Benefits Of An LLC
LLCs have only been around since the late ‘70s, but they’ve quickly become one of the most popular forms of business in the US. Why? LLCs have (or can have) a surprising number of desirable attributes, from limited liability to pass-through taxation.
The reason LLCs have such a wide array of benefits becomes clear when looking at how and why LLCs were first formed—LLCs were created specifically to cherry-pick the most advantageous qualities of both corporations and partnerships.
A BRIEF HISTORY OF LLCS
Essentially, LLCs first came about as a way for businesses to receive a more favorable tax status while limiting their personal liability. Originally, only corporations (or the limited partners in a limited partnership) had limited liability. In other business types (like regular partnerships), owners’ personal assets were at risk if the business were sued.
Unfortunately, the perk of a corporation’s limited liability came with a major downside: corporate taxes. A standard corporation is taxed twice—first on its net income and then again at a personal level when the net income is distributed to an owner. Partnerships, however, have it a bit easier. In a partnership, the business itself isn’t taxed. Profits are passed to the owners and taxed as personal income. This is referred to as pass-through taxation.
Before LLCs, unincorporated businesses in the US had to pass a “corporation resemblance test” to see if they would be taxed as a corporation or a partnership. If a business met three out of four of the following qualifications, the business would be taxed as a corporation:
- limited liability
- centralized management
- free transferability of interests
- continuity of life
On one hand, this meant that limited liability wasn’t the only deciding factor in determining whether or not a business was a corporation. On the other hand, the standard business model at the time was for businesses with limited liability to be corporations—at least in the US.
Abroad, it was a little more common for businesses with limited liability to be taxed as partnerships. This sometimes made things a bit awkward for international businesses trying to do business in the US. An adviser for an international oil company, Frank M. Burke Jr., ran into exactly this problem. To help the oil company keep the tax and liability benefits it had abroad in the US, Burke wrote a proposal for a new type of business organization: the LLC. The LLC had limited liability and centralized management but not necessarily the other two corporate markers, meaning it could technically receive partnership taxation under the corporation resemblance test.
However, finding a state to pass legislation accepting this new business structure was difficult. Legislation failed in Alaska a few times before Wyoming finally brought forth and passed the first LLC statutes. Even then, the IRS was hesitant to issue a strict ruling on the validity of the LLC—it took 11 years and significant lobbying just for the IRS to issue a ruling stating LLCs could in fact be taxed as partnerships while retaining their limited liability.
LLC History: A Timeline
Early 1970s: Burke drafted the first LLC proposal and began meeting with lawmakers.
1975: LLC legislation failed to pass in Alaska.
1976: LLC legislation again failed to pass in Alaska.
1977: Wyoming became the first state to permit the formation of a domestic LLC.
1982: Florida joined Wyoming and became the second state to allow domestic LLCs.
1988: The IRS issued a ruling confirming LLCs could have limited liability and be taxed as partnerships.
1990-1996: The rest of the fifty states slowly introduced and passed LLC legislation.
1996: The IRS made partnership taxation the default for LLCs.
Source: The Story of LLCs: Combining the Best Features of a Flawed Business Tax Structure by Susan Pace Hamill
As described above, LLCs were designed to have the best of both worlds, taking elements of both partnerships and corporations. While limited liability and tax flexibility are clearly the most significant benefits for many businesses, these are just a few of the benefits of an LLC.
An LLC has the same limited liability protections afforded to corporations. When someone forms an LLC, they are essentially creating an entity separate from themselves. If the LLC is sued, the business—not the people who created the business—is being sued. The major advantage to limited liability is the protection of personal assets. In business dealings, the LLC’s assets are at stake, not the personal assets of the individuals in the LLC.
For more about limited liability protections and LLCs, learn about the difference between partnerships and LLCs.
Tax benefits of an LLC
When it comes to tax options, the LLC is king. Without a change in tax election, a single-member LLC is taxed as a disregarded entity (sole proprietorship), and a multi-member LLC is taxed as a partnership. However, both types of LLCs can also choose to be taxed as S corporations or even C corporations.
LLCs can opt to be managed more like a partnership or a more like a corporation. In a member-managed LLC, the members all have voting rights and decision-making powers (like a partnership). In a manager-managed LLC, members are a bit more like shareholders—they can vote on managers, but day-to-day decisions are made by the managers, not members.
Another beauty of the LLC is the lack of annual meetings. Corporations are usually required to hold these meetings. (Granted, no one is really out there checking if a private corporation is holding annual meetings, but there are no annual meeting requirements with an LLC.)
There also aren’t officer roles that have to be decided. In a corporation, you typically need to appoint a president, secretary and treasurer. While you still may need to assign duties to individual members, an LLC doesn’t absolutely require such strict roles or hierarchy.
Fewer reporting requirements (in some states)
While corporations have long had reporting requirements such as annual or biennial reports, some states have yet to apply these requirements to LLCs. Now, this isn’t a perk that is likely to last forever (states don’t tend to miss out on potential revenue sources for long). For the moment, however, fewer reports can mean additional savings in filing fees and paperwork in some states. For instance, neither Arizona nor New Mexico requires LLCs to file annual or biennial reports.
Member information is a common part of state reports, so fewer reporting requirement can also mean better member privacy. In New Mexico, LLCs don’t have state reports, and formation documents don’t require member information—so it’s possible for members to maintain anonymity. This isn’t something that could be achieved with a New Mexico corporation, which must submit owner information in biennial reports.
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