork Required to Set Up an LLC................................. 28
Responsibility for Managing an LLC...................................... 29
Member and Manager Liability to Insiders and Outsiders....... 34
Are LLC Membership Interests Considered Securities?......... 38
Tax Aspects of Forming an LLC.................................... 41
Pass-Through Taxation....................................................... 42
How LLCs Report and Pay Federal Income Taxes................ 43
LLCs and Self‑Employment Taxes...................................... 44
State Law and the Tax Treatment of LLCs............................ 44
Other LLC Formation Tax Considerations............................. 44
How to Prepare LLC Articles of Organization.............. 51
Go to Your State’s LLC Filing Office Online.......................... 52
Choose a Name for Your LLC.............................................. 52
Check Your State’s Procedures for Filing Articles.................. 59
Prepare LLC Articles of Organization.................................... 60
Finalize and File Your Articles of Organization ...................... 67
What to Do After Filing Articles of Organization..................... 69
Prepare an LLC Operating Agreement
for Your Member-Managed LLC.................................... 71
Customizing Your LLC Operating Agreement........................ 72
How to Prepare a Member‑Managed LLC Operating Agreement 73
Distribute Copies of Your Operating Agreement.................. 106
Prepare an LLC Operating Agreement for Managers 107
Choosing a Manager-Managed LLC................................... 108
How to Prepare an LLC Management Operating Agreement 110
Distribute Copies of Your Operating Agreement.................. 130
After Forming Your LLC................................................ 131
If You Converted an Existing Business to an LLC................ 132
Basic Tax Forms and Formalities....................................... 135
Ongoing LLC Legal Paperwork and Procedures.................. 137
Other Ongoing LLC Formalities.......................................... 144
Lawyers, Tax Specialists, and Legal Research......... 153
Finding the Right Tax Adviser............................................. 154
How to Find the Right Lawyer............................................ 156
How to Do Your Own Legal Research................................. 159
How to Locate State LLC Offices and Laws Online... 163
How to Locate State LLC Offices Online............................. 164
How to Locate Your State’s LLC Act Online........................ 164
LLC Forms..................................................................... 165
IRS Form 8832, Entity Classification Election
LLC Reservation of Name Letter
Articles of Organization
LLC Articles Filing Letter
Operating Agreement for Member-Managed Limited Liability Company
Limited Liability Company Management Operating Agreement
Minutes of Meeting
Using the Interactive Forms......................................... 207
Editing RTFs..................................................................... 208
List of Forms..................................................................... 209
Overview of the LLC
Top Ten Questions About LLCs....................................................... 4
1. What Is an LLC?..................................................................... 4
2. How Many People Do I Need to Form an LLC?......................... 4
3. Who Should Form an LLC? ..................................................... 4
4. How Do I Form an LLC?.......................................................... 4
5. Do I Need a Lawyer to Form an LLC?....................................... 5
6. Does My LLC Need an Operating Agreement?.......................... 5
7. How Do LLCs Pay Taxes?....................................................... 5
8. What Are the Differences Between a Limited Liability Company
and a Partnership?.................................................................. 5
9. Can I Convert My Existing Business to an LLC?........................ 6
10. Do I Need to Know About Securities Laws to Set Up
an LLC?.................................................................................. 6
The Benefits of LLCs...................................................................... 6
Limited Liability Status................................................................. 6
Business Profits and Losses Taxed at Individuals’ Income Tax Rates.. 7
Flexible Management Structure................................................... 7
Flexible Distribution of Profits and Losses..................................... 8
Which Businesses Benefit as LLCs?................................................ 9
Businesses That Benefit From the LLC Structure.......................... 9
Businesses That Normally Should Not Form an LLC Using This Book . 9
Comparing LLCs and Other Business Forms.................................. 10
Sole Proprietorship.................................................................... 10
General Partnerships................................................................ 13
C Corporations.......................................................................... 14
Limited Partnerships.................................................................. 18
S Corporations.......................................................................... 19
Business Entity Comparison Tables............................................... 22
In this chapter, we’ll cover the nuts and bolts of the limited liability company, or LLC: the most common questions, the primary benefits, which businesses should choose LLC status, and what other types of business entities there are. We’ll delve into the specific legal and tax characteristics of LLCs in the next two chapters.
If you are familiar with LLCs. If you have followed the development of the LLC over the last few years and know its general legal and tax characteristics (or you simply want to look at the specifics of forming an LLC right now), you can skip the introductory material in this and the following two chapters. Move right ahead to Chapter 4, where you’ll learn how to prepare LLC articles of organization.
Top Ten Questions About LLCs
1. What Is an LLC?
An LLC is a business structure that gives its owners corporate-style limited liability, while at the same time allowing partnership-style taxation.
• Like owners of a corporation, LLC owners are protected from personal liability for business debts and claims—a feature known as “limited liability.” This means that if the business owes money or faces a lawsuit, the assets of the business itself are at risk but usually not the personal assets of the LLC owners, such as their houses or cars.
• Like owners of partnerships or sole proprietorships, LLC owners report their share of the business profits or losses on their personal income tax returns. The LLC itself is not a separate taxable entity.
Because of these attributes, the LLC fits somewhere between the partnership and the corporation (or, for one-owner businesses, the sole proprietorship and the one-person corporation).
2. How Many People Do I Need to Form an LLC?
You can form an LLC with just one owner. For reasons we’ll explain later, LLCs are appropriate for businesses with no more than 35 owners and investors.
3. Who Should Form an LLC?
Consider forming an LLC if you are concerned about personal exposure to lawsuits arising from your business. For example, an LLC will shield your personal assets from:
• suppliers’ claims for unpaid bills, and
• for businesses that deal directly with the public, slip-and-fall lawsuits that your commercial liability insurance policy may not adequately cover.
