Setting Up a Limited Liability Company

Last Updated Oct 22, 2007 7:27 PM EDT

A limited liability company (LLC) affords its members limited liability, tax benefits similar to those of partnerships, and better access to financing. However, LLCs also have greater administrative burdens and must disclose more details about the business's finances. This article looks at the advantages and disadvantages of LLCs and describes how to set up a limited liability company.

What You Need to KnowWhat is unique about a limited liability company?

A limited liability company consists of one or more members. Members may be individuals, partnerships, limited partnerships, trusts, estates, associations, corporations, other limited liability companies, or other business entities. The members of a limited liability company are afforded limited liability that is similar to that afforded shareholders of a corporation (hence the name) and reduced tax obligations that are comparable to a partnership.

Small businesses that want to operate on a broader scale often choose the LLC structure. For one thing, it gives them access to financing without their having to become a public company.

Limited liability companies are owned by their investors, who designate at least one managing member who is responsible for all management activities and who has unlimited liability. Other members' liabilities are limited to the amount of their respective investments. They are not responsible for any of the expenses of the business itself.

First authorized in Wyoming in 1997, an LLC can operate in all 50 states. In most states, limited liability companies may engage in any lawful business activity, but there are exceptions. For example, Florida and Wyoming prohibit banks from being organized as LLCs. Wyoming also prohibits insurance companies from being LLCs, while in North Dakota a foreign LLC is not allowed to engage in farming.

What are the advantages of operating as a limited liability company?

Shareholders in LLCs are referred to as members. These members are liable for the debts of the company only up to the value of the shares each holds. If the business fails, shareholders simply lose the amounts they have invested in the company.

More appealing, perhaps, is the fact that a profitable LLC itself pays no federal income tax. Members report their share of any profits on their individual tax returns.

LLC shares are referred to as units in the company. Issuing units in return for dollars invested allows the LLC to raise money for expansion or other purposes.

There are two other perceived advantages: Employees may be more motivated if they are able to own a share in the business, while suppliers and customers may perceive limited companies to have more credibility than an "ordinary" small business.

Are there any disadvantages?

LLCs must comply with a range of complex and detailed regulations that are not applicable to sole proprietors and partnerships. These rules also can vary by state—and widely, at that. There are additional costs, too, such as the costs of incorporation, annual corporate taxes, and increased administrative and accounting costs.

In addition, a limited liability company cannot exist for more than 30 years. And, if a member dies, withdraws or is expelled, or suffers bankruptcy, an LLC needs other members' consent to continue. Other members also must approve a member's desire to sell or transfer his or her interest.

What to DoSet the Ball Rolling

Establishing an LLC can be a simple procedure. Start by contacting your secretary of state's office or your state's department of corporations to find out exactly what steps are required. In most states, the process begins with a company submitting its articles of organization (or "formation") along with a nominal registration fee. Independent registration agents and attorneys can establish what amounts to a "ready-made" company—in no more than 10 or 15 minutes, some claim! In choosing this option, all documentation is prepared in advance and the company is registered, naming the agency's own staff as directors and secretaries, but no business will be transacted. Once the company begins to operate, the agency simply changes the company's details to match that business and notifies the registrar. Setting up a "ready-made" company can cost as little as $100, plus any applicable state fees, if it operates in just one state. While this method can be faster than doing it yourself, initial costs can increase considerably if changes to the documentation are needed to suit your business needs.

Choose a Name

Every LLC needs—and should display—a name. You should display your company's name outside all your premises so that it can be easily seen and read. It must also appear on all company publications, notices, business letters, checks and invoices. Company directors and its secretary may be fined if the business name is displayed incorrectly. The company's place of registration and registered number must also be displayed on business letters and order forms. In addition, the letters "LLC" should appear at the end of the company name on all cards, letterhead, signs and other media.

Limited liability companies cannot use the name of any other company. Before selecting a name, perform a thorough search to ensure that the name you have chosen is not already in use. Any attorney or registration agent can do this fairly quickly. Once you have selected a name, it's usually possible to reserve it with the state for a nominal fee until such time that your company's registration process is complete.

Even though a proposed name has been checked and/or reserved, don't order stationery, signage, business cards, and such until receiving official notification of filing from your secretary of state or department of corporation's office: The limited liability company is not created or registered until appropriate documents have been filed and approved.

