A limited liability company or LLC is an entity formed under state law that couples the characteristics of a corporation with limited liability for all of its owners (called members of the LLC) with the tax classification of a limited partnership. LLCs can have multiple series of units (similar to Common Stock and Preferred Stock of corporations), a board of managers (similar to a board of directors of a corporation) and similar governance systems as corporations. LLCs are recognized under the laws of most states of the United States.

Because of the organizational flexibility and tax advantages offered by LLCs, they are ideally suited for a wide range of business activities, including those presently conducted in the form of limited partnerships. LLCs are attractive vehicles for small businesses, real estate ventures, venture capital funds and international investments. LLCs have become the most popular entity for new businesses in the United States, but are still uncommon for Silicon Valley technology companies. The primary reason is that they have the same tax issues for Silicon Valley investors as limited partnerships. A secondary reason is that most startup company attorneys do not understand LLCs.

Similar to a limited partnership, an LLC is not subject to federal income tax. The LLC members pay federal income tax on income earned by the LLC in proportion to their share of the LLC’s income. Allocations do not need to be in proportion to investment or voting interest in the LLC, so long as the allocations are consistent with Internal Revenue Code Section 704. On liquidation, the LLC is able to distribute assets without any recognition of gain or loss, whereas a corporation is subject to double taxation on liquidation.

LLCs offer more flexibility than S corporations and provide substantially the same benefits. For example, S corporations may not have more than 100 stockholders, any entity stockholders or non-resident stockholders. LLCs are not subject to these same restrictions. Unlike LLCs, S corporations are not permitted to specially allocate income, gain, deduction or loss among their stockholders or to make disproportionate distributions to their stockholders. S corporations may not have more than one class of stock outstanding, whereas LLCs may have multiple classes or series of stock. There is one primary disadvantage of LLCs versus S corporations. An S corporation is very easy to convert back to a C corporation to take outside investment. If an S corporation issues stock to an entity, it automatically loses its S corporation status. An LLC, on the other hand, needs to be converted into a C corporation. Even though the conversion is not a particularly difficult process, it is more difficult than revoking an S corporation election.

LLCs organized or doing business in California are subject to the minimum annual franchise tax, plus a graduated fee based upon the total income of the LLC from all sources. In some cases, the fees payable in California will be higher than the 1.5% corporation tax.