Not all businesses can operate as LLCs, however. Those in the banking, trust, and insurance industries, for example, are typically prohibited from forming LLCs. Some states (including California) prohibit special licensed professionals such as accountants, doctors, lawyers, and some other state-licensed practitioners from forming LLCs. Many of these professionals may benefit from forming a limited liability partnership.
4. How Do I Form an LLC?
In most states, the only legal requirement to form an LLC is that you file articles of organization with your state’s LLC filing office, which is usually part of the Secretary of State’s office. (Several states refer to this organizational document as a “certificate of organization” or a “certificate of formation.”) A few states require an additional step: Prior to or immediately after filing your articles of organization, you must publish your intention to form an LLC, or a notice that you have formed an LLC, in a local newspaper. We’ll explain how to prepare and file articles of organization in Chapter 4.
5. Do I Need a Lawyer to Form an LLC?
You usually don’t need a lawyer if you’ve decided the LLC is the right entitiy for your business. In most states, the information required for the articles of organization is simple—it typically includes the name of the LLC, the location of its principal office, the names and addresses of the LLC’s owners and/or managers, and the name and address of the LLC’s registered agent (a person or company that agrees to accept legal papers on behalf of the LLC).
The process itself is simple, too. Most states have fill-in-the-blank forms and instructions that can be downloaded. Many states even let you prepare and file articles online at the state filing website, which means you can create your LLC in a matter of minutes. LLC filing offices increasingly allow owners to send them email questions, too. We alert you to situations throughout this book when a lawyer’s advice will be useful and include a discussion in Chapter 8 on how to find and work cost-effectively with an experienced business lawyer.
6. Does My LLC Need an Operating Agreement?
Although most states’ LLC laws don’t require a written operating agreement, don’t even consider starting an LLC without one. An operating agreement is necessary because it:
• sets out rules that govern how profits and losses will be split up, how major business decisions will be made, and the procedures for handling the departure and addition of members
• keeps your LLC from being governed by the default rules in your state’s LLC laws, which might not be to your benefit, and
• helps ensure that courts will respect your personal liability protection, because it shows that you have been conscientious about organizing your LLC.
In Chapters 5 and 6, you’ll learn how to create an operating agreement.
7. How Do LLCs Pay Taxes?
Like partnerships and sole proprietorships, an LLC is not a separate entity from its owners for income tax purposes. This means that the LLC itself does not pay income taxes. Instead, the LLC owners use their personal tax returns to pay tax on their allocated share of profits (or deduct their share of business losses).
LLC owners can elect to have their LLC taxed like a corporation. This may reduce taxes for established LLC owners who will regularly need to keep a significant amount of profit in the company.
These tax consequences will be discussed in detail in Chapter 3, and Chapter 8 explains how to find the right tax adviser for your business.
8. What Are the Differences Between a Limited Liability Company and a Partnership?
The main difference between an LLC and a partnership is that LLC owners are not personally liable for the company’s debts and liabilities. Partners, on the other hand, do not have this limited liability protection. Also, owners of limited liability companies must file formal articles of organization with their state’s LLC filing office, pay a filing fee, and comply with other state filing requirements before they open for business. Partners don’t need to file any formal paperwork and don’t have to pay special fees.
LLCs and partnerships are almost identical when it comes to taxation, however. In both types of businesses, the owners report business income or losses on their personal tax returns. In fact, co-owned LLCs and partnerships file the same informational tax return with the IRS (Form 1065) and distribute the same schedules to the business’s owners (Schedule K-1, which lists each owner’s share of income).
9. Can I Convert My Existing Business to an LLC?
Converting a partnership or a sole proprietorship to an LLC is an easy way for partners and sole proprietors to protect their personal assets without changing the way their business income is taxed. Some states have a simple form for converting a partnership to an LLC (often called a “certificate of conversion”), as described in Chapter 4. Partners and sole proprietors in states that don’t use a conversion form must file regular articles of organization to create an LLC.
10. Do I Need to Know About Securities Laws to Set Up an LLC?
If you’ll be the sole owner of your LLC, which you will manage and operate, and you don’t plan to take investments from outsiders, your ownership interest in the LLC is not a “security” and you don’t have to concern yourself with these laws. For co-owned LLCs, however, the answer to this question is a bit more involved.
If all of the owners of your LLC will actively manage the LLC, their ownership interests in the company will usually not be treated as securities. However, when someone invests in your business expecting to make money from the efforts of others, that person’s investment is generally considered a security under federal and state law.
If your LLC’s ownership interests are considered securities, you must get an exemption from the state and federal securities laws before the initial owners of your LLC invest their money. Fortunately, smaller LLCs, even those that plan to sell memberships to passive investors, usually qualify for securities law exemptions.
We’ll explain this further in Chapter 2.
The Benefits of LLCs
The LLC stands as a unique alternative to five traditional legal and tax ways of doing business: sole proprietorships, general partnerships, limited partnerships, C corporations (also called “regular” corporations), and S corporations. While these business entities offer some of the same benefits as LLCs, none offer all of the same benefits. The combination of structural and tax benefits unique to LLCs includes:
• limited liability status
• taxation of business profits at individual rates
• flexible management structure, and
• flexible distribution of profits and losses.
Limited Liability Status
The legal characteristic most interesting to business owners is undoubtedly the limited liability status of LLC owners. With the exception of corporate entities, the LLC is the only form of legal entity that lets all of its owners off the hook for business debts and other legal liabilities, such as court judgments and legal settlements obtained against the business. Another way of saying this is that an investor in an LLC normally has at risk only his or her share of capital paid into the business.
