The Limited Liability Company (LLC), a hybrid of the partnership and the corporation, has become a popular legal alternative for business owners. Like limited partnerships and corporations, the limited liability company has a separate legal entity from its “members.” Now available in almost all states, the LLC combines the benefits of limited liability and pass-through taxation, much like an S corporation. But the LLC’s legal structure is much looser, allowing many companies that find S corporation status too restrictive to take advantage of its benefits. Small business owners are taking advantage of the LLC because it is easier to set up and maintain than a corporation.
An LLC does not exist indefinitely. Traditionally, the articles of organization must specify the date on which the Limited Liability Company’s existence will terminate. However, many states now allow an LLC to have a perpetual existence. Unless otherwise provided in the articles of organization or a written operating agreement, an LLC is dissolved at the death, withdrawal, resignation, expulsion, or bankruptcy of a member (unless within 90 days a majority in both the profits and capital interests vote to continue the LLC).
There are two ways to split voting power among LLC members: either each member’s voting power corresponds to his or her percentage interest in the business, or each member gets one vote — called “per capita” voting. Most LLCs agree to allot votes in proportion to the members’ ownership interests.
Because the LLC is a fairly new option in the United States (it first became available in Wyoming in 1977, but most other states did not follow suit until the 1990s), the laws governing this business form are largely uninterpreted by court cases. In addition, each state has its own statutes concerning LLCs. Therefore, learning and keeping up with the laws that govern LLCs, which are still being fine-tuned, can be a tricky business. When considering the LLC option, consulting knowledgeable and up-to-date legal and tax advisors is a must.
ADVANTAGES OF FORMING AN LLC
Like corporations, LLCs provide their members (owners) with protection from personal responsibility for the company’s debt. Members are only liable to the extent of their investments in the company. If a customer slips and is injured on company property, a law suit may still bankrupt the business, but it cannot touch the personal assets of the LLC’s members. This limited liability, then, is a great advantage over partnerships. In general partnerships, all members are liable for the company’s debts and in a limited partnership, at least one member must still be liable.
Avoiding Double Taxation
Like S corporations, LLCs enjoy exemption from the double taxation required of C corporations. In other words, the LLC’s profits pass through to the company’s members who report their share of the profits on personal federal tax returns. The company itself does not pay a federal tax before the money is distributed to the members, as in the case of C corporations. But state and local taxes may still be levied against the LLC.
Flexibility of Income Distribution
According to some observers, one of the biggest benefits that small businesses enjoy when choosing LLC status is that allocation of profits and losses for tax purposes is easier under this form. Whereas the amount of profits the S corporation’s shareholders report on their federal tax returns must be proportional to their share of stock, an LLC’s members can determine amongst themselves how to divide their income as long as they follow the Internal Revenue Service’s rules on partnership income distribution.
Another great advantage of LLCs over corporations is the ease of setting up and running them. Whereas incorporation can be an involved and costly process, all that is required to start an LLC is the filing of an Articles of Organization and the drafting of an Operating Agreement defining the company’s policies and procedures (a filing fee, however, will still be required of LLCs). And whereas a corporation requires a board of directors, officers, and regular shareholders’ and directors’ meetings, an LLC is not required to observe such formalities in its operation. An LLC can be run from day to day essentially as if it were a partnership.
No Ownership Restrictions
The biggest drawback of forming an S corporation—the restrictions on the type and number of shareholders the corporation may have—is avoided by forming an LLC. The members of an LLC may be foreign nationals or other companies, both of which are prohibited from owning stock in an S corporation. In addition, there is no limit on the number of members an LLC may have, as there is with an S corporation.
Member Involvement in the Company
One problem with limited partnerships is that those partners who wish to protect themselves with limited liability (which may be all but one of the members) are prohibited from direct involvement in running the company. These partners may have only a financial investment in the firm. All members of an LLC may be directly involved in the company’s management without jeopardizing their limited liability.
Attractive to Foreign Investors
Because LLCs have been in existence in Europe and Latin America for over a century, investors from those parts of the world are particularly knowledgeable about this business form. According to The Essential Limited Liability Handbook, “LLCs often prove to be the most familiar and least imposing business structure for foreign entrepreneurs who wish to enter the American market.”
DRAWBACKS OF FORMING AN LLC
LLCs are still a very new option in most states (only Wyoming and Florida had LLC statutes on the books prior to the 1990s). This means that the statutes governing the establishment of LLCs are still evolving. And there is virtually no case history in the courts to indicate how these laws will be interpreted. The Internal Revenue Service is also still working out its position concerning LLCs, so it will be imperative for small business owners to solicit legal and tax advice on the current laws before making a decision about whether or not to form an LLC. And because the laws may change while the LLC is in existence, it will be important to keep on top of the developments in LLC statutes to determine whether it remains in the company’s best interests to operate as an LLC.
Interstate Business More Complicated
Laws governing LLCs can vary widely from state to state, complicating the conduct of business across state lines. There are, as of yet, no uniform laws concerning LLCs, so an even greater knowledge of the state laws will be required of the company that does business in more than one state.
