When we are talking about business structures, it is important to remember that there are two concepts you must keep straight: 1) the type of entity (or the legal reality) and 2) the IRS’ treatment of the entity. The first is a question of state law, the second is a question or IRS regs and US tax law.
Legal Reality of an LLC. The LLC is a modern innovation. The basic idea behind the LLC was to create a structure that would provide the liability protection of a corporation and yet have the flexibility along with the operational and accounting ease of a sole-proprietorship (or partnership). It is supposed to be (and often is) the “best of both worlds”.
An LLC is an entity that is distinct from its owner(s). It is formed by the filing of the appropriate paperwork with the State. The LLC may enter into contracts, sue and be sued in court, employ people, own property, and (in some circumstances) outlive its owner(s). The owners of the LLC are called members. North Carolina allows for the existence of an LLC that has only one member (some states set the minimum number at 2 or 3), but there is no restriction on the maximum number of members. In North Carolina, LLCs are either “Member-Managed” or “Manager-Managed”. If Member-Managed, any member may exercise daily control of the LLC. If Manager-Managed, a Manager (who may or may not be a Member) is appointed (pursuant to the Operating Agreement) to hold the authority and (usually) the authority of the Members over daily affairs is thereafter limited. Any LLC may delegate management to officers (who would usually be employees, but need not be).
In North Carolina any member by virtue of being a member can act to bind the LLC and may exercise authority over it, but this can be altered in the organizational documents (and should be if there are multiple members). A member’s authority over the LLC and rights relative to the LLC and to other members is governed by the Operating Agreement, if there is one (and there absolutely should be if there is more than one member), or by state law if there is not.
In North Carolina, if you operate under an assumed name (i.e., any name other than the name of the LLC) you are required to register your assumed name (called a d/b/a) in the Office of the Register of Deeds in every county in which you do business.
Advantages. An LLC (if properly set-up and maintained) provides for the protection of the owner’s personal assets from claims against the LLC. (Sole proprietorships and Partnerships provide NO such protection.) This means that if an employee commits a tort, and there is a lawsuit, the LLC may be liable but generally the owner(s) will not be personally liable. The injured party or a creditor can pursue the LLC but not the owner(s) personally. But you should know that there are some major exceptions to this. For more information about this, see “When Am I Personally Liable For My Corporation or LLC?”. It should be noted that, contrary to popular myth, all other things being equal a corporation provides no more liability protection than would an LLC. (Quite frequently, however, all other things are not equal—have I mentioned the value of talking to an attorney about your specific situation?)
The formalities required to maintain an LLC (and its validity), the observance of which are necessary for both tax purposes and liability protection, are much easier to comply with and far less complex for an LLC than for corporations. While you may file Articles of Organization with the State and sail off into the sunset, doing so will probably result in a virtual absence of liability protection if you are sued down the road. There is some work to maintaining the integrity of the LLC (liability protection comes at a price). But it is almost always far less than with a corporation.
The accounting requirements and tax filings for an LLC are also much simpler than for a corporation though, of course, a particular LLC may have its unique complexities. See the tax treatment section below for more on this.
An LLC provides far more flexibility in structuring the relative rights of its owners than does a corporation. It also provides far more opportunities to limit the alienability of ownership interest (alienability is a fancy legal term for the ability of an owner to sell or a creditor to attach an asset), making the LLC an attractive entity for a family business that wants to limit ownership to family members or other specific insiders.
Disadvantages. Corporations can go public. An LLC cannot. If your plan is to go public, you may want to start out as a corporation. (Switching forms after the business is running, while always possible, can be complicated and tricky.)
Venture capital companies generally prefer to work with corporations. So if you are considering seeking venture capital or, for that matter, other third-party investors (as opposed to family members, etc.) that will not be involved in the company on a daily basis, the LLC may not be for you.
If you accept the default state law treatment of your LLC, it will probably dissolve upon the death or bankruptcy of a member. This could be a big problem. But, in North Carolina anyway, it can be cured by proper structuring of an LLC. So can you do it yourself? Yes. Is it advisable? Maybe not.
As we said at the outset, the LLC is the ‘new kid on the block’. As such, case law in some states is relatively undeveloped. Put another way, the law in some respects is still being written. It is also not nearly as uniform between states, especially as it relates to liability protection and taxation. If you are established and operating in North Carolina this is probably not going to be an issue. If you plan to operate in multiple states, it may be a consideration. Some states impose additional taxes on an LLC that they do not on a corporation.
And one other note. Frankly, there are some (mostly) older attorneys and accountants that simply are not familiar with working with an LLC and shy away from them. This is unfortunate, but it is what it is. If someone is telling you that an LLC won’t work, make them tell you why. There could well be a reason, but make sure.
Tax Treatment. Again, flexibility is the main draw of the LLC. There are three options for tax treatment of the LLC.
The first is “pass-through” treatment. This is the IRS default treatment of an LLC. If it is a single-member LLC it is taxed as a sole-proprietor, with the profits (or losses) reported on Schedule C of the owner’s personal tax return. Simple. If there is more than one member, it is taxed as a partnership and the owners divide profits (or losses) and report on Schedule C. For many people, this is the point of forming an LLC. The liability protection of a corporation without the “double-taxation” and tax complexities. The best of both worlds.
But sometimes the operational simplicity of an LLC is sought but from an accounting perspective the business would be better served by being taxed as a corporation. No problem. The LLC can file form 8832 and then will be treated as a corporation by the IRS. It will then file form 1120 to report profits and losses, and the members will not use Schedule C for the profits and losses of the LLC. But they will be subject to the so-called “double-taxation” on profits, just like any other corporate owner(s).
Finally, the LLC can file Form 2553 to receive S-Corporation treatment from the IRS.
One more note: An LLC can elect to change its classification, although doing so may result in tax and accounting complexities and should not be done without careful consideration.
Conclusion. The LLC is the wave of the future. An LLC is the best choice in many situations. In my opinion (in North Carolina), if you are forming an entity to start a small business you should form an LLC UNLESS you have an articulable reason to form a corporation. Now there are reasons to form a corporation instead of an LLC. We have mentioned a few here and there are others. And you may well have one, but that should be the approach. And I am in North Carolina—if you are elsewhere it may be different. The specifics are critical. Feel free to contact us for a consultation where we can review your particular situation and discuss the specific pros and cons in your business.
As a further note: North Carolina law requires certain categories of licensed professionals to form a PLLC (which stands for Professional LLC) if the purpose of the LLC is to engage in the licensed profession. Virtually everything said here applies to a PLLC, but there are some additional ‘strings’ attached with which you must comply. See “What is a PC/PLLC?” for more information.