Limited Liability Companies

Want your business to enjoy the flexibility of a partnership and the legal protection of a corporation? Introducing the limited liability company ("LLC") - California's newest business entity. Because of its dual qualities of corporation protection and partnership tax treatment, the LLC could replace general partnerships, limited partnerships and S corporations as the future entity of choice.

The Basics

An LLC files with the Secretary of State and, once approved, becomes legally registered in California. CC ¶17050.  See the attached form. It must have at least one or more "members" which may be U.S. or foreign individuals or entities, such as partnerships, trusts, corporations, estates or other LLCs.

Professionals (lawyers, accountants and architects) are prohibited from registering as an LLC, but may now form a Limited Liability Partnership.  Note: There are a surprising number of licensed professionals in California who are thus ineligible to form an LLC.

 The LLC uses an operating agreement, similar to a partnership agreement, to control business, financial and tax provisions. The operating agreement may be oral, although it should be in writing and signed by all the LLC's members. It is not filed with the Secretary of State. Management of an LLC may be vested either in the members or in certain designated "managers." Managers do not have to be members of the LLC, and even corporations may serve as managers. Through its provisions, the operating agreement determines whether the LLC is taxed as a partnership or corporation.

There is a $70 filing fee with the Secretary of State when the LLC is first formed.  In addition to the annual $800 franchise tax, the LLC in California is subject to a graduated fee determined as follows:

For tax years beginning on or after January 1, 1999.

• $865 if the LLC's total income from all sources is $250,000 or more, but less than $500,000;

• $2,595 if total income is $500,000 or more, but less than $1,000,000;

• $5,190 if total income is $1,000,000 or more, but less than $5,000,000;

• $7,785 if total income is $5,000,000 or more.

NOTE:  The legislature just raised these fees for the year 2000, while reducing some fees for corporations.

For purposes of the fee calculation, total income is defined as gross income (under IRC Sec. 61) without deducting the cost of goods sold.

The fee is based on the LLC's income from all sources, including income from sources both within and  outside of California.  In certain cases, the fee is calculated by taking into account the income of "commonly controlled limited liability companies".

The Advantages

Members of an LLC are shielded from personal liability to the same extent as corporate shareholders. In general, the LLC will be treated as a partnership for tax purposes; it will be a flow-through entity in which income and losses are reported directly by its members. Unlike an S corporation, special allocations of income, expenses, deductions and losses can be made among its members, and an individual member's losses are not limited by the member's investment in the LLC. Unlike a partnership, management can be vested in nonmembers. Unlike a limited partnership, members may be actively involved in the LLC's management, without risk of personal liability, as can occur to a limited partner.

An LLC is an ideal substitute for an S corporation when foreign shareholders, corporations or trusts are desired as shareholders. The LLC provides estate planning opportunities since trusts and estates are eligible shareholders. Also, the LLC could eventually eliminate both general and limited partnerships as business entities since it offers the same tax treatment and management opportunities, yet with the added advantage of limited liability to all its members. LLCs might also pay a substantially lower California income tax than an S corporation.

The Disadvantages

As a new entity, an LLC offers little legal precedent. Also, Congress has not passed any tax legislation establishing the LLC as a partnership for tax purposes. Thus far, the IRS has ruled that the LLC will qualify as a partnership for tax purposes, but there is nothing in the Internal Revenue Code that permits such treatment. In cases where there is a choice between using an S corporation or LLC, the former should be used as it is an established business and tax entity.

Conclusion

Forming an LLC should be seriously considered whenever two or more people are considering a business or investment venture. The LLC offers distinct advantages over both general partnership and limited partnership structures. It is similar to an S corporation, but without its restrictions. LLCs, however, cannot be used by professionals, or in situations when a regular "C" corporation would take advantage of the corporate reorganization tax provisions or the ability to have separate classes of stock.

An LLC is particularly well suited for real estate ventures containing corporations, trusts or foreign investors or new business ventures involving existing corporations. Also, an LLC is excellent as an estate planning vehicle for investments between an individual and his or her family corporation, trust or partnership.

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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**