Limited Liability Company (LLC) - A Detailed Explanation
Everything You Need to Know About an LLC
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Table of ContentsWhat is a limited liability company (LLC)?How is an LLC created?What must be included in the articles of organization?What are the LLC maintenance requirements?What is an operating agreement?How can a business change into an LLC?Who owns the LLC?Who has control over the LLC?How are members of an LLC compensated?What is the continuity of an LLC?What limited personal liability protection does the LLC offer?How can an LLC member lose personal liability protection?When is an LLC owner personally liable (other than when the court pierces the veil)?How are LLCs taxed?Are LLC distributions treated as active or passive income?What activities affect the owners basis in the LLC?Academic Research
What is a limited liability company (LLC)?
An LLC is a state-recognized entity that blends the characteristics of a GP and a corporation. The primary characteristics of an LLC are flexibility in governance, tax liability similar to that of a GP, and limited liability for the members similar to that of corporations. Note: The LLC has quickly become the most popular business entity form in the United States for small businesses with more than one owner.
How is an LLC created?
An LLC is created by filing articles of organization with the Secretary of States office. The organizer must be an individual and cannot be a corporation. There must be at least one member of the LLC. If it is only one, it is known as a single-member LLC. Like other entity filings, the Secretaries of State charge filing fees for registration. Note: Some states require businesses to publish notice of intent to create an LLC. Notice is generally achieved by publishing a notice in a local newspaper.
What must be included in the articles of organization?
The articles of organization is a simple document containing basic information about the business activity and the organizers. The articles must contain the name of the business (ending in LLC); the business address; the name of the organizer; the name, address, and contact information for a registered agent; and the business purpose. You may record the names of the members or managers if known at the time. Finally, you will need to choose whether the LLC is member-managed or manager-managed (discussed below) and how the LLC chooses to be taxed (as a partnership or corporation - discussed below). Individual states may require additional information. Note: As with other business entities, you should make certain that your chosen business name is available. That is, you must make certain another business in the state is not already using your intended business name. Most Secretary of State websites have a search function allowing you to check the availability of names. If you determine the name you want is available, you can reserve it prior to registration. This will keep others from using the name in the interim. Just because a business name is available, however, does not mean that it does not infringe on someone's trademark. You should conduct a thorough search to make certain using a given name is legal.
What are the LLC maintenance requirements?
Maintenance requirements in an LLC are minimal. The business is not required to have annual meetings. The LLC operating agreement controls the governance and internal operations of the LLC, such as holding meetings, voting rights, keeping of records, etc. At a bare minimum, LLCs must update the corporate records when any major changes take place in the business. This includes changing registered agents, moving addresses, discontinuing operations, etc. Note: The limited maintenance requirements are a big draw of the LLC over other pass-through tax entities that offer limited liability, such as the S corporation.
What is an operating agreement?
The operating agreement is the governing document for an LLC. It serves a purpose similar to the bylaws in a corporation and the partnership agreement in a partnership. The unique aspect of the operating agreement is, like the partnership agreement, it allows a great deal of flexibility in organizing the governance of the LLC. The operating agreement lays out all of the material provisions for governing the business. Common provisions include: Outlining each owners interest in the LLC, Rules for the transfer of LLC interest, The rights of each member, The authority of members, How the LLC will be managed, Allocation of business profits and losses, Voting rights and procedures, Requirements for meetings and records, and Rules for the entrance and exit of members. State law does not require that an LLC have an operating agreement, but it is a very good idea to have one. States have default rules that control the governance of the LLC and the relationships between the LLC members. These rules are comprehensive, but they often do not adequately represent the intentions of the parties.
How can a business change into an LLC?
Sole proprietorships and GPs can easily convert into an LLC by filing articles of organization. The parties then terminate or dissolve the prior business and transfer the assets to the LLC. The Secretary of States office prescribes the appropriate documents for any entity type to covert into an LLC. Many offices have standard forms called certificates of conversion to effectuate the conversion. Note: Corporations are more complicated entities and much care should be taken in converting the entity into an LLC. Converting the entity will necessarily affect the rights of shareholders, the authority of managers, and the relationship with third parties. Further, converting a business entity can have significant tax consequences for the business and its owners. Because the ownership and management structure of a corporation is far more detailed, you should consult a legal and tax professional when considering converting an entity. When converting a business entity, you will need to take care to transfer all incidental aspects of the business, such as building permits, licenses, leases, etc.
Who owns the LLC?
The equity owners of an LLC are known as members. LLCs do not have shareholders; however, members hold membership units that are very similar to equity shares. Example: Will and Grace organize their business as an LLC. They will each own the business and have the title as members. Will holds 60% ownership and Grace owns 40% of the business. In an operating agreement, Will and Grace will authorize a certain number of membership units (e.g., 100). They will then allocate these units among the members as desired (e.g., 60 units to Will and 40 units to Grace). Note: There is generally only one class of equity ownership in the LLC. There are, however, innovative ways of using contracts to provide additional rights and duties between the owners. A common form of special allocation of contractual rights is profits-only interest, which provides a right to share in profits but does not entail traditional ownership rights.
