FAQ's

Limited Liability Companies

1. What is a "limited liability company?"

   A limited liability company (LLC) is an unincorporated association having one or more members. For Federal tax purposes, an LLC may be treated as a partnership or corporation or be disregarded as an entity separate from its owner. By default, a LLC with only one member is disregarded as an entity separate from its owner and must include all of its income and expenses on the owner’s tax return (e.g., Schedule C (Form 1040). Also by default, a LLC with two or more members is treated as a partnership. However, a LLC may file Form 8832 to avoid either default classification and elect to be classified as an association taxable as a corporation.

   The LLC can be managed by managers or members. Managers can be, but are not required to be members. The articles of organization for the LLC must state whether the LLC is to be managed by managers or members. Generally speaking, managers can be compared to the board of directors for a corporation, while members are more like shareholders or limited partners. Members contribute property such as cash or services to the LLC in exchange for their interests.

   The internal affairs of the LLC are governed by an operating agreement that may be oral or written. Such operating agreements are comparable to the bylaws of a corporation or a partnership agreement. Typical provisions of an operating agreement include: (1) information regarding the formation of the LLC including the required designated registered agent’s name and office address; (2) information regarding the members and their relative contributions and interest percentages; (3) how the profits and losses will be determined and allocated; (4) distribution provisions; (5) number, qualifications and compensation of managers; (6) limitations on the power and authority of members and managers; (7) rules for meetings of members and managers and authorization of actions; (8) accounting and record keeping requirements; (9) rules for the withdrawal of members and dissolution of the LLC; (10) provisions for the purchase of a "dissociating" member’s interest; (11) winding up and liquidation provisions; (12) restrictions on transfers of interests (e.g. "buy-sell" provisions), and (13) indemnification and liability limitations for members and managers. In the absence of agreement, the Oregon statutes for LLCs will apply by default.

2. Since S corporations and LLCs are both pass-through entities for tax purposes, how do I decide which one is a better form of business entity to operate my business?

   LLCs and S corporations have two key common attributes, limited liability and pass-through tax treatment. Limited liability means that the S corporation or the LLC is solely responsible for its debts and liabilities. Thus, if the assets of either an LLC or S corporation are insufficient to pay all claims against the entity, neither the members of the LLC nor the shareholders of the S corporation are responsible for the shortfall. The members or shareholders may lose their entire investment but their other personal assets are not subject to the claims of creditors. Pass-through tax treatment means that neither LLCs nor S corporations (with certain exceptions as outlined in FAQ No. 7 under "Corporations" rather, the income or loss of the entity passer through and is reported on the personal income tax returns of the members or shareholders. Generally speaking, this pass-through treatment can be advantageous for a start-up business because any losses in the early years can be passed through to the members or shareholders and deducted by them from income earned from other sources.

   Although LLCs and S corporations share some common attributes, there are significant differences between these types of entities that may indicate that one is preferable for a particular business. You will need to weigh the relative pros and cons of each form of business entity and after consulting with your accountant and attorney, make decisions about which advantages are the most important to your particular business.

   As a general rule, LLCs taxable as a partnership will offer more flexibility for tax purposes than an S corporation. For example, property can generally be transferred tax-free by a member to an LLC and also withdrawn without triggering tax consequences. By comparison, in the case of an S corporation, property can generally be transferred tax-free to the corporation at the time of its organization but later transfers or withdrawals may result in the recognition of gain. Since the S corporation can recognize gain on the distribution of property to its shareholder, it is usually not advantageous to purchase investment property that is likely to appreciate through an S corporation.

   The basis of an LLC member in his or her interest (or the S corporation shareholder in his or her stock) limits the amount of the tax losses from the business that may be passed through to the member or shareholder and reported on his or her personal return. In the case of an LLC, the amount of the LLC’s indebtedness to banks or other third parties is considered in computing the basis of members. On the other hand, an S corporation shareholder’s basis does not include any amount from debt unless the obligation is to the shareholder. As a result, the amount of losses that may be passed through to the S corporation shareholder in the start up years may be less than the amount otherwise available to members of an LLC where bank loans or other outside financing is used to acquire assets or operate the entity.

   The partnership tax rules applicable to a LLC also permit special allocations to be made among the members. For example, one member may have substantial income from other sources and may want to receive the "lion’s share" of losses during the start-up years. Similarly, one member may be contributing the bulk of the cash and want a "preferred return" where the other member is only contributing intellectual property without much value or future services. Special allocations can be used to address these situations. However, special allocations can only be made by LLCs taxable as partnerships. S corporations cannot make special allocations since with an S corporation, all income, loss, and cash distributions must be allocated proportionately among the shareholders based on their stock ownership.

   Not only are the partnership tax rules applicable to a LLC more flexible than those applicable to S corporation, but LLCs can also have more types of "members." Under federal income tax rules, an S corporation may not have more than 75 shareholders, all of whom must be U.S. citizens and certain types of estate or trusts. As a general rule, corporations, partnerships and LLCs cannot own stock in an S corporation.

   These limitations can restrict the ability of an S corporation to bring in outside investors in exchange for equity interests and may limit the ability of S corporation shareholders to transfer their stock to family members.

   LLCs can also provide more flexibility in management where a small number of members want to operate the LLC like a partnership, with each member having a vote on all management decisions without the need for approval by a board of directors. In the case of a manager- managed LLC, the designated managers have all the management powers and the members are generally more like "passive" investors.

   S corporations however, have one very important advantage that is of such significance as to potentially outweigh the other advantages of a LLC. The most significant advantage of S corporations relates to their employment tax treatment. If all members of an LLC participate in management, all the income of the LLC is subject to self-employment tax whether or not it is distributed to the members. This means that the income of the LLC is subject to self-employment tax (15.3%) on a current basis even if not distributed but some portion is retained to provide working capital or to acquire capital assets. By comparison, income of an S corporation is not subject to self-employment tax, rather only the amounts paid out by the S corporation as compensation is subject to employment taxes. Thus, if income is accumulated in the business or is paid out as dividend, it is not subject to employment tax. This treatment can provide substantial tax benefits and can be of such importance to some businesses that it will outweigh all of the advantages of an LLC. Obviously, this decision should be made with the input of your accountant, after projections are made on income and expenses.

   In conclusion, LLCs have some advantages while S corporations have other advantages. The form of business entity that is "best" for your particular business will depend upon which of these "advantages" is deemed most important. For example, if you anticipate having investors with differing tax and cash needs and who may be contributing appreciated property over time, a LLC may be the best choice. Likewise, a business generating losses will generally yield more advantageous tax consequences if operated as a LLC rather than an S corporation due to the basis rules. On the other hand, if you do not expect to bring in outside investors, and expect the business to generate large amounts of income, the employment tax advantages of an S corporation may make that form of entity the best choice. Members of a LLC can provide "professional" services but will have the same vicarious liability for professional malpractice as do shareholders of a professional corporation (P.C.).