Contractors, do you want to become licensed as an LLC?

Obtaining a contractor’s license as a LLC has significant benefits, and operating as a LLC may be attractive to many contractors. In particular, it is an option that should be considered by contractors that currently operate as a sole proprietorship or partnership.

A limited liability company or LLC is essentially a business that blends partnership and corporate attributes with the actual owners or members of the LLC accountable for limited liabilities only. One of the principal advantages of operating as an LLC is that LLCs are pass-through entities for tax purposes meaning the earnings of the LLC flow directly to the members and each member is taxed only on the earnings he/she receives.

The LLC itself is generally not subject to taxation on the income received by the LLC. Therefore, the owners or members of an LLC enjoy the pass-through taxing advantage of a sole proprietorship or partnership, but enjoy limited liability protection similar to that of a corporation.

Another advantage of operating as a LLC is that it is easier for the equity of an LLC to be transferred to the owners than is the case for a corporation. Also, LLCs are generally easier to form than corporations and are not subject to as many corporate formalities. For example, you can form an LLC with just one person.

To create a LLC, you file "articles of organization" with the Secretary of State specifying only a few basic details about your LLC, such as its name address and registered agent. You must also create a written LLC operating agreement.

The operating agreement is a crucial document because it sets out the LLC members' rights and responsibilities, their percentage interests in the business, and their share of the profits.  Operating agreements do not need to be filed with the state.

LLCs have been available in most states for many years. However, until recently, in some states, contractors and other providers of professional services could not operate as an LLC. For example, in California, under prior law, LLCs could not be licensed as contractors.

The concern was that since there were no firmly established guidelines establishing the circumstances under which the owners of the LLC could be held liable for the acts of the LLC in was against the public interest to allow contractors and other provider s of professional services to be licensed as a LLC.

However, that restriction has generally been lifted and most states now allow contractors to operate as a LLC. However, some states imposes surety bond, insurance and personnel liability requirements on LLC licensees that are not imposed on licensees that are corporations, partnerships or sole proprietors. 

For example, in California, a contractor that is licensed as an LLC must post a $100,000 surety bond (in addition to the $12,500 contractor bond) that is required for the issuance, reissuance, reinstatement, reactivation, and renewal of an LLC license for the benefit of any employee or worker damaged by the LLC’s failure to pay wages, interest on wages, or fringe benefits, as well as other contributions.

Surety bond pricing is based off a percentage of the bond amount (roughly 3% to 20%) which is calculated by the contractor’s credit history and financial strength. The financial strength of a LLC is based on the financial strength of the members of the LLC.  Therefore, in order to obtain a surety bond the individual members of a LLC must submit their personal financial information. 

A 2005 study of the surety bond industry called “Surety Credit Survey” revealed that sureties consider LLCs among the most appealing, fiscally responsible contractors because their available tax strategies give owners more freedom to remove equity from the company.

However, even if a contractor is financially sound and qualifies for a low bond rate e.g. 3%, they will still have to pay $3,000 per year for the $100,000 bond required in California for contractors licensed as a LLC.

In addition some states impose liability insurance requirements on contractors operating as a LLC that are not imposed on other contractors. In California, contractors acting as a LLC must carry liability insurance with a cumulative limit of $1 million for LLCs with five or fewer members.

Also, an additional $100,000 is required for each additional member of the personnel of record, not to exceed $5 million total.

Also, in most states a LLC can serve as the General Partner on a contractor license held by a limited or general partnership.  Also, a LLC can be formed and licensed for a particular project.

As a result, forming an LLC for a single project to be complete by a combination for contractors might be an attractive and viable option. However, as noted above, there are potential downsides to operating as a LLC that should also be evaluated before making the decision.

Mark D. Johnson is a partner in the Environmental and Land Use Group in the Los Angeles office of Alston & Bird LLP, whose practice focuses on a variety of construction, environmental and real estate issues.