There’s Never Limited Liability for
Personally Guaranteed Debts
No matter how a small business is organized (LLC, corporation, partnership, or sole proprietorship), its owners must normally cosign business loans made by banks—at least until the business establishes its own positive credit history.
When you cosign a loan, you promise to voluntarily assume personal liability if your business fails to pay back the loan. In some cases, the bank may ask you to pledge all your personal assets as security; in others, it may only require you to pledge specific personal assets—for example, the equity in your home.
A married couple owns and operates Books & Bagels, a coffee shop and bookstore. In need of funds (dough, really) to expand into a larger location, the owners go to the bank to get a small loan for their corporation. The bank grants the loan on the condition that the two owners personally pledge their equity in their house as security for the loan. Because the owners personally guaranteed the loan, the bank can seek repayment from the owners personally by foreclosing on their home if Books & Bagels defaults. No form of business ownership can insulate them from the personal liability they agreed to.
For more information about pledging personal assets to secure business loans, see Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo).
Business Profits and Losses Taxed at Individuals’ Income Tax Rates
The LLC is recognized by the IRS as a “pass-through” tax entity. That is, the profits or losses of the LLC pass through the business and are reflected and taxed on the individual tax returns of the owners, rather than being reported and taxed at a separate business level. (Other pass-through entities include general and limited partnerships, sole proprietorships, and S corporations—those that have elected S corporation tax status with the IRS.) We’ll discuss pass-through taxation further, below.
Flexible Management Structure
LLC owners are referred to as members. A member may be an individual or a separate legal entity, such as a partnership or corporation. Members invest in the LLC and receive percentage ownership interests in return. These ownership interests are used to divide up the assets of the LLC when it is sold or liquidated and are typically used for other purposes as well—for example, to split up profits and losses of the LLC or to divide up members’ voting rights.
LLCs are run by their members unless they elect to be managed by a management group, which may consist of some members and/or nonmembers. Small LLCs are normally member managed—after all, most small business owners want and need to have an active hand in the management of the business. However, this isn’t always true. Especially with a growing business or one that makes fairly passive investments, such as in real estate, investors may not want a day-to-day role. Fortunately, an LLC can easily adopt a management-run structure in situations such as these:
• the members want the LLC to be managed by some, but not all, members
• the members decide to employ outside management help, or
• the members choose to cater to an outsider who wishes to invest in or loan capital to the LLC in exchange for a vote in management.
Uniform LLC Laws
For many years, legal scholars and state legislators have worked hard to have all states adopt the same (or very similar) laws affecting key areas of American business and life. Efforts are being made to adopt a national model LLC act that can be used by individual state legislatures to pass future LLC legislation. One model is the Prototype Limited Liability Company Act, sponsored by the American Bar Association’s Section of Business Law. Another is the Uniform Limited Liability Company Act, developed by the National Conference of Commissioners on Uniform State Laws.
Usually, states adopt portions of the model acts to supplement their current LLC statutes. In short, while LLC laws are fairly similar (they generally try to conform to IRS regulations and to LLC statutory schemes in other states), state-by-state differences remain.
Flexible Distribution of Profits and Losses
An LLC allows business owners to split profits and losses any way they wish (this flexibility is afforded partnerships as well). You are not restricted to dividing up profits proportionate to the members’ capital contributions (the standard legal rule for corporations).
Steve and Frankie form an educational seminar business. Steve puts up all the cash necessary to purchase a computer with graphics and multimedia presentation capabilities, rent out initial seminar sites, send out mass mailings, and purchase advertising. As the traveling lecturer, cash-poor Frankie will contribute services to the LLC. Although the two owners could agree to split profits and losses equally, they decide that Steve will get 65% of the business’s profits and losses for the first three years as a way of paying him back for taking the risk of putting up cash.
By contrast, rules governing the distribution of corporate profits and losses are fairly restrictive. A C corporation cannot allocate profits and losses to shareholders at all—shareholders get a financial return from the corporation by receiving dividends or a share of the corporation’s assets when it is sold or liquidated. In an S corporation (covered in detail below), profits and losses generally must follow shareholdings. For example, an S corporation shareholder holding 10% of the shares ordinarily must be allocated a 10% share of yearly profits and losses.
There are a few wrinkles in the flexibility afforded to LLCs. Because LLCs are treated like partnerships for tax purposes, LLCs must comply with technical partnership tax rules:
• Tax laws require special (disproportionate) allocations of LLC profits or losses to have “substantial economic effect.” In Chapter 3, we’ll discuss exactly what that means and how to help make sure your LLC complies with the requirement. For now, simply understand that the purpose of the rule is to ensure that the members have corresponding economic benefits and risks for profits and losses allocated to them.
• Members contributing services to the LLC may be subject to income taxes on the value of their services. Again, we’ll discuss the tax effects of a member’s future personal services to the LLC in Chapter 3.
Which Businesses Benefit as LLCs?
Here is an overview of the types of persons and businesses for which the LLC form makes the most and least sense. These guidelines aren’t set in stone—certainly you may find that your business breaks the mold.
Businesses That Benefit
From the LLC Structure
LLCs generally work best for:
• Actively run businesses with a limited number of owners. The logistics of making collective business decisions are manageable with a maximum of around 35 owners.
• Small new businesses. New businesses generally wish to pass early-year losses along to owners to deduct against their other income (usually salary earned working for another company or income earned from investments).
• Anyone thinking of forming an S corporation. Like LLCs, S corporations provide limited liability protection to all owners and allow profits and losses to be taxed at individual shareholder rates. However, as we’ll discuss in “S corporations,” below, these benefits come at a pretty high price: S corporations are significantly restrictive and a business can inadvertently lose its eligibility—for example, when a disqualified shareholder inherits or buys stock—resulting in a big tax bill.
