Limited liability companies, or LLCs, have come of age. LLCs have been authorized in Oregon since 1991. But it took legislative refinements in 1993 and 1995 to "get the bugs out." Now, LLCs are becoming the "entity of choice" in many situations.
What is an LLC? LLC stands for "limited liability company." It is a new type of legal entity which combines the best of the two most common type of legal entities - corporations and partnerships. The big advantage of a corporation is that it provides limited liability. The shareholders are not liable, generally, for the debts and obligations of the corporation. However, a corporation is a separate taxable entity. Income left in a "C" corporation at the end of the year is taxed at the corporate rates, and that income may be taxed a second time upon eventual sale or liquidation of the corporation ("double tax"). A partnership is a "flow through" entity for tax purposes. All income left in the partnership is taxed only once, to the partners, and may be withdrawn later tax free. However, all partners of a general partnership are fully liable for all debts and obligations of the partnership, including liabilities from the negligence of another partner.
The LLC combines the best of both. It provides limited liability (like a corporation) and flow-through tax treatment to the LLC owners (like a partnership). An LLC is easy to create, by filing Articles of Association with the Oregon Corporation Division. The LLC functions through an Operating Agreement, which is much like corporate bylaws or a partnership agreement. For a multi-party LLC, the Operating Agreement should also include buy-sell provisions.
In our experience, the following are the most common uses of an LLC:
Sole Proprietorships. Self-employed individuals who conduct business as sole proprietors may consider forming LLCs for liability protection. For income tax purposes, the LLC is transparent except for a new tax identification number. The individual still reports all his or her business activity on Schedule C. However, the LLC provides protection from vicarious liability (e.g., from liability caused by an employee's accident) and from liabilities of the business which the owner has not personally guaranteed.
Professional Groups. Professionals who practice in a general partnership most certainly should consider doing so as an LLC, if not an LLP (a limited liability partnership). There is no reason that a group of professionals should practice as a general partnership, where each partner is fully liable for the malpractice of the all the partners and employees. As an LLC or an LLP, professionals can practice together without the threat of vicarious liability from their partners while still having the simplicity of a partnership for income tax purposes. For a professional who practices in an "office sharing" setting with other professionals, the use of an LLC for his or her own practice can provide a shield against vicarious liability from the other professionals. This is a risk if a court determines that the office sharing arrangement is, in reality, a "de facto partnership."
Real Estate Development and Ownership Groups. LLCs have become the entity of choice for real estate development and real estate investment groups. Generally, corporations have not been desirable because of the potential for "double tax" on capital gain generated by owning the real property inside the corporation. Also, a "flow-through" tax entity is generally preferred in order to pass depreciation writeoffs to the owners personally. Therefore, general partnerships have been the choice until now, notwithstanding the potential of personal liability to the partners. However, an LLC can provide liability protection of an LLC, along with the other benefits of a partnership. In fact, a multiple-owner LLC files a partnership return for income tax purposes. As a result, most new real estate ownership groups are being organized as LLCs, and many real estate ownership groups are converting to LLCs .
Family Estate Planning and Gifting. "Family LLCs" are becoming popular tools to pass family-owned businesses and real estate intact to the next generation and to minimize federal estate taxes in the process. For example, a retired couple with a valuable parcel of commercial real estate may wish to form an LLC to hold the property. Over time, they can give fractional interests in the LLC to their children using the $10,000 per person per year gift tax exclusion. Because the gifted interests are minority interests and because they are not readily marketable, their value can be discounted substantially. This allows larger gifts to be made each year, "leveraging" the $10,000 annual exclusion to $15,000 or $20,000. Even more importantly, after the first round of gifts the LLC interest owned by each spouse is now less than 50%, which allows the value to be discounted substantially for estate tax purposes as each spouse dies. Finally, the ownership of the real estate inside the LLC keeps the property intact and prevents a disgruntled child from forcing the property to be sold or partitioned. Instead, the operating agreement of the LLC would contain buy-sell provisions setting out an orderly system for transfer of interests among the children.