Who has control over the LLC?
Members make an election at the time of organization whether the business will be member-managed or manager-managed. Member-managed LLCs are very similar to GPs. The default rule is that each member has equal authority to manage or act on behalf of the business. As such, members should take great care to outline the authority and rights of members in the operating agreement. Manager-managed LLCs are organized more like a corporation. The members retain the authority to vote for major business decisions, but the manager(s) run the business and control the daily affairs. In such an entity, the members do not have the authority to control or act on behalf of the business. Example: Tom, Dick, and Shirley start a private detective business together and organize as an LLC. Tom and Dick will run the business and act as investigators. Shirley is simply a passive investor in the business. They will share any profits equally, but Tom and Dick will also earn a salary for their services to the LLC. In order to effectuate this plan, they organize as a manager-managed LLC. Tom and Dick are managers and members, while Shirley is just a member. Tom and Dick will have all of the managerial authority, while Shirley has the right to vote on major business decisions and to receive her share of annual LLC profits. Note: The operating agreement should be used to allocate control in a member-managed or manager-managed LLC. Failing to do so risks business liability for the actions of individuals who do not have authority to act on behalf of the business.
How are members of an LLC compensated?
Members of a LLC are not entitled to compensation for their services to the LLC. Rather, they receive a distribution of LLC profits based upon their ownership percentage in the business. Like partnerships, LLCs can allow for special allocations to LLC members. Again, these allocations are subject to the substantial economic effect test. In a manager-managed LLC, on the other hand, managers receive a salary for their services to the LLC. They do not receive a salary, however, if the manager is also a member of the LLC. In this case, the member-manager may receive a special allocation of LLC profits that exceeds her percentage of ownership. Example: In the scenario above, Tom and Dick will not receive a salary for their services to the LLC manager-managed firm. After all expenses are paid, including Tom and Dicks salaries, the profits will be distributed to the LLC members in their respective ownership percentage or pursuant to a special allocation. Note: Manager-managed LLCs treat the managers as employees of the business and the non-manager members more like passive investors.
What is the continuity of an LLC?
An LLC is a separate entity from its owners. The business continues until there is an act of dissolution by the owners. Dissociation of a member may or may not be grounds for dissolution. Like a GP, default rules restrict the transfer of LLC interests to outside parties. If a party seeks to transfer her interest or dissociate from the entity, then it is grounds for dissolution of the entity by the other parties. The business dissolves if a member dissociates from the firm, unless the other parties decide to continue the business within a statutory period of time. Dissolution requires a winding up of the business. This includes the settling of debts and the distribution of ownership interest to the parties. Most LLCs do not depend upon the default rules and address continuity within the operating agreement or within a separate buy-sell agreement. These documents will outline what constitutes events giving rise to dissolution. Note: Common events that are grounds for dissolution of the entity include: bankruptcy of a member, retirement, death or incapacity, a divorce dispute, loss of a professional license, etc. The operating agreement or other governance documents will further control the transfer of ownership, redemption rights for the members, rights of first refusal by the business, valuation of the interest, and other procedures and terms for the dissociation of a partner.
What limited personal liability protection does the LLC offer?
An important characteristic of LLCs is that the members do not face personal liability for the debts of the business entity. Members and employees are, however, agents of the LLC itself. Their actions subject the LLC to potential liability in contract and tort. The benefit of limited personal liability protection is that individual owners are shielded from personal liability created by other members or employees. Remember, an individual is always liable for her own conduct. The limited liability protections of the business entity do not protect against personal liability of ones own actions. Example: Winston and Salem form a member-managed LLC that sells cigarettes to local convenience stores. During one of his deliveries, Winston crashed into a pedestrian and injured her. She subsequently sues Winston and the LLC. Winston is potentially liable because it was his conduct that hurt the pedestrian. The LLC is potentially liable under a theory of vicarious liability, as Winston is an agent of the LLC. Salem, however, will be able to avoid personal liability for the actions of Winston. Salem still runs the risk of the plaintiff attacking the LLC entity form for failure to maintain business formalities. Note: While limited liability is a primary reason for choosing the LLC as an operating structure, it is the subject of a great deal of confusion among business owners. The misunderstanding regards the extent of limited liability afforded by forming an LLC.
How can an LLC member lose personal liability protection?
