A liability shield for entrepreneurs - limited-liability companies

Nation's Business, August, 1994 by Ripley Hotch

Many small firms are choosing a business structure that combines the pluses of a partnership and a corporation.

With surprising speed, states are creating a new form of business organization that tax experts predict will be adopted by many small companies that might otherwise be set up as partnerships or S corporations. The new structure may soon be an option for many sole proprietors as well.

Known as a limited liability company (LLC), the designation has been authorized by legislatures in 43 states--up from eight states just two years ago. The remaining seven states and the District of Columbia are expected to follow suit soon.

A key to the LLC's predicted popularity is the way it combines the advantages of corporations and partnerships--with few of their drawbacks. It provides owners the same shield from personal liability provided by a regular corporation; profits, meanwhile, are taxed only at the individual level, as in a partnership or an S corporation, rather than at both the corporate and the shareholder levels, as in a C corporation.

"The LLC will surpass the S corporation, general partnership, and limited partnership and become the predominant form of organization for small business," says Gordon A. Carpenter, a partner in the Providence, R.I., law firm of Hinckley, Allen & Snyder. He helped craft Rhode Island's LLC law.

In addition, five states--Arkansas, Georgia, Idaho, Montana, and Texas--allow sole proprietors to establish themselves as sole-member LLCs, conferring liability protection on individuals who never had it before. The IRS has not yet offered guidance on the tax ramifications of sole-member LLCs.

Nonetheless, the idea may soon spread. The Uniform Limited Liability Company Act, a draft law prepared for the National Conference of Commissioners on Uniform State Laws, provides for sole-proprietor LLCs.

The conference is made up of members appointed by state governors; all states are represented. It meets annually to consider adoption of uniform laws, frequently dealing with interstate commerce. The proposed uniform LLC act was set to come up for a vote during this year's conference in Chicago in late July. If approved, the proposals would go to the American Bar Association for consideration. Upon ABA approval, the uniform law would advance to the states for adoption.

Most states could be expected to bring their own LLC laws into conformity, triggering rapid growth in LLCs among the nation's 15 million companies organized as sole proprietorships.

"Entrepreneurs have two concerns: limited liability and fair taxation," Carpenter says. Until recently, the best way to achieve those goals was to organize a business as a Subchapter S corporation, named for a section of the federal tax code.

Like a regular corporation, an S corporation provides limited liability protection for its owners. And profits are taxed only once, at the individual, owner/shareholder level.

But S corporations have two major drawbacks. They may have no more than 35 shareholders, and those shareholders must be U.S. citizens. Excluded are foreigners, domestic corporations, and co-owners of partnerships.

These restrictions do not apply to LLCs. There is no limit to the number of shareholders. Moreover, an LLC "can have partnership members, corporate members, and other LLCs as members," says Samuel Starr, tax partner with Coopers & Lybrand in Washington, D.C. "We're seeing them used in many different ways. They're sometimes used as a joint venture for a Fortune 500 company with a small company or individual."

The partnership is another popular form of business organization. Its biggest benefit is that profits are taxed at the individual partner level, not at the partnership level. But a partnership poses a serious drawback concerning liability.

In a general partnership, all partners face liability similar to that of a sole proprietorship. Personal assets are at risk, as well as the assets of the partnership.

Limited partnerships avoid this problem by establishing two classes of partners. Passive, or "limited," partners are exempt from personal liability for the partnership's debts. But state laws require that someone be designated general partner, who is liable.

Because LLCs avoid these liability problems, they already have become a popular choice for real-estate ventures, providing protection from potential environmental liability, says Fernando Murias, tax partner with Coopers & Lybrand in Tysons Corner, Va. Liability for pre-existing but previously undiscovered environmental problems can stop a deal instantly, and the traditional limited partnership still leaves one general partner exposed.

Medical and legal partnerships also are finding the LLC type of organization attractive, not only because of the limited liability but also because the form allows all of the members to be involved in active management.

In fact, the advantages of the LLC form of organization make it attractive to almost any type of business, says Jerry Williford, a Chicago-based tax partner with the accounting firm Grant Thornton. "The LLC is a wonderful entity for any type of business, including manufacturing, retailing, real estate, and wholesale distribution," he says.