Guide to Limited Liability Companies (LLCs)

• Basics

A limited liability company (LLC) is an entity formed under a state LLC statute that combines the organizational and operational features of a partnership with the liability limitation feature of a corporation. All states permit the creation of LLCs with one member as well as LLCs with multiple members.

An LLC may be formed only by filing articles of organization with the Secretary of State of the state in which the LLC is to be organized. A written operating agreement is standard but is not required. The applicable state LLC statute typically controls matters relating to the operation and termination of an LLC not covered by a written operating agreement

As with a limited partnership, limited liability is available for members of an LLC. But with an LLC, all members, not just those who agree not to participate in management, are entitled to the protection of limited liability. As with a corporation, the LLC alone is responsible for its obligations and liabilities. An LLC member has no personal responsibility for the LLC’s obligations and liabilities, although the member’s investment in the LLC is at risk for these obligations and liabilities.

Management of an LLC may be vested in the members, in which case the members each have a right to participate in governance. Alternatively, the LLC may be manager-managed, in which case one or more managers, who may or may not be members, have the authority and responsibility for the management of the LLC.

Profits and losses of an LLC are allocated based upon the provisions of the operating agreement. If there is no agreement controlling this matter, profits and losses may be shared equally between members or in proportion to the members’ capital contributions, depending upon the terms of the applicable state LLC statute.

• Owner’s Liability

All members of a limited liability company enjoy limited liability. No member is responsible for the obligations and liabilities of the LLC. Rather, the LLC alone is accountable for these obligations and liabilities. The assets of the LLC are available to claimants and creditors for their payment. If the assets are exhausted in satisfying the LLC’s obligations and liabilities, the members of the LLC will lose their investments in the company. But the members’ assets are not exposed.

Although LLCs are a relatively new form of business entity and the law relating to member liability is scant, members can probably lose the shield of limited liability under some circumstances. As with a C corporation, if an LLC is severely undercapitalized or if the separate existence of an LLC is not respected, the courts may “pierce the corporate veil” and hold the members of the LLC personally liable for obligations and liabilities of the company.

In considering the liability limitation attribute, it is essential to remember that the liability of LLC members for contractual obligations of the LLC cannot always be limited as a practical matter. Creditors and lenders will often require at least the principal members to personally guaranty loans or indebtedness of the LLC.

• Control

The management of a limited liability company depends upon whether the LLC is member-managed or manager-managed. If an LLC is a member-managed, it operates like a partnership. If an LLC is a manager-managed, it operates like a limited partnership or corporation.

In a member-managed LLC, the members control the management of the LLC and generally function in the same manner as partners in a general partnership. However, whether each member is entitled to an equal vote, or whether members’ votes are weighted based upon their interests in capital or profits, will depend upon the applicable state LLC statute and the terms of the LLC’s operating agreement.

In a manager-managed LLC, the authority to manage the LLC is vested in one or more managers, who may or may not be members. The method of electing or appointing managers and their tenure is determined under applicable state law and the provisions of the LLC’s operating agreement.

A manager-managed LLC operates like a limited partnership if managers must be members and are appointed or elected for lengthy terms. But unlike limited partners in a limited partnership, members of a manager-managed LLC can participate in management without losing their limited liability shield. The extent of the right of members to participate in management is defined by applicable state law and the provisions of the LLC’s operating agreement.

If managers of a manager-managed LLC do not need to be members and if the members elect them on an annual or another periodic basis, the operation of the manger managed LLC will be similar to that of a corporation. In this case, the managers may function as the directors and officers of a corporation.

• Transferability of Ownership Interests

Interests of members in limited liability companies are generally transferrable. But, as with the transfer of a general partnership interest, the transferee of a member’s interest in a limited liability company usually does not acquire the right to participate in management or the right of access to the LLC’s books and records unless the transferee is admitted as a successor member by agreement of the other members.

Under the LLC statutes of some states, the limitations on the rights of transferees of members’ interests may be modified by the articles of organization or operating agreement of the LLC.

If the transferee of a membership interest in an LLC obtains only the right to profits that would otherwise have been distributed to the transferor and the assignor’s share of the LLC’s assets upon dissolution, this will limit the marketability of the membership interest as a practical matter. Also, LLC membership interests, particularly those in manager-managed LLCs, may be treated as securities for securities law purposes, which may create further impediments to transferability.

