The limited liability company (LLC) form of entity is the appropriate form of conducting business for, many, if not most, sole proprietors. The primary reason for this is that this form of entity permits an individual to enjoy the benefits of limited liability and to continue to be taxed as a sole proprietor. Following is a brief summary of several factors we think should be considered by clients currently engaged in business as sole proprietors, a basic explanation of the LLC form of entity and a brief explanation of the process of forming an LLC.
The sole proprietorship is the oldest, simplest and least complicated form of conducting business. There is no more simple manner in which to conduct business for a single individual than as a sole owner who makes all of the decisions relating to the business and is taxed on business income and loss as an individual, with no taxation at the entity level, as is the case with corporations. However, sole proprietors are personally responsible for the performance of all contracts and obligations of the business.
This means that a sole proprietor risks losing assets belonging to him or her which have no relation to the business in the event the income from business operations are insufficient to cover the business’ obligations, including obligations arising from lawsuits. It is just this fact that initially gave rise to the corporate form of entity and today is the main corporate characteristic that most business owners are seeking. Until recently, many sole proprietors have chosen to incorporate and subject themselves to the double taxation features of the corporate form to benefit from the limited liability characteristic attributable to corporate shareholders.
Limited Liability Companies.
The LLC is an entity authorized by statute in Washington. In recent years, the LLC has become available in every state in the country. Today, the LLC provides the best of both worlds in one form of entity, offering both taxation as sole proprietor and limited liability. An owner of an LLC is only liable for the obligations of the LLC to the extent of his or her investment in the company. For an individual who perceives limited liability to be a favorable attribute and who wishes to avoid the double taxation problem, an LLC is the preferred form of entity. In addition, because the transaction costs are low for forming an LLC, we frequently recommend such a conversion.
The single member LLC structure is a relatively new form of doing business that combines characteristics of corporate structure and sole proprietorship structure. Like a corporation, the LLC provides liability protection for the member, and like a sole proprietorship, the member enjoys the benefits of flow-through taxation (meaning that the entity pays no tax, only its member). The owner of the LLC is called a member, and can be virtually any entity, including an individual, corporation, trust, etc.
The LLC was designed with simplicity and flexibility as its hallmarks. An LLC becomes an entity once it is registered with the Washington Secretary of State by filing a document called, “Certificate of Formation.” An initial report must also be filed with the Secretary of State, and annually thereafter. An “Operating Agreement” of an LLC provides the framework for management of the business and other rights and obligations of its members. The Operating Agreement can, for the most part, contain any mix of rights and obligations that the members desire, depending upon their business relationship. For single member LLCs, designing the contents of the Operating Agreement is an uncomplicated process.
As mentioned above, the LLC is not a tax-paying entity. This means that all company profits, losses, and deductions flow directly through the company and are reported on the individual members’ tax returns (Schedule C). This means that the profits earned by an LLC are taxed only once, as opposed to the double taxation incurred by some corporations. Note, though, that self-employment tax is levied on all net income earned by the company. This is a factor which should be carefully reviewed in the context of your particular business in making a determination as to the best form of entity for your particular circumstance.
For a corporation, converting to an LLC can be a complex and expensive proposition. This is because IRS regulations require that a corporation liquidate its assets prior to forming an LLC. This could create a considerable tax liability for the corporation. However, due to the simplicity of the sole proprietorship, the IRS does not deem the conversion to an LLC as a taxable event. This has proved to be a strong benefit to sole proprietors in making the transition into an LLC form of entity.
Once a sole proprietor makes the decision to form an LLC, the Operating Agreement is prepared and signed and then takes effect. Once the Certificate of Formation for the LLC is filed with the Secretary of State, the LLC becomes an existing entity and the owner becomes its member. At that time, the property (real and personal) relating to the business operations must be conveyed to the LLC. In conjunction with this transaction, the approval of any lender holding a security interest in the property of the partnership may be required.
If the nature of a sole proprietorship is such that limited liability is an attractive feature, the owner should strongly consider the formation of an LLC. However, this discussion is only a broad brush summary of some things to consider while deciding whether to form an LLC. Individuals desiring more information, or those contemplating such a conversion, are urged to consult a qualified advisor early in the decision making process.
Disclaimer Notice: It is my intention that the comments, articles, and other information provided on this website are intended to provide you with general information which may be interesting and of value to you. You should not construe any of this information as legal advice or my opinion as it may relate to your specific circumstances. Please feel free to contact me directly if you would like to discuss your own situation and your estate, real property, or business planning needs.