• Existing partnerships. Only the LLC provides partnership-style pass-through tax treatment of business income while insulating all owners (not just limited partners as in a limited partnership) from personal liability for business debts.
• Businesses planning to hold property that will appreciate, such as real property. C corporations and their shareholders are subject to a double tax on appreciation when assets are sold or liquidated—taxation occurs at both the corporate and individual level. S corporations that were originally organized as C corporations may also be subject to double tax on gains from appreciated assets, as well as a penalty tax on passive income (money from rents, royalties, interest, or dividends) if it gets too high. Because the LLC is a true pass-through tax entity, it allows a business that holds appreciating assets to avoid double taxation.
Businesses That Normally Should Not Form an LLC Using This Book
The LLC is not normally suitable for:
• Existing S or C corporations. While it may be possible to convert an existing corporation to an LLC without hefty tax or legal costs, you’ll need the help of a lawyer and a tax adviser to make sure you don’t get stung.
• Highly profitable LLCs in certain states. Some states have a graduated LLC license fee schedule, meaning the more profitable the LLC, the higher the tax. In California, for example, LLCs with gross income over $5 million must pay an annual fee of approximately $12,000. Such a stiff tax is unusual; check on your state tax website (see Appendix A) or ask your tax adviser to find out whether you face this unpleasant prospect. Of course, in states with a high LLC fee or tax, chances are good that the state also has enacted fees that apply to other pass-through tax entities (limited partnerships and S corporations). In these states, you may decide that forming a general partnership, which isn’t taxed separately, is the least expensive way to go—but you won’t qualify for limited liability for business debts.
Where Does a Web-based Business Need to Organize and Qualify?
What if your corporation operates a website? Where does it need to organize and, if necessary, qualify to do business? Your company operates out of a physical location, such as your home or office, and this is probably where you’ll form your LLC. Of course, you may use servers located somewhere else, but the location where you and your employees do business related to the website (maintaining the site, taking and fulfilling orders, answering customer email) most likely represents your primary physical place of business. Most small business owners reasonably decide to form their LLC in the state where their primary place of business is located.
But what about other states? Do you have to qualify your LLC to do business in other states? After all, people located in other states can load your website’s pages into their Internet browser and order merchandise from your site. But the general rule is that you don’t have to qualify to do business in another state unless you either have a physical presence in that state (for example, a sales office or warehouse) or you have certain types of repeated and successive business transactions within that state (for example, your website enters into agreements with other companies in that state). Of course, this is a very general analysis, and the answer can vary depending on the type, amount, and location of activity related to the website that you engage in (and each state’s qualification statutes). If you want to learn more about the issues surrounding operating an Internet business, see LLC or Corporation?, Mancuso (Nolo), or Nolo’s article “Qualifying to Do Business Outside Your State.”
Comparing LLCs and Other Business Forms
Anyone considering an LLC will want to compare this business form to the three traditional ways of doing business:
• sole proprietorships
• partnerships, and
• C corporations.
In addition, to fully understand the pros and cons of LLC status, you’ll need to compare the LLC to two variants on these traditional business forms that come closest to resembling the legal and tax characteristics of the LLC:
• limited partnerships, and
• S corporations.
This section provides general information on the characteristics of each type of legal entity, focusing on the main reasons why businesspeople adopt one form over another. Our aim is to explain most of the information you’ll need to decide whether the LLC is right for you. However, please realize that we can’t cover every nuance of tax and business organization law as it applies to your business. Furthermore, the area of pass-through taxation is no piece of cake, even to tax specialists. You may need to check with a tax adviser to make sure the LLC makes sense to you from a tax standpoint, and to learn about any of the special tax areas (some of which are covered in Chapter 3) that may have special relevance to your business. For a quick overview of the different legal and tax characteristics of the various entities, see the business entity comparison chart, at the end of this chapter.
The simplest way of being in business for yourself is as a sole proprietor. This is just a fancy way of saying that you are the owner of a one-person business. There’s little red tape and cost—other than the usual business licenses, sales tax permits, and local and state regulations that any business must face. As a practical matter, most one-person businesses start out as sole proprietorships just to keep things simple.
Other Ways of Doing Business: More Information From Nolo
For further examination of the legal and tax characteristics of the various ways of doing business, see the following Nolo titles:
• LLC or Corporation?, by Anthony Mancuso. This book explains in depth the legal and tax differences between LLCs and corporations, as well as the legal and tax effects of different forms of doing business as a company grows.
• Form a Partnership: The Complete Legal Guide, by Denis Clifford and Ralph Warner. This book discusses general partnerships and shows you step by step how to prepare a general partnership agreement.
• Incorporate Your Business: A Legal Guide to Forming a Corporation in Your State and How to Form Your Own California Corporation, by Anthony Mancuso. These books provide in-depth treatment of the corporate structure and show you how to incorporate in each state. Incorporation forms are included.
Sole Proprietorship Is Limited to One Person
If your sole proprietorship grows, you’ll need to move to a more complicated type of business structure. Once you decide to own and split profits with another person (other than your spouse), by definition, you have at least a partnership on your hands.
Sole Proprietor Is Personally Liable
for Business Debts
Unfortunately, although a sole proprietorship is simple, it can also be a dangerous way to operate, especially if the work you do might result in large debts or liabilities from lawsuits. The sole proprietor is personally liable for all debts and claims against a business. For example, if someone slips and falls in a sole proprietor’s business and sues, the owner is on the line for paying any court award (if commercial liability insurance doesn’t cover it). Similarly, if the business fails to pay suppliers, banks, or other businesses’ bills, the owner is personally liable for the unpaid debts. The owner’s personal assets, such as a home, car, and bank accounts, are fair game for repayment of these amounts.