The death, dissolution, incapacity, bankruptcy, or withdrawal of a member of an LLC cause a dissolution of the LLC under the laws of most states. This result is subject to modification by the terms of the operating agreement under some state LLC statutes.

Under the check-the-box regulation, which became effective January 1, 1997, a limited liability company is no longer classified for federal income tax purposes based upon the number of corporate characteristics it possesses. Therefore, members’ interests can be made freely transferable, and an LLC can continue in existence following the death, dissolution, incapacity, bankruptcy, or withdrawal of a member, without jeopardizing an LLC’s entitlement to be taxed as a partnership.

Dissolution can disrupt the operation of the LLC’s business pending formation of a new LLC or other entity by the continuing members. It may jeopardize the ability of the continuing members to continue to operate the business. Accordingly, LLC operating agreements typically provide that the LLC may continue following the death, dissolution, incapacity, bankruptcy, or withdrawal of a member, subject to the other members of the LLC agreeing to purchase the interest of the member affected by the event of dissolution.

• Organizational and Maintenance Costs

A limited liability company is about as expensive as a limited partnership from the standpoint of organizational costs but may be more costly from the standpoint of operational costs. As with a limited partnership, an LLC is more expensive than a general partnership from the perspective of organizational and operational costs.

As with a limited partnership, the creation of an LLC requires the filing of articles or organization with the secretary of state in which the LLC is to be organized, and the filing of annual reports with that state is required. Also, if the LLC is taxed as a partnership, which is the normally the intended result, the LLC will be required to file an annual information income tax returns like a partnership even though its income or losses will be passed through and reported on members’ returns.

If an LLC wishes to do business in states other than the state in which it is organized, it will be required to qualify in those other states. As with a limited partnership, this will entail annual filings and payment of fees on a yearly basis.

The accounting requirements for an LLC are typically the same as those for a partnership or limited partnership. The complexity of the accounting records required will depend upon the nature of the LLC’s business and the number and involvement of its members.

Unlike a general or limited partnership, an LLC needs to keep records of its members’ management decisions and member meetings. Concern about the possible application of the piercing the corporate veil doctrine may make it advisable for LLCs to hold regular member or manager meetings like a corporation, with the result that the expenses of maintaining an LLC may be about the same as those for a corporation.

• Tax Attributes

A limited liability company may be treated as either a partnership or an association taxable as a corporation for federal income tax purposes. An LLC created under the laws of a state of the United States with two or more members will be treated as a partnership for federal income tax purposes unless it files an election to be taxed as a corporation. If the LLC has a single member, it will be disregarded as an entity separate from its members for federal income tax purposes unless it files an election to be taxed as a corporation.

The tax attributes of a member-managed LLC that is treated a partnership for income tax purposes are generally the same as those of a general partnership. The one difference is that since members have limited liability, at-risk rules may restrict the member’s deduction of their share of the losses of the LLC.

The tax attributes of a manager-managed LLC that is treated a partnership for income tax purposes are generally the same as those of a limited partnership. Members who are not managers are treated the same way as limited partners for self-employment tax purposes. Accordingly, these members may not be subject to self-employment tax on their share of LLC profits.

Advantages

• All members of a limited liability company enjoy limited liability for obligations and liabilities of the limited liability company, even if the members participate in management.
• There is no limitation on the number or types of members. All states allow for the creation of single-member or multiple-member LLCs.
• Management is flexible. All members may be involved in management, as with a partnership, or management authority may be vested in one or more managers, as with a corporation or limited partnership.
• Business profits are subject to only one tax, at the individual member level, and are not subject to double taxation as would be the case if a C corporation earned the profits.
• Losses are available on the members’ personal income tax returns and can offset other income (subject to the passive loss rules and at-risk rules).
• Special allocations may be made for income tax purposes.
• Disproportionate distributions may be made to members.
• An LLC may be converted to a partnership, limited partnership, C corporation, or S corporation in what is ordinarily a tax-free transaction.

Disadvantages

• The organization of an LLC requires a state-level filing, and compliance with operating formalities may be necessary to preserve limited liability.
• Qualification is required for doing business in other states.
• Regular reporting to governmental entities is required.
• Unless otherwise provided by the agreement, the termination will, in some states, result from the death, dissolution, incompetence, bankruptcy, or withdrawal of a member.
• Business profits are taxed as income to the individual members and will be subject to self-employment tax unless the LLC is manager-managed. Some members do not participate in management.
• Transfer of interests may be subject to securities law regulation.