What's hot in the world of new-business organization?  It's the limited liability company.

All 50 states now allow the organization of a limited liability company (LLC).  I like to think of the LLC as a special gift to time-strapped small-business owners who dislike extra administration and paying extra income taxes.

Startup entrepreneurs tell me they are confused about this type of business entity.  It's not a corporation and it's not a partnership entity.  Actually, it is an entirely different type of business structure with different tax rules (see below). 

What's often confusing about LLCs is the terminology. Whereas investors in corporations are called "stockholders," investors in LLCs are called "members."

Corporations are governed by documents called articles of incorporation and bylaws. Meanwhile, LLCs are governed by, in most states, articles of organization and the operating agreement.  Preparation of these documents represents the biggest expense associated with forming an LLC or corporation.

Some advantages of LLCs

Entrepreneurs often ask me if it is better to organize a corporation and seek lower tax rates by electing S corporation status or by organizing the business as a limited liability company. 

While no single strategy is right for every business situation, LLCs offer a few significant advantages:

1.  Simpler administration.  Unlike corporations, LLC organizers are not statutorily required to hold meetings of its member owners nor keep meeting minutes.  As well, they don't need to prepare formal written resolutions to issue new company stock, acquire assets, open bank accounts, or make big changes in the company's business direction.  Entrepreneurs who know they won't keep good records themselves or hire someone who will, should favor an LLC organization.

2.  Tax benefits.  The LLC structure allows a company to bypass traditional corporate taxes and instead "pass through," as accountants say, to the owners' personal income tax return.  This means that company profits or losses are generally reported just one time, at the personal level.

In contrast, business profits in a standard C corporation are taxed by the federal government and again by most states. Then, to the extent that entrepreneurs take out profits in the form of dividends or bonuses, entrepreneurs pay Uncle Sam one more time through their personal tax returns.  This is frequently referred to in the small business community as "double taxation."

3.  Better protection against liability than a sole proprietorship. Both LLCs and C corporations provide owners with some limitations of liability.  If, for example, a business obtains a bank loan without signing a personal guarantee, shareholders and company managers would generally not be personally liability for missed payments, assuming no fraud is involved.

4.  Real estate benefits.  An LLC business structure is also a common favorite among real estate developers.  LLCs allow developers an easy way to involve different investors in different real estate projects. 

Also, there are certain tax benefits for holders of real estate that are expected to appreciate in value.  Even better, developers who spend the majority of their time in the real estate profession and are active in the management of the properties can usually write off real estate losses against other forms of income without limitation. 

Some potential drawbacks of LLCs

Consider carefully your future growth plans when determining your organization.

1.  Venture capitalists generally don't like LLCs.  Entrepreneurs who expect to raise money one day from the venture-capital community should choose corporate organizations.  Knowledgeable non-real estate investors strongly prefer this organization type, not only for their benefit, but the long-term financial benefit of entrepreneurs, too. 

Given the overriding goal of one day selling a VC-funded company through a public offering or to another corporation for a lucrative profit, a corporate structure makes this transaction easy to administer from a securities and accounting standpoint. Corporate structures are preferred for employee stock-option plan administration, and there are well-established rules for corporate governance. 

I frequently remind entrepreneurs that they increase their risk of rejection when they present company structures—LLCs, partnerships, and sole proprietorships—that are outside the norm of the VC community.    

2.  It's not cheap to change business structure.  A standard C corporation and S corporation are both corporate entities.  So if a C corporation chooses to become an S corporation or vice versa, the corporation and its documents and shareholders don't need to change.  What will change is the way taxes are calculated and reported to the IRS. 

Changing an LLC to either a C corporation or an S corporation, however, involves more legal and accounting work, preferably by qualified professionals.  Entrepreneurs will need to establish an entirely new corporate entity, prepare articles of incorporation and bylaws, issue new shares in the corporation, and more, to complete the process.

3.  You will likely need to hire an attorney.  The second-most common question entrepreneurs ask me about LLC organization is if they need an attorney.   Given the variability of state laws, I encourage entrepreneurs to hire a competent business attorney instead of buying do-it-yourself LLC organization kits.  This recommendation is especially worthwhile for first-time entrepreneurs as well as existing sole proprietors who want to "convert" to an LLC business structure. 

Sure, hiring an attorney may sound intimidating or costly, but it's just not worth it to pinch pennies on potentially big-dollar issues.  Each state has varying rules for LLC fees and formation, which is where an attorney can help sort out the information.  For example, some states don't allow single-member limited liability companies, which can be helpful to freelance entrepreneurs who want to shield their personal assets from business calamities.

Read up on LLC rules and fees

My recommendation to entrepreneurs is to first visit their state's Secretary of State Web site to read about general LLC rules and fees. 

Next, when they meet with a local corporate attorney, here is what they should discuss: the nature of their business operations, expectations for raising money, number of founding entrepreneurs, states where revenues will most likely be generated, and aptitude for maintaining business records.

The more that professional advisers know about an entrepreneur's business goals, the easier it will be to send them out into the world of active business building, heading in the right direction.

Here's another look at limited liability companies.