Nolo's Quick LLC: All You Need to Know About Limited Liability Companies

Chapter 1
An Overview of LLCs
Introduction

The LLC is a relatively new and highly popular alternative to the five traditional ways of doing business: as a sole proprietor, a general partnership, a limited partnership, a C (regular) corporation, and an S corporation. In this book I'll explain not
only how LLCs work and why so many small business people are forming them, but also how the LLC compares to each of these other business forms (see Chapter 2).

By and large, the business media have heralded the arrival of the LLC with unabated enthusiasm. And, in my opinion, this fanfare is justified. The LLC is the first business ownership structure that allows all owners of the business to quickly and easily
achieve the dual goals of "pass through" tax treatment (the same tax treatment sole proprietors and partnerships receive) and limited personal liability protection

A. Basic LLC Features

Now let's look more closely at the specific legal and tax characteristics that make the LLC so attractive and set it apart from the other business ownership structures. As you'll see in Chapter 2, most of the LLC's characteristics are shared by at least
some of the other business structures. What makes the LLC unique is that it's the only business entity with its particular mix of legal and tax attributes -- most importantly, limited personal liability for LLC owners (the same legal protection that
owners of a corporation enjoy) and, unless they elect otherwise, pass-through taxation (like sole proprietors or the owners of a partnership). The legislators who thought up the LLC business structure were smart enough to realize that there was no need
toreinvent the wheel -- all they had to do was combine the best legal and tax aspects of the corporation and the partnership.

A Very Short History of the LLC
The LLC is the American version of a type of business organization that has existed for years in other countries. Specifically, it closely resembles the German GmbH, the French SARL, and the South American Limitada forms of doing business, all of which
allow small groups of individuals to enjoy limited personal liability while operating under partnership-type rules rather than the more complex tax rules that apply to corporations.

In the U.S., the Wyoming legislature enacted the first LLC legislation in 1977, followed by Florida in 1982. In those days, doing business as an LLC was risky, in part because the IRS had not yet made it clear whether it would tax an LLC as a partnership
or a corporation. In fact, because the central promise of the LLC -- to enjoy the tax status of a partnership with the personal liability protection of a corporation -- seemed almost too good to be true, few business owners were brave enough to avail
themselves of this new business model. Similarly, most other states were unwilling to pass legislation authorizing LLCs until the IRS gave its approval.

The first big break in the LLC stalemate came in 1988, when the IRS ruled that an LLC formed under the Wyoming statute was eligible for pass-through tax status. This nod of approval from the IRS created an immediate national wave of enthusiasm for LLCs
in the business press, and all 50 states plus the District of Columbia quickly adopted LLC legislation.

But it wasn't until January 1, 1997 that LLCs really went mainstream. That's when the IRS threw out its old and unnecessarily complicated tax classification regulations, agreeing that multiowner LLCs could henceforth enjoy partnership tax status (and
that one-owner LLCs could be taxed as sole proprietors) without the need to jump through a bunch of previously required technical hoops. And even better, the IRS decided to give LLC owners the flexibility to change their tax status by electing corporate
tax treatment if they wish. (Chapter 4 explains this option.)




Number of Owners (Members)

Contrary to what you may have read just a few years ago, you can now form an LLC with just one person in any state (or the District of Columbia).

While there's no maximum number of owners (legally called "members") an LLC can have, for practical reasons you'll probably want to keep the group reasonably small. There's no magic number here, but any business that's actively owned and operated by more
than about five people risks serious problems maintaining good communication and reaching consensus among the owners.

Of course, if some of your co-owners will be passive investors only -- and you'll have a small management group calling the day-to-day shots -- you can sensibly consider having more owners. (See "Flexible Management Structure," below, for more on this
type of arrangement.) But I still think there is a commonsense limit to the total number of members (including active owners and inactive investors). In my experience, once you get more than about ten investors, you'll find that accounting and
communication issues are likely to use up too much of your time. Outside investors will want to stay informed and may make your business life more complicated if your management choices do not result in increasing profits in future years. Also, the
larger your investor group grows, the more likely you are to run into securities law complexities (see Chapter 6 for more on this).

Limited Personal Liability Protection
The owners of an LLC are not personally liable for the debts of their business or claims made against it (with a few exceptions, discussed in "Exceptions to Owners' Limited Liability," below). This legal protection is written into each state's LLC law.
Because almost every business will accumulate debts and face some risk of being sued, this is a popular -- and valuable -- feature. Without limited personal liability, all business owners are 100% legally responsible to repay these debts, even if they
have to use their own money. With limited liability, their personal assets should remain untouched, even if the business fails under a heavy weight of debts and judgments.

How a Business Can Go Into Debt
Businesses accumulate debt as a routine part of their activities. For example, when sales or net profits are low, employees, suppliers, and other routine business expenses must still be paid. In times like these, a business might take out a loan or use a
line of credit with a bank to handle cash flow fluctuations and pay their bills. Many businesses also defer payment of expenses by buying needed materials and supplies from vendors on account (usually with a 30-day grace period to pay these
balances). In short, there are many reasons why a company, even a successful one, might take on debt as it transacts business.

Example 1: George and Vera quit their day jobs to go into business for themselves. They plan to sell a new brand of wireless modem under an exclusive distributorship license with the modem manufacturer. They believe they can ultimately develop a large
repeat-customer base of consumers who are looking for the latest, easiest way to connect their computers to the Internet. George and Vera realize, however, that it will be slow going at the start of their new venture, which makes them worry about what
will happen if they are not able to resell all the modems they have to buy up front to qualify for their distributorship license. In a worst case scenario, they might even have to close their new business. While they are ready to accept the risk of their
business failing, they are frightened that they could be left so much debt that they might have to sell their personal assets to pay it off, or even declare bankruptcy.

If George and Vera operated their business as a partnership, they would be right to worry, because any debts their business takes on would automatically become their personal debts. But if George and Vera instead form an LLC, they'll have a lot less to
worry about. If their business idea does not succeed, their business debts will not become their personal debts. As long as George and Vera do not personally guarantee (cosign for) any debts of their LLC, they are simply not on the hook for debts the
business cannot repay. They'll be able to go back to their unforeclosed-upon houses, reapply for their day jobs, and start building their dreams and fortunes again.