LIMITED LIABILITY COMPANIES--THE BEST OF ALL WORLDS?

A limited liability company (LLC) is a business structure that combines some of the best features of sole proprietorships, partnerships and corporations. LLC owners, like their counterparts for partnerships or sole proprietorships, report profits or losses on their personal income tax returns. Like a corporation, however, the owners of an LLC have "limited liability," that is, they are shielded from personal liability for debts and claims arising from the business.

Limited Liability

The limited liability for LLC owners is not absolute. Owners still can be held liable if they (1) personally and directly injure someone; (2) personally guarantee a loan or business debt on which the LLC defaults; (3) fail to deposit taxes withheld from employees' wages; (4) intentionally commit a fraudulent or illegal act that harms the company or someone else; or (5) treat the LLC as an extension of their personal affairs rather than as a separate legal entity. The last exception to limited liability is the most significant. It carries the potential for complete removal of the protections for individual owners. If the line between LLC business and personal business becomes too blurred, a court could find that a true LLC does not exist, leaving the owners personally liable for their actions.

Ownership

Most states allow a single individual to be the sole owner of an LLC. An LLC makes the most sense in circumstances where there is a concern about personal exposure to lawsuits stemming from operation of the business. Most laws prohibit establishment of an LLC in the banking, trust, and insurance fields.

Unlike corporations, LLCs can carry on their business without holding regular ownership or management meetings. Of course, formal meetings backed up by written minutes still may be advisable to document important decisions, such as a change in membership or a major expenditure.

Formation

Setting up an LLC is relatively simple. Articles of organization must be filed with the appropriate state office, usually the Secretary of State. The articles of organization include the name and principal office for the LLC, the names and addresses of its owners, and the name and address of the person or company that agrees to accept legal papers on behalf of the LLC.

Even if it is not legally required, the owners should prepare an operating agreement that spells out the owners' rights and responsibilities. The absence of an operating agreement will mean that state statutes will govern the operation of the LLC by default. An operating agreement acts as a guide for resolving common issues that an LLC will face, and thereby helps to avert misunderstandings between the owners. It also underscores the authenticity of the LLC itself, which can be helpful when a judge is deciding whether the owners are protected from personal liability.

A standard operating agreement includes the members' percentage interests in the business; the members' rights and responsibilities; the members' voting power; allocation of profits and losses; how the LLC will be managed; rules for holding meetings and taking votes; and "buy-sell" provisions that control what happens when a member wants to sell his interest, becomes disabled, or dies. Although it is frequently overlooked when an LLC is created, a buy-sell agreement is important as a sort of "premarital agreement" among the owners. The buy-sell provisions can clarify and ease the transition when the inevitable changes come to the members of the LLC.

Taxes

Since an LLC is not considered separate from its owners for tax purposes, the LLC pays no income taxes itself. Like a partnership or sole proprietorship, an LLC is a "pass-through entity." Each owner pays taxes on a share of profits, or deducts a share of losses, on a personal tax return. The IRS regards each member as a self-employed business owner, not an employee of the LLC. There is no tax withholding, and owners must estimate taxes owed for the year, then make quarterly payments to the IRS.

Conversion

By converting to the LLC business structure, sole proprietors and partnerships can gain the protection afforded to LLC owners without changing the way their business income is taxed. Conversion usually can be accomplished either by filling out a simple form or filing regular articles of organization. Federal and state employer identification numbers will have to be transferred to the name of the new LLC, as will such items as sales tax permits, business licenses, and professional licenses or permits.

The process for creating an LLC is streamlined and free of highly technical considerations. However, there is an important place for professional advice concerning such matters as choosing an LLC over other business structures, preparing or reviewing the operating agreement, and setting up accounting systems.

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BEWARE OF PREDATORY HOME LOANS

At a time when stock prices have tumbled, so have interest rates on home equity loans and mortgages, and many homeowners are borrowing against their homes to generate cash. As a result, more people are at risk of being victimized by "predatory" lenders. A predatory loan occurs when a company misleads, tricks, or even coerces someone into taking out a home loan with excessive costs and without regard to the homeowner's ability to repay. The consequences of such a loan can be especially severe since the defaulting borrower could lose the home itself.

