In selecting the type of entity for a business, most clients have two overriding concerns: limiting the liability for the owners of the entity and favorable income tax treatment. Historically, persons forming a business had two basic choices: a partnership or a corporation. However, in 1993, New Jersey became the thirty-fifth state to enact a Limited Liability Company statute. Limited Liability Companies (LLCs) are hybrids of partnerships and corporations, and have become a very popular method of business formation. There are a number of advantages and disadvantages of an LLC which should be considered prior to the formation of your business enterprise.
Advantages of LLCs
In New Jersey, LLCs may be made up of one or more members, and are formed upon the filing of a Certificate of Formation. Once formed, the LLC is a separate legal entity from its member(s). One of the major advantages of an LLC is that its members’ liability is limited to their interest in the business (similar to a corporation). The internal functioning of the LLC is normally governed by an “Operating Agreement.” An Operating Agreement is like an “owner’s manual” for how the LLC will operate, giving it a “formal” presence and making it easier to deal with lenders and other third parties.
The Operating Agreement provides flexibility in the management of the LLC. Unless otherwise prohibited by statute, the Operating Agreement may address the voting rights of members; the assignability of a members interest; the creation of “managers” who will handle the day-to-day operations of the LLC; allocation of profits and losses among members; allocation of distributions among members; and the time or events effecting the dissolution of the LLC, as well as many other issues that effect the operation of the company.
Once formed, an LLC may carry on any “lawful business purpose or activity.” It is not necessary to specify the purpose for which the company is organized in the Certificate of Formation. However, it is advisable to avoid utilizing an LLC for purely personal reasons, such as holding personal assets like a family home.
One of the other major advantages of an LLC is its allowance of “pass-through” tax treatment so that there is only a single level of tax at the member level using the more favorable partnership rules, as opposed to the double taxation normally faced by shareholders in a
corporation. This is similar to Sub-Chapter S treatment?? For corporations. For businesses already formed as partnerships, the IRS rules governing conversion from a partnership to an LLC are generally favorable, and can be accomplished with very little impact upon the individual members.
Disadvantages of LLCs
The allowance of one member LLCs is relatively new in New Jersey. While a substantial majority of states permit the formation of one member LLCs, several, including California, do not. Therefore, caution should be exercised in creating a one member LLC that will be engaging in interstate commerce. However, the LLC statutes in almost all states contain “nondiscriminatory provisions,” which provide that the law of the jurisdiction of formation of the LLC governs its organization, its internal affairs, and the liability of its members. Therefore, a one member LLC should be afforded the same liability protections in all states that recognize LLCs in general.
Perhaps the greatest disadvantage in choosing an LLC as your business entity is the uncertainty which the term continues to imply. It is essential that the IRS and Congress continue to provide favorable tax treatment for LLCs. Furthermore, in litigation, it appears that Courts will treat LLCs similarly to corporations. However, the ability to “pierce the corporate veil” of an LLC is not firmly established.
All fifty states have adopted LLC statutes. Therefore, if you conduct business in more than one state, the statute in each such state should be carefully reviewed in order to provide that your LLC complies with each states rules and regulations and is authorized to conduct business in each state in which it operates. Unlike various other business entities, the rules governing LLCs continue to evolve and you must be mindful of potential pitfalls.
The advantages of an LLC far outweigh its disadvantages. However, you should consult with your tax advisor and legal counsel prior to converting your current business or beginning a new one in order that your specific needs and concerns are addressed.
James M. Maggio, Jr. & Darrell Felsenstein are associates at WJ&L, LLP whose practices include Business and Corporate matters.