State Issues
LLCs were created at the state level to address a problem that sole-proprietors and general partners had. If the businesses were sued, the personal assets of business owners could be taken to satisfy the judgement. LLCs gives these business people the same limited liability protections that corporations have to protect their personal assets. It took over a decade before all states had LLC laws created, so there are a lot of variations and it is important for you to check your state statues.
Most states tax LLCs the same way they are taxed under federal law, which means pass-through treatment is allowed and C-Corporate entity-level income taxes can be avoided. However, some states may impose other taxes such as franchise taxes, business/occupation taxes, or other registration fees.
Be aware that most states permit LLCs to have a perpetual life. These flexible statutes state you don't need unanimous consent to continue the business if certain events occur and members may transfer their ownership interests. However, there are other states that base their statues on earlier tax law and may place limits on the life of the LLC, require articles of organization to be filed or require unanimous consent to transfer ownership interests.
Some states restrict which type of business is allowed to form LLCs. For example, California doesn't allow financial institutions, insurance companies or trust companies to operate as LLCs. Arizona, Delaware and a few other states prohibit banks and insurance companies. A few states prohibit lawyers and law firms. Although these restrictions are becoming rarer, it is something that has to be checked for.
Comparing LLCs
For years, businesses have chosen partnerships and S-corporations to provide limited liability and passthrough taxation advantages. Due to certain restrictions on those forms, they produced many drawbacks. That is why the newer LLC classification is becoming so popular for many entrepreneurs.
C-corporations have a lot more legal and accounting rules and often require hiring lawyers and accountants. For the small business owner, the LLC is a lower-cost, simpler alternative. Because the LLC has passthrough taxation, it avoids the double taxation problem that confronts C-corporations.
S-corporations have often been the traditional choice for operating a closely held business, but the LLC has clear tax and non-tax advantages over the restrictions of the S-corporation. In fact, because of its more complete passthrough tax treatment and greater operational flexibility, the LLC may replace the S-corporation as the entity of choice for the closely held business. Unlike the S-corporation, there is no restriction to the maximum number of members or a single class of stock or membership interest. On the other hand, being relative new, the LLC entity does not have a lot of case law behind it like S-corporations do and have differing rules among the states.
Partnerships are taxed basically the same as an LLC classified as a partnership, but there are two crucial differences between the two. First, at the state level, there is no legal distinction among LLC members which are comparable to the general partners and limited partners in a standard partnership agreement. In the LLC, no member is liable for the debts of the business. Second, all members in an LLC can participate in the management of the company, whereas limited partners in a standard partnership are prohibited from taking an active role.