For the most part, predatory lending has been associated with companies that specialize in marketing to people with poor credit histories or who are simply strapped for cash. Typical targets are elderly people with high medical bills or overdue home repairs, middle-class individuals swamped by credit card debt, and lower-income consumers with less access to reputable lenders.

A typical consumer may not know the terms for predatory practices, but the borrower will recognize some of these behaviors. In a "bait and switch" scheme, the lender promises one thing but offers something different at closing, when it really matters. "Equity stripping" results from encouraging heavy borrowing from home equity, beyond the consumer's ability to make payments. "Loan flipping" is multiple refinancing, to the point that fees, and possibly higher rates, become unmanageable. When a lender engages in "loan packing," it has added charges to the loan contract for overpriced or unnecessary items.

There are federal laws designed to protect consumers from some of the predatory lending practices. The Truth in Lending Act requires lenders to give timely information about loan terms and costs, and it allows borrowers on loans secured by a home to cancel the loan up to three business days after signing the contract. The Home Ownership and Equity Protection Act requires providers of "high cost" refinancing or home equity loans to give the borrower key information about the loan three days before closing. It also prohibits the making of a home equity loan without regard to a borrower's ability to pay it back. These laws play an important role, but the best deterrent to predatory lending is informed and vigilant consumers.

Some of the most effective preventive measures are only common sense, but in practice they are too often ignored: (1) think through the decision to borrow before taking the plunge, and be wary of a lender who hurries you; (2) select a lender with a good reputation in your community, and steer clear of home improvement contractors or loan brokers who contact you out of the blue; (3) compare quotes from at least three lenders, then negotiate for the best possible deal. And remember, the loan with the lowest monthly payment is not necessarily the best loan; and (4) read and make sure you understand the loan documents before signing them, keeping an eye out for discrepancies between what may have been discussed previously and what is in the fine print.

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AN EXPENSIVE TEE SHOT

For some, golf courses are like outdoor board rooms. The emphasis is as much on conducting business as it is on lowering handicaps. But if business transactions have taken priority over the game itself, there is a risk that an injury caused by someone's negligence can have repercussions for the firm's bottom line.

A member of a golf club invited a guest for a round of golf and a sales pitch as to why he should come to work for the member's family business. The guest was new to golf, and his host did not fill him in about basic golf etiquette. The guest teed off on the first hole when another golfer on the same hole was only about 70 yards down the fairway. The tee shot struck the golfer in the eye, causing permanent partial loss of vision and a scar.

The injured golfer sued the club member for negligence for not controlling her guest, as required under the club's rules. She argued that the member did not meet her duty of stopping her guest from teeing off before the fairway was clear. In fact, the member had hit first, giving her uninitiated guest the impression that he could do the same.

Before the case could get to a jury, it was settled for a substantial amount. Most of the settlement cost was borne by the club member's family business, because the golf outing was as much for recruiting an employee as for recreation. This case suggests the need for company policies requiring employees to supervise their guests when entertaining on a golf course, including a basic review of golf etiquette and safety for novice golfers.

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IRS MAKES IT EASIER TO SETTLE TAX DEBTS

The Internal Revenue Service has published new regulations that will make it easier for taxpayers to negotiate settlements of their tax debts. The regulations expand the "offer in compromise" program, under which settlements can be reached with taxpayers who cannot pay their entire tax debts.

Under the old policies, the IRS could accept a taxpayer's offer of settlement only if there was a doubt about whether the taxpayer was liable or the debt could ever be collected. These bases for compromise remain in effect, but the new regulations add flexibility, making the IRS decision to accept or reject a compromise offer dependent on the taxpayer's particular circumstances. The bottom line is that a taxpayer is eligible for a compromise where collection of the entire tax debt would create economic hardship or where there are compelling public policy or equity considerations favoring a settlement.

It may be evidence of hardship if a taxpayer cannot: (1) earn a living due to a long-term illness or disability, and it is foreseeable that resources will be exhausted; (2) pay basic living expenses if assets are liquidated to pay the tax debt; or (3) borrow against equity in assets, and seizure or sale could make it difficult for the IRS to collect the tax debt.

Even with loosened-up rules, the IRS will only come so far to meet a taxpayer in a settlement. The new rules do not allow a compromise that "would undermine compliance with the tax laws." The burden is on the taxpayer to make the case for compromise. Absent exceptional circumstances, the IRS will presume that an uncompromising application of the tax laws gives a fair and equitable result.