Sole Proprietor’s Taxes
Sole proprietors report business profits or losses on IRS Schedule C, Profit or Loss From Business (Sole Proprietorship), included with a Form 1040 individual federal tax return. Profits are taxed at the owner’s individual income tax rates.
Because the owner is self-employed, he or she must pay an increased amount of self-employment (FICA) tax based upon these profits—about twice as much as an incorporated business or corporate employee would personally pay. This increased FICA tax doesn’t necessarily mean that sole proprietorships are more expensive tax-wise than other business forms. For instance, if you are both a corporate shareholder and employee, as is the case for the owner/employees of most small corporations, you end up paying a similar amount of total FICA taxes.
Sole Proprietorships Compared to LLCs
The LLC requires more paperwork to get started and is more complicated than a sole proprietorship from a legal and tax perspective. Although LLC owners, like sole proprietors, report business profits on their individual tax returns, the co-owned LLC itself is treated as a partnership and must prepare its own annual informational tax return. The payoff of the LLC for this added complexity is that owners are not personally liable for business claims or debts (unless personally guaranteed, as with a personally guaranteed bank loan).
If You Own a Business With Your Spouse
Generally, if a husband and wife run an unincorporated business together and share in its profits and losses, they are considered the co-owners of a partnership, not a sole proprietorship, and they must file a partnership tax return for the business. However, if one spouse manages the business and the other helps out as an employee or volunteer worker (but does not contribute to running the business), the managing spouse can claim ownership and treat the business as a sole proprietorship.
Another exception to the general rule that a spouse’s business is considered a partnership occurs when all of the following four criteria are met:
1. The business is unincorporated and is not a state-created business entity such as an LLC or limited partnership.
2. The only members of the business are a husband and wife who file a joint 1040 tax return.
3. Both spouses materially participate in the trade or business.
4. Both spouses elect not to be treated as a partnership (the spouses do not file a separate partnership return for the business).
In this case, the spouses can elect to divide up the profits of the business and report them separately for each spouse on their joint 1040 tax return. They do this by filing two Schedule Cs (one for each spouse) with their joint 1040 tax return, showing each spouse’s share of profits on a separate Schedule C. Each spouse must also file a self-employment tax schedule (Schedule SE) to pay self-employment tax on his or her individual share of the profits. If the spouses qualify for this exception, each spouse gets Social Security credit for his or her share of earnings in the business.
What if spouses jointly run a state business entity such as an LLC? In this case, the spouses will normally be treated as partners and must file a partnership tax return for the LLC. However, there is yet another special exception to partnership tax treatment available in several states. Specifically, IRS rules say that an unincorporated business that is owned solely by a husband and wife as community property in the community property states of Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin can treat itself as a sole proprietorship by filing an IRS Form 1040 Schedule C for the business, listing one of the spouses as the owner. Only the listed spouse pays income and self-employment taxes on the reported Schedule C net profits. This means only the listed Schedule C owner-spouse will receive Social Security account earning credits for the Schedule SE taxes paid with the 1040 return. For this reason, some eligible spouses will decide not to make this Schedule C filing and will continue to file partnership tax returns for their jointly owned spousal LLC. Also note that the IRS treats the filing of a Schedule C for a jointly owned spousal LLC as the conversion of a partnership to a sole proprietorship, which can have tax consequences.
For more information on spousal businesses, see the section titled “Community property,” in the IRS Publication 541 section on “Forming a Partnership,” and other information on the IRS website, at www.irs.gov. In all cases, be sure to check with your tax adviser before deciding on the best way to own, and file and pay taxes for, a business you own with your spouse.
A partnership is a business in which two or more owners agree to share profits. If you go into business with at least one other person and you don’t file formal papers with the state to set up an LLC, corporation, or limited partnership, the law says you have formed a general partnership. A general partnership can be started with a handshake (a simple verbal agreement or understanding) or a formal partnership agreement.
Partners should always create a written partnership agreement. Without an agreement, the default rules of each state’s general partnership law apply to the business. These provisions usually say that profits and losses of the business should be split up equally among the partners, regardless of the amount of capital contributed to the business by each partner. Rather than relying on state laws, general partners should prepare an agreement that covers issues such as the division of profits and losses, the payment of salaries and draws to partners, and the procedure for selling partnership interests back to the partnership or to outsiders.
Number of Partners in a General Partnership
General partnerships may be formed by two or more people; there is no such thing as a one-person partnership. Legally, there is no upper limit on the number of partners who may be admitted into a partnership, but general partnerships with many owners may have problems reaching a consensus on business decisions and may be subject to divisive disputes between contending management factions.
General Partnership Liability
Each owner of a general partnership is individually liable for the debts and claims of the business. In other words, if the partnership owes money, a creditor may go after any member of the partnership for the entire debt, regardless of that member’s ownership percentage (although one partner can sue other partners to force them to repay their shares of the debt).
In addition, each partner may bind the partnership to contracts or enter a business deal that binds the partnership, as long as the contract or deal is within the scope of business undertaken by the partnership. In legal jargon, this authority is expressed by saying that each partner is an “agent” of the partnership.
The personal liability for partnership debts, coupled with the agency authority of each partner, makes the general partnership riskier than limited liability businesses (corporations, LLCs, and limited partnerships).
General Partnership Taxes
A general partnership is not a separate taxable entity. Profits (and losses) pass through the business to the partners, who pay taxes on profits at their individual tax rates. Although the partnership does not pay its own taxes, it must file an information return each year—IRS Form 1065, U.S. Return of Partnership Income. The partnership must give each partner a filled-in IRS Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc., which shows the proportionate share of profits or losses each person carries over to his or her individual 1040 tax return at the end of the year.