No Perpetual Existence
Most states require that an LLC’s Operating Agreement set a limit to the company’s existence (usually 30 years). And in the absence of a clause in the Operating Agreement providing for the continuance of the LLC in the event of the death or withdrawal of a member, the LLC will cease to exist when such events occur. The transfer of ownership is also more restricted for an LLC (like a partnership) than for a corporation.
A few types of entities cannot be organized as LLCs. These include banks, insurance companies, and non-profit organizations. The situation may change in the future. Banking groups are pressuring the IRS for rule changes which would permit them to form such entities, particularly newly constituted banks.
CREATING AN LLC
It is important that the organizer(s) of a prospective LLC follow the “enabling statutes” or formation laws of the state in which the company will be formed in order to be designated as an LLC. Without this designation, the company will lack the protection of limited liability and will be treated as a general partnership. Therefore, the first step in creating an LLC is to find out your state’s specific enabling statutes.
The organizer does not have to be one of the company’s members. The organizer’s function is to file the articles of organization, a task which can be accomplished by a lawyer, a hired agent from a service company specializing in such business, or a manager of the prospective company.
Naming an LLC
Before forming an LLC, the company name must be reserved with the secretary of state or its equivalent. Most states require that the words “Limited Liability Company” or the abbreviation “LLC” be included in the name of the company. In some states, “Limited Company” or “LC” is the preferred designation. In all states, however, the name of the LLC must not resemble the name of any other corporation, LLC, partnership, or sole proprietorship that is registered with the state.
The Articles of Organization
This form, called the articles of organization or certificate of formation, must be obtained from the secretary of state’s office or its equivalent, filled out by the organizer(s), and filed with the same office. A filing fee, which varies from state to state, will also be charged. This simple document requires, at minimum, the company name and address, a description of the business to be conducted, the name and address of the registered agent (the contact to whom notices of lawsuit or other official matters can be served), the names of the company’s members and managers (usually the members themselves), and the dissolution date. Other information may be required, depending on which state the articles of organization are filed in. It is important that the articles describe the business in a way that will allow the Internal Revenue Service to designate the company a partnership for tax purposes, and not a corporation. In order for the IRS to do so, the articles must show that the company possesses no more than two of the following four characteristics (which describe a corporation):
- Perpetual existence.
- Centralized management.
- Free transferability of ownership interest.
- Limited liability.
One of the easiest ways to show that the LLC is not a corporation is to limit its existence. In fact, most states require that a dissolution date be determined in the articles of organization. On this date the LLC’s assets will be liquidated and its business will cease (occurrences such as the mutual written agreement of the members or the death or retirement of a member may also terminate the LLC’s existence before the dissolution date). If no date is specified, a default period of usually 30 years will be enacted. However, the members may decide to continue the LLC’s existence at a later date.
Filing fees vary from state to state, from $50 to $500. In addition, some states require the LLC to publish an announcement of its creation to the public in a generally circulated newspaper. This latter requirement can be very expensive, ranging from $500 to $2,000.
The Operating Agreement
At the first meeting of the members, called the organizational meeting, an operating agreement should be drafted. Although each state has laws governing how LLC’s should be operated, the members should create their own operating agreement to document that all members agree on how the company should be run. It should be carefully constructed with an eye to preventing future disagreements and deadlocks. Most basically, the agreement should address the division of profits, members’ voting rights, and company management. A good operating agreement will address the following issues:
- Who the members are and how they will be elected in the future.
- Grounds on which members may be terminated, and procedures to execute such terminations.
- Stipulations regarding allocation of business shares after the death of a member.
- If a member becomes disabled, how will the company provide for him/her (with disability insurance or out of its own funds)?
- How managers will be selected and what their duties, salaries, and grounds for dismissal will be.
- How major decisions will be made. (Which decisions will require unanimous approval of the members and which a simple majority vote? Which decisions can be delegated to the manager in charge of daily affairs?)
- How often meetings will be held and how much notice members must receive.
- Who will keep records and how they will be kept.
- How members will invest in the LLC: will only cash contributions be allowed, or can members contribute services as well? If so, which services will be accepted and how will they be valued?
- How profits and losses will be allocated to members.
- How compensation (salary) for actively participating members will be determined.
- How new capital should be acquired should the company need it.
- What procedures must be followed to transfer interests in the company.
- What banking procedures should be followed.
- Penalties, if any, if members or managers fail to act in accordance with the operating agreement.
Bennett, Elizabeth. “Federal Tax Advantages Help LLCs Gain Favor in Delaware.” Delaware Law Weekly. 29 March 2006.
Fink, Philip R. “Limited Liability Companies: Tax and Business Law.” The Tax Adviser. June 2005.
Krebsbach, Karen. “Community Banks Press IRS Change:
De novo and startup banks are eager to consider LLC status. But to be truly worthwhile, an IRS rule change is needed to make the switch more tax advantageous. So what’s the holdup?” US Banker. October 2005.
Schnee, Edward J. “Debt Allocation and LLCs.” Journal of Accountancy. September 2004.
Thompson, Margaret Gallagher. “Where We Were and Where We Are in Family Limited Partnerships.” The Legal Intelligencer. 1 August 2005.
U.S, Department of the Treasury. Internal Revenue Service. “Publications—Limited Liability Company (LLC).” Available from http://www.irs.gov/businesses/small/article/0,id=98277,00.html. Retrieved on 4 April 2006.