What is an LLC?

Limited liability companies, or LLCs, combine many features of corporations and partnerships. Like a corporation, an LLC protects its owners, known as members, from being personally responsible for any debts of or legal claims against the LLC. But, an LLC is taxed like a partnership instead of a corporation for federal income tax purposes, allowing certain items such as income losses and other tax items to "flow through" to the members in proportion to their ownership interest.

Partnerships and LLCs allow for both partners and members to be involved in the managing of the business. But, partners have personal liability in a general partnership for all debts and obligations of the partnership. In a limited partnership, limited partners are shielded from liability but are unable to participate in managing the partnership. LLCs allow for the members to manage the business and still shield themselves from personal liability for the debts and obligations of the business.

Both LLCs and S corporations allow profits and losses to "flow through" to members and shareholders. Both members and shareholders report their income, debts or deductions from the business on their personal federal income-tax returns. But, LLCs are not as statutorily restricted as S corporations. S corporations may have only 75 owners, whereas LLCs have unlimited ownership numbers. S corporations may have only a single class of stock and may not have preferred stock. LLCs may have preferred "ownership units" for its members. The owners of an S corporation must be U.S. citizens, resident aliens, estates or certain trusts. LLC members are almost any type of entity, including but not limited to the types eligible for S corporations plus, partnerships, corporations, nonresident aliens and discretionary trusts.

Almost any type of business can be structured as an LLC. Any business that desires limited liability and partnership taxation is a candidate for becoming an LLC. LLCs work particularly well for family businesses that have exposure to product or other liability, real estate enterprises, entrepreneurs, and high-tech companies. Professional firms may also form LLCs, but they must comply with various specialized, but not burdensome, rules found in New Hampshire’s Professional Limited Liability Company Act.

An LLC is formed by filing a formal application, called a "Certificate of Formation," with the Secretary of State. The 1997 amendments to the New Hampshire LLC Act eliminates the two-member requirement and provides for a single member LLC. Usually an operating agreement is prepared as a supplement to the Certificate of Formation. Though not required, the operating agreement is highly recommended.

Upon proper organization, the IRS taxes an LLC like a partnership. The structure of an LLC must not be the same as a corporation or the IRS will tax the business entity as a corporation. There are four key features that distinguish a corporation for federal tax purposes:

For an LLC to be taxed as a partnership, it must not contain more than two of these characteristics. Where limited liability is usually the main reason for forming an LLC, the LLC must not have two of the last three features. Recent changes in IRS Rules have made this of less concern.

The New Hampshire LLC Act contains default provisions which apply to all LLCs unless specifically addressed in the Certificate of Formation or operating agreement. These default provisions limit the life of an LLC to 30 years, restrict transferability of membership, and decree that all LLCs have decentralized management. Thus, if nothing is stated in the Certificate of Formation or operating agreement to the contrary, the LLC will be taxed as a partnership.

NO. Members may set any guidelines they wish, and still receive the tax benefits, so long as the LLC does not contain more than two of the four characteristics of a corporation. Under the New Hampshire LLC Act, all LLCs formed have limited liability by statute, and cannot waive this limited liability.

Continuity of Life. Most LLCs will dissolve upon the death, insanity, bankruptcy, retirement, resignation, or expulsion of any member, collectively known as the events of dissolution. When LLCs adhere to this scheme, they lack continuity of life. This can create problems for certain businesses because of the lack of stability it provides. To combat this instability, the operating agreement may provide the remaining members with voting rights that allow them to continue the LLC. Usually these rights do not cause the LLC to take on continuity of life, but careful wording of the provision must be used to avoid corporate taxation. An LLC may have continuity of life provided it has decentralized management and no free transferability of interests.

Centralized Management. As in a partnership, all of the members of an LLC may participate in management. In this scenario, the LLC’s management is decentralized. Members may not want this decentralized management if certain members lack the business expertise to vote or represent the LLC as agents. In this case, members can grant management responsibility to a certain number of members who will run the day-to-day operations. This is not a problem as long as the LLC does not have continuity of life or free transferability of interest.

Free Transferability of Interests. In partnerships and corporations, shareholders and partners may freely transfer their interests to a third party. In an LLC, members may not freely transfer their interests to a third party. This may cause some difficulty in certain businesses. A provision in the operating agreement may allow members to transfer their interests to a third party without requiring the consent of other members.

As one can see, an LLC and its members are not bound by the default provisions of the LLC Act. These are only a few of the scenarios and solutions to questions about LLC taxation and formation. The key to remember is that the LLC should lack two of the four basic characteristics that make up a corporation.

The 1997 amendments now makes it much easier for businesses to change their form of entity, i.e. corporation to LLC, LLC to corporation, limiter partnership to LLC, etc. Normally, the conversion is without taxation on the federal or New Hampshire level.