General Partnerships Compared to LLCs
General partnerships are less costly to start than LLCs because most states do not require a state filing (and fees) to form them. The major downside to running a general partnership over an LLC is the exposure to personal liability by each of the general partners. Although a general business insurance package (possibly supplemented by more specialized coverage for unusual risks) can mitigate possible effects, each partner is still personally responsible for all business debts and for any liabilities not covered by the business’s insurance policy. LLC owners, on the other hand, avoid this personal liability problem altogether.
General partnerships and LLCs come out about even on a couple of important issues:
• Partnership agreement or operating agreement. Even small partnerships and LLCs should start off with a good written partnership agreement or operating agreement. This, of course, takes time and if you don’t do the work yourself, is likely to cost $1,000 to $5,000 in legal fees, depending on the complexity of your business and the thickness of your lawyer’s rug. (We help you prepare an operating agreement in Chapters 5 and 6 of this book.)
• Taxes. General partnerships and LLCs can count on about the same amount of tax complexity, preparation time, and paperwork. Even though you’ll probably turn over most year-end tax work to a tax adviser (for either a co-owned LLC or partnership), understanding and following basic partnership tax procedures takes a fair amount of time and effort.
To establish a C corporation, you prepare and file formal articles of incorporation papers with a state agency (usually the secretary of state) and pay corporate filing fees and initial taxes. A corporation assumes an independent legal and tax life separate from its owners, with the result that it pays taxes at its own corporate tax rates and files its own income tax returns each year (IRS Form 1120).
Corporations are owned by shareholders and managed by a board of directors. Most management decisions are left to the directors, although a few must be ratified by the shareholders as well, such as the amendment of corporate articles of incorporation, sale of substantially all of the corporation’s assets, or the merger or dissolution of the corporation. Corporate officers are normally appointed by the board of directors to handle the day-to-day supervision of corporate business, and usually consist of a corporate president, vice president, secretary, and treasurer.
A C corporation is nothing more than a regular corporation. The letter “C” simply distinguishes the regular corporation (one taxed under normal corporate income tax rules) from a more specialized type of corporation regulated under Subchapter S of the Internal Revenue Code, discussed in “S Corporations,” below.
Number of Corporate
Shareholders and Directors
In most states, one or more persons can form and operate a corporation. In a few states, the number of directors necessary for a multi-owner corporation is related to the number of shareholders. For example, if there are two shareholders, two or more directors must be named; if three shareholders, then three or more directors are necessary.
Corporate Limited Liability
As we have mentioned, a corporation provides all its owners (shareholders) with the benefits of limited liability—before other limited liability entities (such as the LLC) were available, that was a major reason many businesses organized as corporations.
Legal and Tax Existence
The corporation has a legal and tax existence separate from its owners. This leads to the following corporate characteristics:
• Separate taxes. A corporation files its own income tax return and pays its own income taxes.
• Tax benefits of employee fringe benefits. The corporate form allows owner-employees (shareholders who also work in the business) to deduct a number of corporate fringes paid to employees (including themselves) from corporate income, such as the direct reimbursement of medical expenses. Also, corporations can provide tax-favored stock bonus, stock option, and other equity-sharing plans for employees.
• Legal formalities. Because a corporation has a separate legal existence, you must pay more attention to its legal care. This means owners must don directors’ and shareholders’ hats and hold and document annual meetings required under state law. Owners must keep minutes of meetings, prepare other formal documentation of important decisions made during the life of the corporation, and keep a paper trail of all financial dealings between the corporation and its shareholders. Owners also need to tend to other formalities, such as appointing officers required under corporate statutes. A corporation should issue stock to its shareholders and keep adequate capital on hand to handle foreseeable business debts and liabilities.
Shoddy corporate procedures can cost you. It can be dangerous to set up a thinly capitalized corporation, treat corporate coffers as an incorporated pocketbook for your personal finances, fail to issue stock, neglect to hold meetings, or overlook other formalities required under your state’s corporation code. If you do (or don’t do) these things, a court or the IRS may “pierce the corporate veil” (a metaphor carried over from a long line of court cases) and decide that the corporation is simply an “alter ego” of the shareholders of a small corporation. If this happens, the business owners (shareholders) can be held personally liable for any money awarded by a court against the corporation.
Corporations Compared to LLCs
Corporations are similar to LLCs in the types of paperwork and fees necessary to get them started with the state. Both must prepare and file organizational papers with the secretary of state and pay filing fees. Both should adopt a set of operating rules that sets out the basic requirements for operating the business—corporations adopt bylaws; LLCs adopt operating agreements.
What sets the corporate form apart from LLCs is how they are taxed. Corporations are taxed separately from their owners at corporate income tax rates. This can result in tax savings if money is left in a business for expansion or for other business needs. That’s because initial tax rates applied to corporate income are normally lower than the individual tax rates of business owners.
Justine and Janine own and operate Just Jams & Jellies, a specialty store selling gourmet canned preserves. Business has boomed and their net taxable income, split equally by the partners, has reached a level where it is taxed at an individual tax rate of over 30%. If the owners incorporate, or if they form an LLC and elect corporate tax treatment, they can keep money in their business, which is taxed at the lower corporate tax rates of 15% and 25%, saving overall tax dollars on business income.
What About the Double Taxation of Corporate Profits?
You’ve probably read about the awful consequence of double taxation when a corporation makes money. Specifically, corporate profits are first taxed at the corporate level, then any profits paid out as dividends to shareholders are taxed at each shareholder’s dividend tax rate. Doesn’t this result in a big comparative advantage for LLCs that are taxed as partnerships, where the owners pay taxes just once on business income at their personal rates?
