States Partnership Return of Income, the same as a General Partnership) and each limited receives an IRS Schedule K-1 (1065), Partner’s Share of Income, Credits and Deductions, from the Limited Partnership. Each limited then files the K-1 with his or her individual IRS 1040 tax return. The issue of taxation will be discussed more fully in Chapter Four.
Limited Liability Company
A Limited Liability Company is a new form of entity introduced into the United States in 1977. The LLC combines certain advantages of partnerships and Corporations and has been called an “incorporated partnership.”
Genesis of the LLC
The Limited Liability Company can be traced to a German entity known as the Gesellschaft mit beschranker Haftung (GmbH). Created in 1892 and combining limited liability with flow-through taxation, this entity soon found converts in a number of Latin American and European countries, including Portugal (1901); Panama (1917); Brazil (1919); France (1925); Chile (1929); Argentina (1932); Uruguay (1933); Mexico (1934); Belgium (1935); Switzerland (1936); Italy (1936); Peru (1936); Columbia (1937); Costa Rica (1942) and Honduras (1950).
As United States businesses engaged in international commerce after World War II, many became exposed to the benefits of these foreign LLCs. Finally, Hamilton Brothers, an oil exploration firm that had used LLCs throughout Latin America, saw the benefits of the United States offering such an entity. They lobbied the Wyoming legislature to enact LLC legislation and effective June 30, 1977, Wyoming became the first state to offer LLCs. Florida followed in 1982, and by 1994 all 50 states had enacted permitting legislation.
One of the primary advantages of an LLC is that no one has personal liability, as in a Limited Partnership. As discussed, the general partner of a Limited Partnership is personally liable for the debts of the partnership. The way to minimize this is to form a separate Corporation or LLC to serve as the general partner, thus encapsulating personal liability within a protected entity.
However, with an LLC, both managers and members (akin to the directors and officers and shareholders of a Corporation) are free from personal liability. This LLC feature removes the need to form a separate Corporation or LLC manager.
LLCs also offer the previously mentioned Limited Partnership features of restrictions on transfers and protection from creditors. LLCs are also useful for family wealth transfers, although some CPAs and estate planning professionals are more comfortable using Limited Partnerships for this purpose.
Flow-Through Taxation
As has been mentioned throughout, one of the most significant benefits of the LLC, and a key reason for its existence, is the fact that the IRS recognizes it as a pass-through tax entity. All of the profits and losses of the business flow through the LLC without tax. They flow through to the business, real estate, or asset-holding owner’s tax return and are dealt with at the individual level.
Again, a C corporation does not offer such a feature. In a C corporation, the profits are taxed at the corporate level and then taxed again when a dividend is paid to the shareholder – thus the issue of double taxation. In a Sub S corporation, profits and losses flow through the Corporation, thereby avoiding double taxation, but may only be allocated to the shareholders according to their percentage ownership interest. As described below, LLC profits and losses flow through the entity and may be allocated in a flexible manner without regard to ownership percentages. As such, the LLC offers the combination of two significant financial benefits that other entities do not.
Flexible Ownership
In 1997, the IRS abandoned its creaky rules on tax classification, allowing for single-member LLCs. State legislatures immediately followed suit and amended their statutes to allow for single-member LLCs.
As a result, you can now form an LLC and be the sole member. You can enjoy the benefits of limited liability and flow-through taxation and not answer to anyone (except, of course, possibly your spouse and the IRS). And, because the IRS views a single-member LLC as a “disregarded entity” for tax purposes, you may not even need to file an LLC tax return. Instead, the LLC’s profits and losses can flow directly onto your personal tax return, be it Schedule C, E, or F (depending on the type of trade or business carried on by your single-member LLC). And, a single-member can also include a husband and wife as joint tenants, or a living trust. Better yet, while the IRS views a single-member LLC as a disregarded entity (thus obviating the need for an LLC tax return), the law still views a single-member LLC as being entitled to limited liability protection. Single member LLC’s are so popular that in Chile they have created the EIRL (Empresario Individual Responsabilidad Limitada), a nationally chartered single member limited liability entity.
But for every benefit comes a drawback. Several U.S. states now deny asset protection to single member LLCs. (We shall explore the reasons for this in Chapter Eight.) In varying degrees, California, Colorado, Florida, Kansas and Montana, among other states, do not support single member LLCs. Additional states may follow suit. (Know that Nevada and Wyoming do protect the single member LLC.) But again, when weighing the advantage of no LLC tax return, you’ve got to weigh it against a possible loss of entity protection. Many people may choose to have a two or more member LLC just to be safe, and to file an LLC tax return as necessary.
Another flexibility benefit has to do with ownership. One of the reasons that people have a problem utilizing the Sub S corporation is the limit on owners. When LLCs were created, a Sub S corporation could only have 35 or fewer shareholders. The IRS has since raised that number to 100. Certain foreign citizens and domestic entities are still prohibited from becoming shareholders of a Sub S corporation.
The LLC offers the flexibility of allowing from one member to an unlimited number of members, each of whom may be a foreign citizen, trust or a corporate entity. And unlike an S corporation, you won’t have to worry about losing your flow-through taxation in the event one shareholder sells his or her shares to a prohibited shareholder.
Flexible Management
LLCs offer two very flexible and workable means of management. First, they can be managed by all of their members, which is known as member-managed. Or they can be managed by just one or some of the members or by an outside nonmember, which is called manager-managed.
It is very easy to designate whether the LLC is to be member- or manager-managed. In some states, the Articles of Organization filed with the state must set out how the LLC is to be managed. In other jurisdictions, management is detailed in the Operating Agreement. If the members of an LLC want to change from manager-managed to member-managed, or vice versa, such a change can be accomplished by a vote of the members.
In most cases, the LLC will be managed by the members. In a small, growing company, each owner will want to have an active say in how the business is operated. Member management is a direct and simple way to accomplish this.
It should be noted that in a Corporation there are several layers of management supervision. The officers – president, secretary, treasurer and vice presidents – handle the day-to-day affairs. They are appointed by the board of directors, which oversees the larger, strategic issues of the Corporation. The directors are elected by the shareholders. By contrast, in a member-managed LLC the members are the shareholders, directors and officers all at once.
In some cases, such as the following, manager management is appropriate for conducting the business of the LLC:
1. One or several LLC members are only interested in investing in the business and want no part of management decision-making.
2. A family member has gifted membership interests to his or her children but does not want them (perhaps because they are not ready) to take part in management decisions.
