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Limited Liability Companies – What, Why, and How?

Updated: Feb 19

LLCs are by far the most popular type of limited liability entity. Since the relatively recent creation of the LLC, LLCs have quickly overtaken corporations as the most common type of entity offering the limited liability shield. In fact, they are often treated as the "default" by clients ("I want an LLC unless you can convince me I need something else").


But what is it? How is it different from a corporation or a partnership?


What is an LLC?


"LLC" stands for "limited liability company" (note: it does not stand for "limited liability corporation"). LLCs are a type of business entity in which the potential liability of its owners (called "members") is limited to the members' investment in the entity. This is similar to corporate shareholders.


But members can also engage directly in management and control of the entity, making LLCs more like a partnership. This is not always true of corporations.


Why form an LLC?


LLCs were created to offer the "best from both worlds" of corporations and partnerships. That is, LLCs would have the limited liability shield of corporations while maintaining the relative informality and lower costs of operating a partnership.


LLCs are flexible; they can cater to anything from the simplest to the most complicated business structure or management structure. And they are simpler to form and manage relative to corporations. In some states, the standard for maintaining corporate records might be lower (for example, many states do not require LLCs to have annual meetings or keep annual meeting minutes; this is not usually true for corporations).


You can also choose how the LLC will be taxed: either as a corporation or as a partnership. Most LLCs choose to be taxed as a partnership to avoid the double taxation associated with many corporations.


How do I form an LLC?


As with corporations, you file articles with your state secretary of state. This forms the entity. This filing is called the articles of organization in California and the certificate of formation in Texas.


You will want to have an operating agreement (also called an LLC or company agreement) that lays out the governance and internal structure of the LLC. And you will need to hold an initial meeting (as you would with a corporation). These are not technically required for purposes of formation, but they it is better to have these at the outset, even if you're the sole member, rather than later.


What are the downsides?


LLCs are deceptively simple, leading many business owners to form them on their own without thinking through whether an LLC is the right option. Although comparatively cheaper than corporations, LLCs can sometimes have greater costs to set up and maintain than other entities (like general partnerships).


Your state might also charge an annual franchise tax (California's is $800, though there have been efforts to lower this; Texas's is based on the entity's income, but for most this will be zero).


LLCs often require subsequent filings, as in California (a statement of information with the Secretary of State every two years) and in Texas (with the Comptroller of Accounts every year).


Finally, in some industries, LLCs might be more expensive, or even completely unavailable. For an example of the former, contractors licensed by the state of California will have substantially higher costs if they form LLCs instead of corporations. For an example of the latter, California attorneys (and many other licensed professions) cannot form an LLC for operating a law practice. Cal. Corp. Code sections 17701.04(e), 13401(a).


Where did LLCs come from?


In the mid-20th century, the IRS had a number of factors for determining how to tax an unincorporated association (whether as a partnership or as a corporation). The Wyoming legislature got creative with those factors, and in 1977, came up with the LLC, offering limited liability to its members (as with corporate shareholders) but without tipping the scales too far towards being taxed as a corporation (and thus, LLCs were taxed as a partnership).


Other states were hesitant, waiting to see what the IRS response would be. In 1988, the IRS finally responded, saying that Wyoming LLCs would be taxed as partnerships. By 1996, all 50 states allowed for the creation of LLCs.


Can LLCs own other LLCs?


Yes, and this is fairly common.


In fact, in the real estate industry, this is incredibly frequent. For example, a developer might itself be an LLC. To develop a residential neighborhood, the Developer LLC could form an LLC to own the property as a whole ("Property LLC"). Then as homes are built, Property LLC (owned entirely by Developer LLC) could start transferring those to other entities. For example, if the development sections off 10 lots for houses, Property LLC could transfer those lots to Home 1 LLC, Home 2 LLC, etc. The result would be Property LLC as essentially a holding company.


This seems complicated, and it can be both complicated and expensive at the offset. But it would still be simpler and more cost effective than forming corporations or LPs for the same structure. And the extra entities provide relatively low cost liability shields (if you do everything you're supposed to).


And in some states, it gets simpler and more cost effective still with the series LLC. The series LLC deserves its own post, but for now just be aware that it exists (in some states, like Texas, but not California) and that the Developer LLC situation above could be accomplished with one LLC instead of many.


Conclusion


An LLC is a business entity that combines the flexibility and lower costs of partnerships with the limited liability of corporations. Whether this is the right entity for your business depends on a number of factors, but is often considered the default when deciding on an entity.

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