For small, actively run corporations, we say no. Here’s why. To avoid the penalty of double taxation, smaller corporations rarely pay dividends to the owners. Instead, the owner-employees are paid salaries and fringe benefits that are tax deductible to the corporation. As a result, only employee-shareholders pay income taxes on this business income.
So cast a critical eye on any article decrying the double taxation of corporate profits for small businesses. Unless you are forming a corporation with passive investors who expect to receive regular dividends as a return on their investment in your corporation, double taxation will generally not be a big deal.
Exception: When (and if) appreciated assets of a corporation are sold, both the corporation and its owners may have to pay income taxes on profits from the sale. If you are thinking of incorporating, it’s important to plan for this possibility of double taxation of sales proceeds received from the sale of appreciated assets (such as real estate that has risen in value).
This corporate tax distinction can be eliminated if the LLC members wish. That is, LLC members can elect to have their LLC taxed as a corporation. We’ll discuss this option, and why some LLCs take it, in Chapter 3.
Even though an LLC may now elect corporate tax treatment, there may be other reasons to favor the corporate form over the LLC, such as the availability of corporate equity sharing plans. Also, a number of people—perhaps including persons you may wish to do business with—associate the corporate form with an added degree of formality and solidity. And, of course, the ability to go public (make a public offering of corporate shares) is a traditional feature of the corporate form that more successful small businesses may be able to capitalize on. (Forget about going public with an LLC; the practical and tax restrictions on transferring membership interests rule out this possibility.)
There are several downsides to corporate life. We’ve already mentioned the complexity of complying with state law corporate procedures by holding annual and special director and shareholder meetings. (Some states have tried to lessen the impact of these state-mandated formalities with the creation of the close corporation form—see the sidebar, “A Look at Close Corporations,” below.)
A Look at Close Corporations
Several states have enacted special corporate statutes that allow small corporations to dispense with normal operating rules. These corporations, called “close” or “statutory close” corporations, usually must meet a number of legal requirements:
• The corporation must have a limited number of shareholders, usually no more than 35.
• Shares of stock must not be sold or transferred to outsiders unless the transaction is approved by all shareholders.
• The corporation must elect close corporation status in its formation documents or in an amendment to these papers.
• The corporation must operate under partnership-type rules specified in a shareholders’ agreement. (The drafting of this agreement is time consuming and can involve fairly high attorneys’ fees.)
Ten to 15 years ago, legislators in corporately active states, including California, Delaware, Illinois, and Texas, expected business organizers to line up to form close corporations under the newly enacted state laws, but few were formed. The close corporation’s failure to spark the interest of business organizers was due to the following reasons:
• Few corporations want to forego the customary formality of appointing a board of directors, electing officers, and assuming the other traditional accoutrements of corporate life.
• Management of a corporation by its shareholders is normally seen as novel and potentially chaotic.
• Preparation and adoption of a custom-tailored shareholders’ agreement is a time-consuming incorporation step most organizers want to avoid.
• Shareholders do not want restrictions on their right to sell or transfer shares, which are mandatory under typical close corporation statutes.
In many ways, the close corporation resembles the LLC by giving owners the protection of limited liability while allowing them to operate under partnership-type legal rules. The big difference is that unlike for LLCs, the IRS never bestowed the general mantle of pass-through tax treatment on close corporations. Had close corporations successfully obtained pass-through tax treatment with the IRS and been able to operate informally without having to prepare a special shareholders’ agreement, perhaps they would be vying today for the popular attention currently enjoyed by LLCs.
A limited partnership is similar to a general partnership (discussed above), except that instead of being composed of general partners only, it has two types:
• Limited partners. One or more partners contribute capital to the business, but neither participates, in its day-to-day operations nor has personal liability for business debts and claims.
• General partners. One or more partners manage business operations and have personal liability for business debts and claims.
To get this special type of partnership started, you must file papers (certificate of limited partnership) with the state and pay an initial filing fee.
Number of Partners
Limited partnerships may be formed by two or more people, with:
• at least one person acting as the general partner, who has management authority and personal liability, and
• at least one person in the role of limited partner.
Limited Liability Only for Limited Partners
Limited partners enjoy the same kind of limited liability for the debts and liabilities of the business as do the shareholders of a corporation and the members of an LLC. General partners of limited partnerships, on the other hand, have the same personal liability described above for general partnerships.
Limited Partnership Taxes
For tax purposes, limited partnerships normally are treated like general partnerships, with all owners having to report and pay taxes personally on their share of the profits each year. The limited partnership files an informational tax return only, and is not subject to an entity level federal income tax.
Limited Partnerships Compared to LLCs
There are two major differences between limited partnerships and LLCs. First, a limited partnership must have at least one general partner, who is personally liable for the debts and other liabilities of the business. This differs from LLCs, where all members are covered by the cloak of limited liability.
Second, limited partners are generally prohibited from managing the business. A limited partner who becomes active in the business of the limited partnership typically loses the limited partner status with its attendant limited liability protection. (There are exceptions to this ban under the newer Revised Uniform Limited Partnership Act, which has made the rounds through state legislatures and has been adopted, at least in part, in most states.) In contrast, LLC members are given a free hand in managing and running the business, either by themselves or in conjunction with outside managers.
This second restriction of the limited partnership makes it more of a gamble for investors, who must turn over management of the business to a general partner. Such an arrangement may work well for outsiders who want to invest cash or property in a business run by others, but it won’t work well for businesses that are funded and run primarily by their owners. Investors in actively run businesses who want limited liability status for all owners generally benefit by forming an LLC or a corporation: Both of these entities permit investors to help run the business while enjoying the personal protection of limited liability.
Now we come to our last comparison, and the one with the pickiest technical distinctions: the S corporation versus the LLC. Below, we address the main similarities and differences, but you may need to ask your tax adviser for further particulars if you want to understand the ins and outs of comparing these two business forms.
