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USA LLCs in a Nutshell - Part I (Basics)

From www.Gasgoo.com| February 25,2007

Over the last couple of years the "Limited Liability Company" became a popular choice of legal entity especially for smaller companies in the United States. While traditional forms of legal entities such as "Sole Proprietorships", "General Partnerships", "Limited Partnerships" and "Corporations" have been around for some decades, the LLC is a very recent addition and become widely accepted in the late 1980s and early 1990s. Still, many people only have a vague idea what a "LLC" actually is and what it can be good for. In this article, we will look at some basic aspects of this very interesting legal entity for USA businesses.  

What does "Legal Entity" or "Business Entity" mean?
The expression "LLC" as well as for example the term "Corporation" is referring to a legal term called "business entity" or "legal entity". It is crucial to understand that legal entities are abstracted from the actual persons which own the business. When Mr. John Doe owns a LLC, the actions he is doing in the name of the LLC are legally not performed by himself, but by the LLC. A LLC as a legal entity can do almost the same as Mr. John Doe himself. A LLC can for example buy products, a LLC can sell products, and a LLC can make contracts with other legal entities or with individuals and so on. There are of course much more details to consider and a variety of important exclusions apply. You should for example not assume that you now can simply can break the law and let the LLC holding responsibility for it. In any case you would personally be hold responsible for criminal actions! But for the moment, just bear in mind: When you own and run a LLC, the LLC is "responsible" for the business and not you as a person as long as you do business in the name of the LLC.

Now that we have that principle of abstraction on our mind, we can go further into other aspects of the USA LLC.

What is so special about Limited Liability Companies?
Any literature or reference about the LLC in the USA is usually pointing out the "uniqueness" of the USA LLC and the way it is supposed to be superior to many other entities. This uniqueness is determined by one magic combination of the advantages of a Corporation with the advantages of a Partnership while eliminating most of the disadvantages of both. A LLC has all the advantages of a partnership: It is flexible in the way it can be created, owned and managed; it doesn't have many formal requirements such as shareholder meetings or formal meeting minutes and finally: it is taxed as partnership (with regular individual income tax). In addition to those advantages the American LLC got one of the major advantages of a Corporation as a bonus: The owners of an American LLC are only liable with their share of interest and not with their own personal assets.

USA LLC: What is it?
An U.S. Limited Liability Company (LLC) is a business entity with one or more members which typically operate a business. A LLC is a corporate entity with limited liability for the owners. Unlike a traditional US Corporation, the members of a LLC can choose to enjoy the tax benefits of a General Partnership – the IRS (Internal Revenue Service) would then treat the LLC as a partnership while it would operating as a corporate entity

What does Limitation of Liability really mean?
In general, the owners of a LLC are not liable with their personal assets if the company gets in financial trouble. There are some very rare cases where it is possible in theory that members of LLCs can sue each other over a larger amount than the assets brought into the LLC. That could for example apply, if owners did not do business in good faith. The other potential exclusion of the limitation of liability is any form of tort which may require additional insurance protection against cases of personal injury to protect one's private assets.

Tax Status of a LLC
Generally, any corporate entity such as for example Corporation is subject to corporate taxation. That means that taxes are potentially paid twice: first the corporation pays corporate income tax. Then, when profits in form of dividends are paid to the shareholders, they would pay taxes again: this time the dividend would add to their personal income and is subject to personal income taxes.

Contrary to that, the default setup for the LLC is a so-called "pass through" tax status with the Internal Revenue Service (IRS). That would relief the LLC from the corporate taxation. Dividends from the LLC would now only be subject to the regular personal income tax. However, there are maybe specific reasons to have a U.S. LLC setup for corporate taxation which is an option, too.
For actually filing taxes, the process is pretty simple: If it is a one-person LLC and it is not taxed as a corporation, the owner simply files Schedule C under Profits and Losses from a business in his personal tax returns. If the LLC has multiple members, the filing requirements of a General Partnership would apply: The LLC files a Partnership Income Tax Return which shows the allocation of income and losses to the partners (K1). The members then add this to their Individual Income Tax Returns (1040) on Part II of Schedule E. (I am sorry for all those numbers and abbreviations, but I guess most taxation systems in most countries are a little complicated).

An additional form of taxation one may want to consider when dealing with LLCs, is the so-called "Self-Employment Tax". This tax represents "Social Security" and "Medicare" payments to the government. When someone is employed by a company, he or she currently pays 7.65% to the Federal Medicare and Social Security System. The employer has to match that and pays an additional 7.65%. Since for example an one-person LLC has only one employee which is employer at the same time, the member has to pay both parts of Self-Employment tax which is currently 15.3%. There are some exceptions however.

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