Establish An Operating Agreement

Limited liability companies may have to establish an official operating agreement that conforms to state law and that is provided to all members before they purchase any units. The operating agreement describes, in detail, the company's operations; managing members; accounting procedures; procedures for the purchase, sale, or transfer of units; and related details.

Standard "boilerplate" versions of operating agreements are available; however, experts recommend contacting a business attorney who specializes in establishing corporations and LLCs to assist you. If an LLC is not properly formed, many of its advantages vanish.

Appoint a Managing Member and Set Purchasing Terms

Each LLC must have at least one managing member. The managing member is responsible for all management decisions, operating the company, and its general oversight. The managing member has unlimited liability, as well.

All members purchase shares—or units—in the company, giving them a percentage of ownership (membership interest) in proportion to their investment. Minimum unit purchases are usually required for initial membership, with an option to increase or decrease ownership once membership has been established. Detailed terms for purchasing (and selling) units usually are included in an operating agreement.

Consider Tax Obligations

The managing members of a limited liability company are treated as employees and must pay income tax on their earnings and any distribution of profits. Other members' tax implications vary, based on the LLC's performance and any profit distributions for a given year. The LLC is not responsible for the payment of any members' taxes.

In many cases, limited liability companies are required to pay an annual base-level corporate tax as well as additional tax on the profits they make. Companies are required to complete annual tax forms that are submitted to their state. These forms are submitted separately from the managing members' income tax forms but are reflected in the individual tax returns each managing member completes.

Remember That Legal Responsibilities Continue After Incorporation

After establishing an LLC, it's essential to keep your secretary of state or department of corporation's office informed of any changes to the original information submitted in your articles of organization. In most cases, states provide annual amendment forms to companies to ensure that the information they have on file is up to date and correct.

Most states also require that a set of forms to dissolve the LLC be submitted at the time it ceases operation. Taxes are due for each operating year until such time as the notices of dissolution have been filed and approved.

It's important to understand that legal requirements vary by state and can change at any time. That's why it's smart to maintain a relationship with an attorney who can alert you about any changes.

Take Care Over Financing

Limited liability companies can operate with funds from the usual sources—banks, other financial institutions, and venture capital firms, for instance. But due to myriad and varying rules, regulations, and tax treatments, both LLC members and potential investors first need to review funding decisions carefully to ensure they understand exactly how federal and state taxing authorities will treat profits and dividends. For example, some states with corporate income taxes or franchise taxes based on income treat limited liability companies as corporations for state income tax purposes.

Accounting and distributions

A separate line item needs to be established for each managing member as well as for each other member that reflects his or her percentage ownership of the LLC. Distributions are then made once the company becomes profitable. The LLC's operating agreement should specify how frequently distributions are made.

What to AvoidYou Fail to Use an Attorney or Accountant

If you decide to organize your business as a LLC, it is essential to get advice from an attorney and/or accountant! Required procedures can be maddeningly complex, and corporate and tax law changes constantly. Your attorney and accountant should keep you informed of any new developments so that you can ensure that your business complies.

You Don't Follow Funding Regulations

Submitting private placement offerings and related paperwork to potential investors is a well defined and regulated process. While in most cases you do not have to submit LLC registration materials to the Securities and Exchange Commission (SEC), you are still responsible for following the guidelines for private placements that the SEC has established and monitors. Here again, consult an attorney who specializes in such funding to make sure you comply with all the rules and regulations. Remember: improperly formed and funded LLCs lose all their advantages.

You Fail to Keep Up To Date

Even with guidance by an attorney and accountant, anyone considering establishing a limited liability company needs to research the decision thoroughly and review as much information as possible about the opportunities and challenges the LLC structure presents. State authorities ranging from the office of the secretary of state to departments of consumer affairs should have information and resources to help you.

Given the ease of being able to e-mail documents to the state registration authorities, the need for expert advice may seem less important. Don't be misled. In addition, if and when you do file, keep detailed records.

Where to Learn MoreBook:

Mancuso, Anthony. Nolo's Quick LLC: All You Need to Know About Limited Liability Companies.4th Edition. NOLO, 2007.

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LLC Glossary: