Limited Liability Corporations: Advantages and Disadvantages
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Definition of a limited liability corporation (LLC)
This paper will first commence by giving the exact meaning of a limited liability corporation.
A limited liability corporation (LLC) is the usual incorrect name used instead of a limited liability company. Therefore the limited liability company and the limited liability company both refer to the same thing. Following the clarification made above it is therefore correct to say that a limited liability company (corporation) is a legally known business institution that gives a limited type of liability to its members (owners). It must be remembered that the limited liability corporation as it is known is not a corporation but is also a kind of association that is unincorporated. The only existing feature that is similar between a limited liability corporation (company) and a corporation is that both have or give their owners limited liabilities.
The LLC bears the flexibility advantage over the normal corporation. In order to further simplify the definition of an LLC; it is a business entity that has both the qualities of a partnership type of business and a corporation (Mancuso, 2007).
The Internal revenue service authority has realized that the LLC are very popular due to their flexibility. The owners of these LLCs are also known as members and these members could range from individual to corporations, foreign institutions and even other LLCs.the American LLCs have an unlimited number of maximum members.
Its also true as regulated by the IRS that certain business institutions cannot be LLCs these institutions include:-
- Insurance companies
- Nonprofit organizations
History of limited liability corporations (LLC)
This type of business has been in existence for a while now and it has been adopted in many parts of the world, this type of business is also protected and bound by law in the many different countries. There operations might be slightly different but the main principles that govern their running remain the same (Shenkman, Weiner & Taback, 2003). The different history stories will give a clear a picture of how the LLCs operate in the different countries and their governing principles. This paper will look at the history of LLCs in the United States of America.
History of LLCs in the United States of America
The LLCs in the United States were as a result of inspirations from a German business organization, the business organization is known as the GmbH.The American LLCs also got their inspirations from the business model of many Latin American countries also known as the Lamitadas (Wood, 2000).
The history of the LLCs in America is quiet interesting with the LLCs making their first appearance in the year 1977 in a state called the Wyoming. The Wyoming state had come up with a Limited liability Company act for an oil company, three years later there was a ruling by the Internal Revenue Service (IRS) and a private letter was issued to the LLC Company that was formed under the Wyoming LLC act. The letter had stated that the IRS would treat the LLC under the Wyoming LLC act as a partnership for the purposes of Federal Tax (Humphreys, 1998).
The IRS would later propose legislations that would deny all business enterprises (that had owners whose liabilities were limited) the partnership classification, further complicating matters for the LLCs.
Many American states introduced the LLC act in the year 1988 due to the uncertainties that were arising due to the tax issue that were facing the LLCs. This is because the IRS in that year did pass a revenue ruling that finally accepted the Wyoming type of LLC companies formed under the Wyoming LLC act as partnerships for tax related purposes.
Every state had installed an LLC act by the year 1996 and in that same year a body called the National Conference of Commissioners on Uniform State Laws worked to adopt the Uniform Limited Liability Company act. This act was then revised in the year 2006.
Facts about taxation of LLCS
There are a few facts about the Taxation of LLCs that must be noted, these facts include the regulation and guide lines that have been issued by the IRS to give direction on the system of taxation for the LLC owners.
The guidelines also highlight the type of tax returns to be filed and how to file the tax returns.
The following are some of the guidelines given by the IRS
For single owned LLCs
For the purposes of filing a federal tax return, it is a common practice by the IRS to ignore the fact that the business entity is an LLC.
This step is only meant for the taxation process and the business entity is still legally recognized as an LLC.
There are two categories of reporting the income and expenses.
The first category is for those LLCs that are owned by individuals and the IRS expects the LLC's income and expense to be reported on the form 1040, schedule C, E or F.
In situations where the only member of the LLC is a corporation then the LLC's income and expenses must be reported on the corporation's return which is form 1120 or 1120S (www.irs.gov)
Taxation for LLCs with multiple owners
These types of LLCs usually file a partnership return which is done in the form 1065 (www.irs.gov)
All LLCs must meet their employment tax requirements as stipulated by the IRS, it is therefore a fact that all the LLC employees are subject to withholding tax.
The LLCs must also file form W-2 and form 1099 upon request.
The issue of self employment is also captured by the IRS and it is a requirement that the LLCs must file the schedules C or F where the owners are subject to self employment taxes on their earnings.
In situations where the LLCs file for the partnership returns then the members must pay taxes on their share of partnership earnings (www.irs.gov)
There is a special rule that applies in a situation where the LLC has operating losses, and this rule also limits the amount of deductions because of the owners Limited liabilities for the LLC debts.
Advantages of an LLC
The LLCs usually enjoy a degree or room to choose in what category to be taxed i.e. the LLCs can either choose to be taxed as a sole proprietor, corporation or even as partnerships.
The owners' liabilities are limited
Depending on the legislation of a given country the owners usually enjoy a degree of protection against
Liability for the debts of the LLC, this would depend on the laws that govern the LLC in that particular country.
Reduced Administrative Work
The LLCs usually enjoy a much more reduced level of paper work and also administrative works compared to the corporations meaning that they would incur less costs by reducing their administrative works.
No double taxation
The LLCs are normally taxed once unless they choose otherwise for example if they decide to be taxed as the(C) corporations
No taxation at LLC level
According to the tax category in which the LLCs are placed they are usually only taxed from the individual level, this means that the owners of the LLCS are the ones who are taxed but the LLCS are not taxed as the company.
Some laws to provide or state that the LLCs are different entities from the individuals, hence if an individual or owner is affected in any way by the law then this does not affect the company or if the company is involved in a legal suit then this does not affect the owners of the company.
According to Shenkman, Weiner and Taback (2003), the other advantage of the LLCs is that the owners can usually retain the gains of the company as capital gains or even better as income that is foreign sourced meaning that the LLC is able to maintain the character of its income this only happens in cases where the LLC has chosen not to be taxed as a corporation.
Easy setting up of the LLC
It is quiet possible to set up the LLC in some states of America because it only requires one person to be involved (physically).
Assigning of membership interests
When it comes to the LLCs it is possible to assign the membership interests; the economic advantage brought about by the interests can be separated and even assigned, this gives the assignee the benefits that result from distribution.
These listed advantages that are enjoyed by the owners are most appreciated and the owners are keen to work within the confines of the Law.
The owners have particularly been keen on the tax flexibility of the LLCs as stipulated by most laws, thus the owners can enjoy a far much reduced burden of taxes that are levied thus they enjoy significant profit margins (www.irs.gov).
The fact that most laws recognize the LLCs as separate entities it is easy for the owners not to be victimized incase of a Legal tussle between the company and any other entity.
With proper and strategic utilization of the advantages the owners can be able to maximize their business potential and have a competitive advantage in the business market.
The disadvantages of LLCs
Lack of definite title of authority
One of the major challenges facing the LLC is the fact that the LLC as a business entity lacks a definite title of the designated authority that can enter into an agreement or a contract on the behalf of the LLC for example the title used by LLC include President, Chief executive officer, partner and managing director.
Threat of being treated as a disregarded entity
Since the LLCs are a new a concept and the many states apparently do not really recognize the LLCs but instead view them as sole proprietorship incases where it is owned by an individual or as partnership incases where it is run by a group. This means that the LLCs lose the advantage and instead their liabilities become unlimited.
The third disadvantage is that in a situation where the LLC is outside the American jurisdiction then there is a greater possibility for the LLC to be treated as a corporate therefore stripping it of the advantages it enjoys as the LLC.
The fact that the LLC's structures not properly understood by many is a clear indicator that its reception is also limited among the greater public. The LLC also does not have a board of Directors.
In some situations where the LLCs are just starting the members are usually required by creditors to personally guarantee the loans on the behalf of the company, this directly implies that the members or owners become directly liable for the debts incurred by the company.
Difficulty in raising capital
This may occur due to the fact that the general operating structure of the LLCs is not understood well by the investors; hence they are more relaxed to invest their money simply because they do not have the hopes of making profits through the Initial public offer (Mancuso, 2007).
There is also a possibility of the owners of the LLC getting into trouble for not having an operating agreement; this is possible mainly due to the fact that there is no legal requiring for the members to have one.
How the disadvantages affect the company
Some of the above disadvantages greatly affect the company, starting by the increased inability to raise capital; when this occurs or when a company is unable to attract the required number if investors to help it raise capital the operation costs of the company become difficult to meet, secondly without the optimum amount of capital the company becomes unable to meet optimally its set out objectives and it then even becomes difficult for this particular company to even expand.
The lack of a definite title authority to enter into agreement might make the potential business partners to enter into any binding business agreement for fear of losing out by either entering into an agreement with a company representative who does not have the authority to legally enter into a binding agreement, meaning the company might lose out on many business opportunities (Humphreys, 1998).
The issue of jurisdiction and taxation issues might be unfair to the company and in turn hurt the company profits in the long run, this is mainly because of the fact that the US LLCs might be considered as corporate for tax purposes which should not be the case thus they will lose more revenue through the taxes levied on them.
Another thing that could really hurt the company is the fact that some creditors demanding that the owners guarantee loans that have been taken for the LLC,this not only strips the owners of their right to limited liabilities but also limits the capacity or the amount of credit that can be taken for the LLC for one simple reason and that is the fact that the individuals might have a limited capacity to guarantee the loans compared to if the LLC took the loan as separate entity (Humphreys, 1998).
The fact that the LLCs are not really recognized in many states and that incase of an individual the LLC is only recognized as a sole proprietorship does actually limit its extent of operations and also exposes it to liabilities that face the sole proprietorship as a business entity.
Operational tax issues
At the state level
The operational tax issues might not have guidance at the state level simply because different states do have there different laws and guidelines event though the laws are harmonized there are those states that would differently treat the issue of operational tax.
There are two aspects to this operation tax. The first aspect is the LLCs category of filing namely C and F
This mostly requires that the members file their self employment taxes on their earning.
The filing of partnership returns
Here there is a general requirement that the owners must pay tax from their share of partnership earnings.
This usually limits the owners or members on the amount of loss that they are able to deduct
Cody, T., Hopkins, D.A., & Perlman, L.A. (2007). Guide to Limited Liability Companies. (9th ed.). Boston: CCH.
Humphreys, T.A. (1998). Limited liability companies. Sydney: Law Journal Press.
Mancuso, A. (2007). Form Your Own Limited Liability Company. (5th ed.). Edinburgh: Nolo.
Mancuso, A. (2007). Your Limited Liability Company: An Operating Manual. (5th ed.). Edinburgh: Nolo.
Shenkman, M.M., Weiner, S., & Taback, I. (2003). Starting a Limited Liability Company. (2nd ed.). New York: John Wiley and Sons.
“The American Recovery and Reinvestment Act of 2009: Information Center.” Retrieved August 24, 2009 from http://www.irs.gov/newsroom/article/0,,id=204335,00.html?portlet=6
Wood, R.W. (2000). Limited liability companies: formation, operation, and conversion.
(2nd ed.). Atlanta: Aspen Publishers Online.
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