Limited Liability: A Safer Strategy For Small Business

In Germany, it's called a GmbH; in France, it's a SARL; in South America, Limitada. The English equivalent won't ring many bells, either, because limited liability companies (LLC) are new to most Americans. But small-business owners should familiarize themselves with this new type of status that maximizes tax advantages and liability protection. "It protects you from liability just like a corporation, but you avoid the double taxation. You get the best of both worlds," says Jerry Williford, a partner at accounting firm Grant Thornton in Chicago.

Until recently, outside of a sole proprietorship, small-business ventures had to organize as a C or S corporation, or as a partnership. Each of these entities has major drawbacks. With a C "corp," owners get taxed twice--once on the corporate income and again on personal income when the corpmrate income is distributed as dividends.

S corps address this by passing the company earnings through to the owners, who are then taxed only at their individual rate. But numerous restrictions make S corps inflexible. Only individuals--not corporations--and U.S. citizens can be shareholders. That's a real drawback in these days of increasing global alliances. Also, an S corp can have no more than 35 owners and can issue only one class of stock.

A partnership solves all these problems. Profits are taxed only once at the individual level, anyone from anywhere can be an owner, and the company can issue more than one class of stock. However, while S and C corps protect owners against personal liability if the company is sued, partnerships don't. With a general partnership, all partners are equally responsible. In states where it's allowed, partnerships avoid liability by using limited-partnership status. This enables all but one "general" partner to be limited, or protected. Commonly, partners set up a subsidiary with a small stake in the company to be the general partner and shoulder the liability.

Limited liability companies take away the need for that by providing all the flexibility of a partnership with the same kind of protection offered by a corporate structure. "People were getting there through the back door," says Barbara Spudis, a partner at Chicago law firm Baker & McKenzie and head of an American Bar Assn. task force on LLCs. "But they have to set up two entities, which is more expensive and time-consuming. An LLC is really a more streamlined way of getting there."

PRIVATE PRACTICE. Although forms similar to the LLC have been common outside the U.S. for many years, they are relatively new here. Wyoming passed the first law allowing LLCs in 1977, but not much happened with them until 1988, when the Internal Revenue Service ruled that it would treat LLCs as partnerships for tax purposes. In the past two years, LLC activity has increased markedly. More than 40 states have adopted them, and about 20,000 have been formed. Two big holdouts, New York and California, are expected to approve LLCs by the end of the year.

LLCs have their limitations, however. For one thing, only privately held companies can use them. However, it is easy to switch from an LLC to C-corp status if you should later decide to go public. You simply form a new corporation and transfer the assets of the LLC to it.

If you want to go the other way, from corporation status to LLC, you have to liquidate the corporation by paying capital-gains tax on any appreciation in the company. So it works better for companies just starting up. Another problem is that although LLCs should provide liability protection for owners, they are so new that the extent of that protection hasn't been tested in court. Also, standard forms for administrative matters such as opening a bank account and licensing need to be adapted.

Still, it has been a boon to some of Spudis' clients already, including Richard Schramm, whose industrial-diamond company, International Superabrasive Ltd., teamed up with a Ukrainian diamond manufacturer via an LLC. Schramm wanted to avoid double taxation, so he had to choose an S corp or a partnership. But the S corp couldn't have foreign or corporate investors, and "the Russians weren't familiar with a partnership and thought it didn't sound official enough," says Spudis. "An LLC did because the word, company, in the name reassured them."

HOMEWORK. While LLCs could play an important role in the global marketplace, more often it's the liability shield that companies covet. Houston real estate developer Robert Wilson switched from a general partnership to an LLC to protect a building complex he is refinancing. "It's worth it from the standpoint of the liability," he says. "You can't sneeze in business today without getting sued."

For an idea of how LLCs work, study some limited partnership agreements, says David Neufeld, executive director of the Association of Limited Liability Companies in Washington (202 965-6565). His organization can help you find a lawyer knowledgeable about LLCs. Or contact your Secretary of State's office. If your state hasn't adopted an LLC statute, you can form one in another state without moving.

Technical books on LLCs are available from a number of publishers, but Commerce Clearing House (800 835-5224) puts out a user-friendly introduction, A Guide to Limited Liability Companies ($22.50), as well as a monthly newsletter called Limited Liability Companies Advisor ($169 a year). It could pay to look into this new option. Some attorneys and accountants are already predicting that limited liability companies will become the structure of choice for small businesses.

              S corp  C corp  Partnership     company
      Limited         YES     YES     NO      YES
      Double          NO      YES     NO      NO
      Shareholder     YES     NO      NO      NO
      Transferability YES     YES     NO      NO
      of shares
    Before it's here, it's on the Bloomberg Terminal.