F. C., of Bensonhurst, N.Y., wrote with this question:

I've heard about a company which acts like a partnership, with income and expenses taxable only to the individual partners, and which also acts like a corporation by limiting personal liability. It's called a limited liability company ("LLC"). I know you usually talk about estate planning but would you please tell me how this company works?

Dear F.C.:

I'm glad to help! And, your question is welcome because a good estate plan requires review of all pieces of the financial management puzzle, including tax planning, retirement planning, investment planning and protection of assets. This two part question will be answered in this and my next column and the two parts considered will be:

1. Why an LLC over another type of business entity?
2. How is an LLC validly formed for tax purposes?

LLC's are an alternative to the more traditional business forms, such as sole proprietorships, general or limited partnerships, and corporations. It is a recent type of business entity, with about 35 states having statutes allowing them and most of the others having proposed such statutes.

Your question rightly stated the important interests to be achieved as flow-through taxation and limitation on member personal liability. Flow-through taxation, or nontaxation of the entity for federal tax purposes, means all items of income and expense are taxed only to the individual member, which is generally what you want, avoiding the double taxation associated with corporations, once to the corporation and then to the members (shareholders) on receipt of dividends. A sole proprietorship has flow-through taxation but the member (proprietor) is personally liable; however, this is the easiest entity to set-up and maintain.

A general partnership has flow-through taxation but each member (partner) is personally liable. A limited partnership has flow-through taxation and all limited partners enjoy limited liability, but a limited partnership requires at least one member be a general partner who has unlimited liability and the limited partner may lose that status if they assist in the operation of the partnership from day-to-day.

A regular (C) corporation has double taxation but members generally enjoy limited liability. A small business (S) corporation, on the other hand, has flow-through taxation and each member enjoys limited liability, but there are restrictions on who may own shares as well as the type of business operations allowed.

An LLC gives all its members limited liability, allows them to personally operate the business, and has few restrictions on who may be a member or what type of business may be operated. The only question then left is "How is an LLC validly formed for tax purposes?"

Limited liability is conferred by state legislation while federal tax status is determined by federal law. Generally, an unincorporated entity must have no more than two of the following "corporate" characteristics, and of course it must have members who want to conduct business and share profits: 1) limited liability; 2) centralized management; 3) continuity of life; and 4) free transferability of interests. Because limited liability is the desired result, an LLC must strive to have no more than one of the other characteristics.

In my next column, I'll discuss the dynamics of each characteristic and how to achieve flow-through taxation in their interplay.

Dear F.C.:

I'm glad to help! And, your question is welcome because a good estate plan requires review of all pieces of your financial management puzzle, including tax planning, retirement planning, investment planning and protection of assets.

My last column, the first of two parts, considered "Why an LLC over another type of business entity?" I compared a sole proprietorship, a general and a limited partnership, a regular (C) and a small business (S) corporation, and an LLC. I found the LLC an attractive alternative because it achieves the important interests of flow-through taxation and giving all of its members limited liability, while it also allows all members to personally operate the business, and has few restrictions on who may be a member or what type of business may be operated.

This second part explores the remaining question "How is an LLC validly formed for tax purposes?" Limited liability is conferred by state legislation while federal flow-through tax status is determined by federal law. Generally, an unincorporated entity, which must have members who want to conduct business and share profits, must also have no more than two of the following "corporate" characteristics: 1) limited liability; 2) centralized management; 3) continuity of life; and 4) free transferability of interests. Because limited liability is the desired result, an LLC must have no more than one of the other characteristics or it will not be a flow-through entity.

Centralized management means that less than all of the members, as members, make necessary management decisions and have continuing exclusive authority to do so. If the LLC hires a management company, it may have the corporate characteristic of centralized management.

Continuity of life means that the entity doesn't dissolve upon a triggering event, such as death, retirement, or expulsion of a member. Even if it does dissolve, meaning it lacks the corporate characteristic, the law says the remaining members may give themselves the important right to continue the entity. But, if the entity is automatically continued upon the triggering event, it will probably have continuity of life.

Free transferability of interests means that a member may transfer all of their membership attributes, such as their right to profits, to vote, and to participate in management, among others, without the consent of the other members. The LLC may not have this corporate characteristic when a member may transfer some of their membership attributes but must retain others. Similarly, the LLC may not have this corporate characteristic when the consent of members owning a majority of the capital interests, as opposed to unanimous consent, is required for transfer.

If you are considering the LLC move, please recognize this is a new and evolving business form. The interplay between the corporate characteristics, and the law of the state(s) in which the LLC is formed and will operate, is complex and organization is the key. Good business judgment demands you seek competent counsel.