For starters, an S corporation follows the same state incorporation formalities as a C corporation. Typically, this means filing articles of incorporation and paying a state filing fee. An S corporation also must make a special one-page tax election under Subchapter S of the Internal Revenue Code to have the corporation taxed as a partnership (by filing IRS Form 2553, Election by a Small Business Corporation, with the IRS).
Number of S Corporation Owners
Generally, an S corporation may have no more than 100 shareholders (who must be individuals or certain types of trusts or estates). But spouses and other members of a shareholder’s family who own shares in an S corporation are counted as one shareholder.
Limited Liability of
S Corporation Shareholders
All S corporation shareholders are granted personal protection from the debts and other liabilities of the business, just like C corporation shareholders and LLC members.
Tax Election of S Corporation
S corporations benefit from the same basic pass-through treatment afforded partnerships and LLCs, so profits and losses are reported on the individual tax returns of the S corporation’s shareholders. However, the S corporation must still prepare and file an S corporation annual income tax return each year, similar (from a time and energy standpoint) to the co-owned LLC preparing its own partnership informational tax return.
S Corporations Compared to LLCs
Like any other type of corporation, an S corporation requires some legal care and maintenance—more than is typically needed for an LLC. Regular and special meetings of directors and shareholders are held and recorded to transact important corporate business or decide key legal or tax formalities.
The main difference between S corporations and LLCs has to do with the requirements for electing S corporation tax treatment and some of the unique tax effects that result from this election. To be eligible to make an S corporation tax election with the IRS, the corporation and its shareholders must meet a number of special requirements. Here are a few of the S corporation tax requirements that can present a problem:
• Individual shareholders of an S corporation must be U.S. citizens or have U.S. residency status. If shares are sold, passed to (by will, divorce, or other means), or otherwise fall into the hands of a foreign national, the corporation loses its S corporation tax status.
• Shareholders must be individuals or certain types of qualified trusts or estates. Generally, S corporations can’t have partnerships or other corporations as shareholders. Under typical state statutes, LLCs may have both natural (individual) and artificial (corporate, LLC, partnership, trust, and estate) members.
• There can be no more than 100 shareholders in an S corporation.
• S corporations must have only one class of stock. Different voting rights are permitted, meaning that S corporations may have one class of voting shares and another consisting of nonvoting shares. But all shares must have the same rights to participate in dividends and the assets of the corporation when the business is sold or liquidated. Having only one class of stock limits the usefulness of the S corporation as an investment vehicle. Investors typically like to receive special classes of shares that have preferences regarding corporate dividends and participation in the liquidation assets of the corporation when it is sold or dissolved.
• An S corporation that loses its status cannot reelect it for five years. An S corporation can lose its S corporation tax status—perhaps inadvertently; for example, if some shares fall into the hands of a disqualified shareholder. Even if the corporation again becomes qualified, it must wait until five years have elapsed from the year of the disqualification.
Two special tax effects not suffered by other pass-through tax entities, such as LLCs and limited partnerships, often present problems for S corporation shareholders:
• S corporation shareholders can’t receive special allocations of profits and losses. Corporate profits and losses must be split up proportionately to the percentage of shares owned by each shareholder. This point may sound technical or theoretical, but even for smaller businesses it has practical—and sometimes negative—significance.
Ted and Natalie want to go into business designing solar-powered hot tubs. Ted is the “money” person and agrees to pitch in 80% of the first-year funds necessary to get the business going. Natalie is the hot tub and solar specialist and will contribute her skills as a solar systems and hot tub designer in overseeing the design and manufacture of the tubs. Ted and Natalie want a portion of Natalie’s first-year salary to go toward paying for her initial shares in the enterprise. They also want Ted to get a disproportionate number of shares in recognition of the extra risk associated with putting cash into the business up front. Instead of getting two shares for every one of Natalie’s shares, which reflects the ratio of Ted’s cash to the value of Natalie’s services, they want him to receive four shares for every share that she gets. Unfortunately, while this disproportionate doling out of shares may make a lot of practical sense, it is not permitted under S corporation rules.
• S corporation entity-level debt can’t be passed along to shareholders. An S corporation generally can’t pass the potential tax benefits of borrowing money along to its shareholders. In other pass-through entities, such as partnerships and LLCs, business debt (money borrowed by the business) increases the tax basis of the owners (we’re simplifying here, but this is the effect of these special rules). This is good for a couple of reasons. First, the owners can deduct more losses from the business on their tax returns. Second, the higher the basis, the less gain—and the lower the taxes due—when owners sell their interests or the business itself is sold. This technical tax point is illustrated in the following example.
Mitch’s Barbecue Pit Corp., organized as an S corporation, is a promising business in search of outside capital for expansion. A special blend of seasonings in Mitch’s secret rib sauce consistently brings in overflow crowds to his two downtown locations. A number of people have expressed interest in investing in Mitch’s expansion into other cities. It’s expected that the venture will generate business losses in its first years immediately following the capital infusion. Mitch’s will borrow funds from banks to supplement cash reserves and working capital. At first, interested investors plan to simply use the early S corporation losses to offset other income on their personal tax returns. However, the investors’ tax advisers warn that because S corporation debt cannot be used to increase the tax basis of the shares held by the investors (as it could in a partnership or LLC) investors won’t get to write off all the expected business losses on their individual tax returns. This technical tax disadvantage of the S corporation ultimately results in Mitch’s having difficulty finding investors to fund its planned business expansion.
We won’t go into this technical point further. Just realize that an S corporation has less flexibility than other pass-through entities to use borrowed money of the business to increase the tax benefits to the owners on their annual individual tax returns and lower the tax bite when the business or their interests in it are ultimate