One topic that often arises with clients who are sole proprietors of a business is the subject of transitioning to another business entity, such as a corporation. There are two important reasons to consider changing entities: tax planning and liability protection.

Corporations and limited liability companies, unlike sole proprietorships, offer liability protection – members/shareholders are generally not personally liable for the company’s debts.

However, they are at risk for their investment in the LLC or corporation. (It’s important to understand that an entity alone typically cannot protect you fully, so there is usually a need for insurance.)

While there are numerous entity options for small-business owners, the discussion should include a consideration of the limited liability company.

An LLC is a hybrid of a partnership or sole proprietorship and a corporation. The entity can be treated as if it were a corporation for liability purposes and taxed as a partnership or a sole proprietorship.

Both S-Corps and LLCs are similar in that income “passes through” to the owners’ individual tax returns, avoiding double taxation that a corporation may generate.

LLCs are often attractive to a growing business for several reasons:

• They are simple and inexpensive to create and operate.

• There are no limits on members and type of members.

• Profits are taxed only once.

• Members’ losses can be deducted.

• Maine specifically allows for single-member LLCs.

• Generally, member contribution of appreciated property does not generate a taxable event.

• Liquidation is usually tax-free for members.

On the other hand, there are a number of trade-offs in forming as an LLC:

• The life of an LLC may be limited.

• LLCs are dealt with differently from state to state.

• Normally, LLC members have the right to depart from the LLC.

• Member-employee fringe benefits are taxable.

The LLC can be a superior selection for many business ventures with a limited number of active investors.

It is well suited for real estate investments, passive investments or joint ventures between existing businesses. It is also a good choice for closely held family businesses concerned with maintaining control within the family.

LLCs are relatively economical and easy to form and sustain. However, because LLCs are a creature of state law, you need to file articles or a certificate of organization within your state, and you need an operating agreement that outlines how the LLC will work and the relationship between members.

A major benefit of LLCs is that member losses can be deducted on each member’s personal tax returns. Furthermore, within certain limits, a member’s deductions can be specially allocated. For example, a member in a relatively high tax bracket can have a larger number of deductions allocated to him or her.

In most LLCs, members participate in the general management of the entity. However, members can choose to elect a small committee to manage the day-to-day operations. The committee of managers then would have the power to bind all LLC members.

All of the LLC’s assets are distributed to the members when the LLC is liquidated. In most cases, the members are not taxed. However, the LLC members may recognize gains or losses to the extent that money is distributed to them in liquidation of the LLC.

In the end, an LLC may be the best fit for your business. However, the LLC does have limitations, so a full investigation of all the entity options can help you make the right choice. The best way to start is to examine your personal goals, pull together your team of advisers and seek lots of input.