Personal liability protection is based upon the presumption that the business entity is completely separate from its members. Members who fail to maintain business formalities demonstrating this separation may lose their personal liability protection. This is known as piercing the veil and is discussed further in the context of corporations. Example: In the scenario above, suppose Winston and Salem fail to maintain business formalities. For example, they regularly right checks out of the business bank account to pay for their personal expenses. Further, the business is under-capitalized to support operations and there is no insurance policy to cover potential claims against the business. If this is the case, the plaintiff pedestrian may be able to overcome the LLCs liability shield and hold Salem personally liable for the tortious conduct of the business. Note: The considerations for when a court will pierce the veil of liability protection and subject the owners to personal liability for the debts of the business are similar for corporations and LLCs. The primary method of losing this protection is by failing to adequately maintain a separation between personal and business funds.
When is an LLC owner personally liable (other than when the court pierces the veil)?
The limited liability afforded by the business entity protects members from liability arising from the business and from the conduct of others. As with other business entities, LLC members are always personally liable for their own tortious conduct. Further, LLC members often guarantee loans made to the LLC. If the LLC defaults, the LLC member will be personally liable. Lastly, an LLC member may be liable to the LLC for conduct outside her authority that causes liability for the business. That is, the LLC may be able to bring an action against the member to recover for losses caused by the members conduct. Example: Continuing on the previous example, Winston is potentially personally liable for crashing into the pedestrian. The LLC entity status does not protect him from liability arising from his own conduct. Further, the LLC will be vicariously liable for Winston's actions because the tort was committed in the scope of employment. The LLC only insulates other LLC owners from personal liability for the debts and torts of the business (including its agents), but cannot protect a person from their own conduct. Note: The above example discusses liability for the tortious activity of the business or its agent. Liability for debts of the business is different. The LLC entity status may protect an individual for the debts of the business. An individual who incurs a debt on behalf of the business is not personally liable for the debt, even though she may have signed the agreement on behalf of the LLC to incur the debt. Review Chapter 3 on agency law for a discussion of exceeding the scope of ones authority.
How are LLCs taxed?
LLCs, like partnerships, are pass-through tax structures (unless the members choose to be taxed as a corporation). The tax regime for LLC members is very similarly to that of partners, except for a few notable exceptions discussed below. Any profits of the business pass through and are recorded on the members tax return. The LLC must complete an informational return demonstrating the profits or losses of the business and the allocation to members. The business must also provide a Form K-1 to the partners indicating their share of profits or losses. While the law is being developed, members of member-managed LLCs generally pay self-employment taxes on their distributions. This is because their distribution is treated as active income. Managers in manager-managed LLCs, unless they are also members, receive wages from the LLC. The LLC must withhold payroll taxes and the manager must pay FICA taxes. Further, a manager who is also a member must pay self-employment taxes on any distribution from the LLC, because the income is considered active income. Example: Craig and Jeff are co-owners of a consulting firm that is organized as an LLC. The LLC has several employees and other operational expenses. At the end of the year the firm made a profit of $100,000. The LLC will have to file an informational return demonstrating all revenue and expenses. It will also indicate the amount of profits attributable to each owner. Craig and Jeff will receive a K-1 from the LLC indicating their share of the business profits. This amount will be reported on their individual tax returns. Note: Currently non-managing members generally do not pay self-employment taxes on distributions, because their status if very similar to that of limited partners in a LP.
Are LLC distributions treated as active or passive income?
This is an on-going issue between courts and the IRS. The IRS has proposed the treatment of certain non-managing LLC members as passive investors subject to the passive activity rules. Courts have not yet adopted this stance and have held that LLC members should apply the test for material participation in determining whether losses are active or passive. Example: In the scenario above, assume Craig is an active member of the LLC and the sole manager of the firm. Craig earns a salary from the firm for his services as manager. Jeff is mostly a passive investor who seeks to receive a share of the firms total profits. If the court holds that Jeff has done enough to be considered a material participant, all compensation (salary or share of earnings) received by Craig and Jeff is considered active income. Unlike a LP, where Jeff's share of profits would be assumed to be passive income, in an LLC all profits may be determined to be active income to the owners. Note: Tax planners generally treat LLC members who do not materially participate in operations as passive investors.
What activities affect the owners basis in the LLC?
Unlike the GP, loans to the LLC do not necessarily increase the LLC owners basis. There is limited room for an increase in at-risk basis for LLC members who personally guarantee loans to the LLC. The IRS has taken the stance that, when there is more than one personal guarantor of a business, then personally guaranteeing a loan to the business does not increase ones at-risk basis. Example: Continuing the scenario above, Craig's basis in the business is $10,000 and Jeff's basis is $20,000. These amounts reflect the initial capital invested in the business by each LLC member. Craig later personally guarantees a loan to the business for $10,000. This may raise Craig's basis to $20,000 because he is the loan guarantor. If, however, Jeff also guarantees the loan, then the IRS may disallow an increase in the at-risk basis of either member. Note: The rule that joint personal guarantees of a loan do not increase an LLC owners basis is different from the rule in a GP. This is another topic that is subject to dispute and may be a common point of contention in the future.