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What are the main characteristics of a “limited liability company”?
A limited liability company (LLC) is a state recognized entity that blends the characteristics of a GP and a corporation. The LLC has quickly become the most popular business entity form in the United States for small businesses with more than one owner. The main characteristics of an LLC are as follows:
• Creation and Maintenance – An LLC is created by filing articles of organization with the state secretary of state’s 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. Some states require businesses to publish notice of intent to create an LLC. Notice is generally achieved by publishing notice in a local newspaper. The LLC must make annual filings with state and make corrective filings when ownership of the LLC changes. There are very little mandatory governance and maintenance requirements for an LLC. The law does not require the LLC to have meetings or make reports to its owners. Any governance requirements are established by the LLC members and are outlined in the LLC operating agreement. This document 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 of an LLC are a big draw of the LLC over other pass-through tax entities that offer limited liability, such as the S corporation. An operating agreement is not required to form or maintain and LLC, and, in many cases, members of a LLC will not create one. In such a case, the state default rules regarding LLC governance apply to the business entity.
• Continuity – An LLC is a separate entity from its owners. The business continues until there is an act of dissolution by the owners. The operating agreement generally lays out the events that give rise to dissolution. It will generally provide for the ability of members to transfer ownership interest in the LLC, such as at the time of a member leaving (dissociation) or passing it to heirs upon death. The agreement may also determine whether dissociation of a member is grounds for dissolution. If the LLC does not have an operating agreement, the default rules restrict the transfer of LLC interests to outside parties. The default rule in most states is, if a party seeks to transfer her interest or dissociate from the entity, 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.
⁃ Note: Dissolution requires a winding up of the business. This includes the settling of debts and the distribution of ownership interests 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 specifically outline what constitutes events giving rise to dissolution.
• Ownership – The owners of an LLC are known as “members”. Members hold membership units that are very similar to equity shares or stock owned by shareholders (owners) of a corporation. Each member’s ownership percentage is recorded in the operating agreement. If the LLC does not have an operating agreement, the default rule is that all members of the LLC have equal ownership.
⁃ Note: Some states do not require the designation of membership units. These states allow LLCs to record ownership as a percentage. This method is similar to the method of recording ownership in a partnership.
• Control – Control and authority to act on behalf of the LLC can be in one of two structural formats. The organizers of an LLC make an election at the time of organization whether the business will be “member-managed” or “manager-managed”.
⁃ Member-Managed LLCs – Member-managed LLCs are very similar to GPs. Each member has authority to manage and act on behalf of the LLC. The default rule is that each member has equal authority. As such, members should take great care to outline the authority and rights of members in the operating agreement. This can be used to limit the authority of the member-manager. If third parties are aware of the limited authority of a member-manager, the LLC will not be obligated if the member-manager exceeds her authority when dealing with that third party.
⁃ Example: Derek and I form a member-managed LLC. We do not have an operating agreement to limit either of our authority. The default rule is that both Derek and I have complete control over LLC operations and unfettered authority to act on behalf of the LLC. If we enter into an operating agreement that limits either of our authority, it is only effective to limit our dealings with third parties if those individuals are aware of the contractual limitations.
⁃ Manager-Managed LLCs – Manager-managed LLCs are organized more like a corporation. The members do not have the authority to control or act on behalf of the business. Manager(s) run the business and control the daily affairs. The managers of the business may also be members, or they can simply be employees of the LLC hired to run the daily affairs. The members, however, retain the authority to vote for major business decisions.
⁃ Note: State registration documents generally indicate that an LLC is manager-managed. This should put third parties on notice that a member who is not a manager does not have authority to represent or act on behalf of the LLC. This may provide a defense against any claims of apparent authority if a member attempts to interact with third parties as a manager.
⁃ Example: Veronica and I form a manager-managed LLC. We are both members, but I am designated as manager. As manager, I have total control over the daily operations of the LLC. Also, I have complete authority to interact with third parties on behalf of the LLC. Veronica, as a member, has certain decision-making rights regarding the structure or governance of the LLC, but she does not have authority to manager operations or interact with third parties on behalf of the LLC.
• Limited Personal Liability – The LLC entity provides personal liability protection for its members from the debts and torts of the business entity. Members and employees are agents of the LLC and their actions subject the LLC to potential liability in contract and tort. If an agent breaches an LLC obligation or commits a tort within the scope of employment, a plaintiff may sue the LLC. The LLC (to the extent of its assets) may be liable to the plaintiff. The personal assets of the members, however, are not at risk in the lawsuit. 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 one’s own actions.
⁃ 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.
• Compensation – LLC compensation is based largely on the tax election. Most LLCs choose to be taxed as partners rather than corporation. As such, LLC members are compensated in accordance with partnership principles. That is, an LLC member is not entitled to compensation for her services to the LLC. Rather, she receives a distribution of LLC profits based upon her ownership percentage in the business or pursuant to some special allocation of profits. These special allocations are subject to the substantial economic effect test by the IRS.
⁃ Note: Employees of an LLC who are not owners receive a salary from the LLC. In a manager-managed LLC, managers receive a salary for their services to the LLC. If the manager is also a member, however, she does not receive a salary. A member-manager may, however, receive a higher distribution of LLC profits or special allocation as compensation for services to the LLC.
• Taxation – LLCs may choose to be taxed as a partnership or a corporation. See the sections on partnership and corporate taxation for further explanation.
⁃ Note: While the law is being developed, members of member-managed LLCs that are taxed as partnerships generally pay self-employment taxes on their distributions. This is true regardless of whether the member actually takes part in management. 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. 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.” In a manager-managed LLC, members who do not actively part in operations argue that their distributions are passive income and not subject to self-employment taxes. The IRS has taken the opposite view, but the issue is still largely unsettled.
• Discussion: Why do you think limited liability companies have become the most popular business entity within the United States?
• Practice Question: In a short paragraph, can you describe the primary attributes of a limited liability company?