The following is a general explanation of factors that go into whether or not an LLC is the most appropriate form of business organization. 

Selection of LLC for Business Organization. 

The Hawaii LLC law gives owners a lot of flexibility in how a business is owned and managed.  An LLC allows the owners of a business to create a separate legal entity from themselves.  With an LLC, the owners can either centralize the management in Managers (manager managed LLC) or can keep all management at the owner level (member managed LLC).  With an LLC, the owners can include special restrictions on either Managers or Members.

Although the Hawaii LLC statute requires that an LLC either be at will (can be ended at any time by its owners) or have a definite stated expiration, the law does not limit how long the term can be.  If a very long term is desired, the expiration can be set a hundred or a thousand years in the future.

Like a corporation, an LLC will allow its owners to limit their liability for the business to the amount of the capital that they invest in the business.

In recent years, the ability to limit liability has become increasingly important.  Like a corporation, the owners of an LLC can limit their liability to the amount they invested in the business.  The LLC owner (member), like the shareholder in a corporation, is not as exposed to liability from lawsuits since the member generally is not responsible for the negligence of an LLC's employee.  However, the protection is not absolute and using an LLC is not a substitute for appropriate liabilityinsurance.  If the owner personally is negligent in injuring someone or damaging their property, that owner will be liable even if the negligence occurred while the owner was acting for the LLC.  Similarly, if an owner with responsibility for the LLC payroll does not see that appropriate employee withholdings are made for income tax and FICA, that owner may be held personally liable and may be subject to penalties.  

The flexibility of the LLC as compared to a corporation is one of the main reasons that an LLC may be more attractive to use than the corporation.  Another factor is that an LLC with more than one member can choose to be taxed as either a partnership or corporation for income tax purposes.  This allows owners in an LLC to avoid the potential complications of the income tax laws when distributions of appreciated property from the business become necessary.

One factor which favors corporations over LLCs is that the operating history of LLCs in the United States is relatively short and the case law covering various aspects of operating the business entity is accordingly not developed for LLCs as it is for corporations. 

At this point in Hawaii, the choice of business entity for multiple owner businesses are a corporation, general partnership, limited partnership, limited liability partnership, and limited liability company.  Limited liability companies and to some extent limited liability partnerships allow owners to limit their liability for business liabilities in a manner similar to that of corporate shareholders, while allowing income tax treatment under the partnership income tax laws.  In many cases, it will be possible to convert partnerships into limited liability companies without adverse income tax consequences, but in that case, the terms of the partnership must be carefully set up to minimize the problems on the conversion.  Converting a corporation to a limited liability company is also possible, but involves a much greater risk of adverse income tax consequences.

Operating an LLC

State corporation statutes set substantially fewer minimum requirements for the operation of an LLC than for a corporation.  Hawaii's statute requires that the LLC file annual exhibits with the State.  If the LLC has an Operating Agreement, it must be in writing.  The state law also provides that Operating Agreements and Articles of Organization cannot have certain provisions that would eliminate some rights provided to members of an LLC by that law.  With those exceptions, the state law generally gives the owners great latitude in defining their rights in the LLC documents.

Although there are fewer required formalities for LLC's than for corporations, it is still important to conduct the business of an LLC so that it appears to the outside world that the business is being run as an LLC and not as the personal business of its owners.  Using the LLC name on letters, invoices and other business documents help establish this distinction as does the use of the LLC titles by the managers or members. 

Ownership of LLC

Members are the owners of an LLC.  The simplest type of LLC will have one class of members, all of whom have profit and loss shares and all of whom have voting rights in LLC business. If the LLC is manager managed, the members select the managers.  Members typically have voting rights proportionate to their profit and loss shares. However, the members can agree otherwise.  With manager managed LLC's, the members can arrange it so that management is kept to certain people by naming them Managers, while having the ownership of the member's interest pass to other persons.  The members can also agree to special provisions which allow some members to receive preferential distributions. The Hawaii law will recognize these provisions.  However, if the LLC chooses to be taxed as a partnership for income tax purposes, the income tax regulations may require that the income tax effects be calculated differently than the LLC documents would indicate.  Since in most cases the multi member LLC will elect partnership income taxation, the typical LLC documents will avoid conflicting with the partnership income tax regulations. 

Membership Transfers and Offerings. 

The LLC documents or agreements between members and the LLC can regulate and restrict the terms and types of transfers of membership rights.  In most LLCs, there are very restrictive provisions governing the transfers.

Offerings of the membership interests may be governed by federal and state securities laws and certain offerings require registration of information and documents with either the federal SEC or the State equivalent.  The registration requirements are designed to provide investors with important information concerning the membership rights and the LLC.  The registration process can be very costly and may take many months to complete. For most LLCs, one or more exemptions from these laws apply so that either an abbreviated filing procedure is used instead of full registration or no registration is not required at all. However, the antifraud provisions of the federal and state securities laws apply even to transactions that do not require registration so those offering memberships must be careful at all times not to make material misrepresentations to offerees with respect to the memberships or the business.

Funding the LLC

Members typically invest money or property in an LLC for membership interests.  For LLCs there is no minimum capitalization.  However, if a substantial business has too little capital, it may be vulnerable to attacks by creditors or by the IRS and State Tax Office.  Although there are some limitations and exceptions, contributing capital assets that are expected to appreciate in value over time to an LLC does not raise the same concerns as a contribution to a corporation.  If the LLC elects income taxation as a partnership, the same rules that apply to partnerships will apply to LLCs.

Converting an ongoing business into an LLC from a corporation can become complex and frequently requires a thorough analysis into the consequences.  The process often requires extensive analysis of the assets and liabilities of the business and sufficient time should be allowed so that this can be done properly.  Converting a partnership into an LLC is usually not as complicated since in most cases, for income tax purposes, the tax partnership will simply carry over into the LLC.  If there are changes in the interests of the members or if liabilities or equity interests are shifted in the process, there may be some income tax consequences, but that would be true even if the partnership did not convert into an LLC.

Income Tax Considerations. 

In most multi member LLCs, the income taxation will be partnership income taxation.  For one member LLC's the choices will be between not recognizing a separate tax entity from its sole member or being taxed as a separate corporation.  The uncertainties and risks of being able to choose the form of taxations were resolved when the IRS decided to use the "check the box" regulations under which the multi member LLC can simply choose corporate, or partnership income taxation with no risk that the IRS would challenge its eligibility.  Similarly, the check the box regulations allow the member to simply choose between ignoring the separate income tax existence of the LLC from its sole member or having it taxed as a corporation.

Employment Law

Forming an LLC may create a separate legal entity which may be an employer.  For small businesses, this may significantly increase payroll and operating costs since the member who actually performs services in the business will be counted as an employee for withholding, FICA, unemployment and workers compensation purposes.  In some cases, this can dramatically increase costs and must be considered.

Decision to Select Income Tax Treatment

The decision as to whether or not to select the appropriate income tax treatment under the check the box regulations involves looking at many factors.  It is difficult to do so without the help of tax professionals as well as an attorney. If you have not already done so, you should consider retaining a certified public accountant (CPA) to help you in considering your options and in setting up your accounting system.