LIMITED LIABILITY COMPANIES

This Article is designed to be of general interest. The specific techniques and information discussed may not apply to you. Before acting on any matter contained herein, you should consult with your personal legal adviser.

This Article addresses the use of entities for business purposes: the conduct of an active business. For information about the use of entities for Estate Planning purposes, see Family Limited Partnerships.

Effective September 30, 1994, California provides a new option in which to conduct business: Limited Liability Companies.

In the past, investors and businesspeople were limited to several traditional business forms:

Sole Proprietorship: one owner, with or without employees, running a business under his own name or with a Fictitious Business Name ["doing business as (dba)"]. A sole proprietor is personally liable for all business debts and obligations.

Partnership: two or more people conducting business together.

• General Partnership: General Partners have equal management rights. Each is personally (jointly and severally) liable for all Partnership debts and obligations.
• Limited Partnership: At least one Partner is a General Partner who is the manager and is personally liable for all Partnership debts and obligations. Limited Partners have no liability for Partnership obligations but cannot take part in management of the Partnership. Limited Partnerships have $800 annual California Tax.

Partnerships are not taxpayers. They are `flow through' entities which file tax returns allocating income or loss to the individual Partners (in any reasonable manner agreed on by the Partners). Partners may deduct losses in excess of their actual investment.

Fringe benefits for Partners are not deductible.

Corporation: Business formed under state law, owned by one or more Shareholders. Shareholders elect Directors who provide overall guidance to the Corporation; Directors appoint Officers who manage day to day operations of the business; Officers hire employees. In a small business, the sole owner may be the only director, officer, and employee. Corporate formalities must be followed [recognition of which `hat' the owner is wearing and documentation to substantiate in what capacity a shareholder/director/officer/ employee is acting: minute books, meetings, and various other formalities].

Corporations provide limited liability for owners (unless they are personally at fault). Failure to follow corporate formalities may cause the owners to lose their protection and be found personally liable for corporate obligations. "Piercing the corporate veil" refers to imposition of liability on the owners for corporate responsibilities. This is also referred to as the "alter ego doctrine": if an owner treats the corporation as an extension of himself (rather than as a distinct and separate entity by following corporate formalities), he is personally responsible for corporate liabilities.

Regardless of the corporate shield, Courts are quick to impose liability on an owner who is personally at fault. For example, a sole owner of a bakery corporation who fails to exercise proper diligence and hires a deliveryman will be personally responsible if the driver causes an accident and the corporation has insufficient assets to cover the loss to the victim.

There are two types of Corporations:

A Subchapter "C" Corporation is a separate taxpayer and pays tax on any net profits: the owner-employee pays tax on any salary or distribution of profits (dividends). In a small C Corporation, the owners `zero out' corporate income by payment of salaries to the owners-employees. This avoids payment of corporate tax [which might be followed by profits distributions - dividends - which are taxable to the owners, resulting in two layers of tax on one set of profits ("double taxation")]. Fringe benefits provided to all employees, including owners, are deductible.

California imposes annual $800 minimum tax.

Subchapter "S" Corporations are not taxpayers. They are `flow through' entities which file tax returns allocating income or loss to the owners proportionally, based strictly on the percentage owned by each owner. Owners are limited in deducting losses; the most which can be written off is the owner's actual cash investment in his stock. Fringe benefits for owner-employees of an S Corporation are not tax deductible.

California imposes tax of 2½% on net income, with a minimum of $800.

Tax Disadvantages of S Corporation

Limited Liability Companies [LLCs]

Tax laws applicable to Partnerships allow LLCs to make special allocations of income and deductions with total flexibility. The tax disadvantages of an S Corporation do not apply to an LLC.

California LLC owners are called members. LLCs may not be used for professional services (medical, legal, accounting).

The documents to form an LLC are a hybrid of Corporate Articles of Incorporation and a Partnership Agreement. An LLC may be managed by either: all members; elected members; or managers who are not members.

There are two downsides to an LLC:

1. Fringe benefits provided to owner-employees are not deductible.
2. California imposes a minimum tax of $800 PLUS a sliding scale amount based on the gross income: $-0- if the gross income is less than $250,000; the top rate is $4,500.

The California gross receipts tax seems inherently unfair. Taxes should be based on profits, not gross receipts. Due to the high tax cost, an LLC might not be right for every business. However, every new business should consider it as an available alternative.

In general, the availability of LLCs means that new S Corporations will not be formed. The LLC offers the best attributes of both a Corporation and a Partnership.

Since an LLC is federally taxed as a Partnership, there are no tax consequences of conversion from either a Limited Partnership or a General Partnership into an LLC.

However, conversion of a Corporation (either a C or an S) into an LLC should be done only after careful tax analysis. The conversion is treated as a dissolution of the corporation (painfully taxable if the corporation holds appreciated assets), followed by formation of a new LLC.

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