Frequently asked questions about Limited Liability Companies (LLCs)

A Limited Liability Company is a relatively new type of business entity. Under state law, an LLC is neither a partnership nor a corporation, but a new and different type of entity, created pursuant to statute. Limited Liability Company owners are referred to as “members” and have rights that are similar to those of corporate shareholders as well as being similar to partners in a partnership. In general, the members (owners) of an LLC are not personally liable for the company’s debts and obligations, just as corporate stockholders are not personally liable for the debts and obligations of the corporation. At the same time, however, a Limited Liability Company with two or more members usually qualifies for taxation as a partnership, i.e., flow-through taxation. (A single-member LLC will not be treated as a taxable entity distinct from its member.) As a result, the Limited Liability Company may offer the best of both worlds, which are limited liability similar to a corporation as well as the flexibility and tax advantages of a partnership.

A number of states allow a Limited Liability Company to have a perpetual existence. Earlier Limited Liability Companies were required to provide a date on which the company’s existence would terminate. In most cases, unless otherwise provided in the articles of organization or a written operating agreement, a Limited Liability Company is suspended upon the death, withdrawal, resignation, or bankruptcy of a member, with some exceptions.

A major disadvantage is that there is no reliable continuity. If a member is dismissed, dies, is disabled or resigns, then the Limited Liability Company is dissolved unless the Articles of Organization or Operating Agreement state otherwise. When the Limited Liability Company is formed, it is required in some states that a date for the future dissolution of the Limited Liability Company be recorded. However, a corporation continues to exist as an entity in the event of the death, disability or dismissal of a director(s) or officer(s). There a lot of paperwork involved in creating a Limited Liability Company.

Yes. To complete the creation of a Limited Liability Company includes drafting an Operating Agreement. The Operating Agreement must be created either prior to or directly after the filing of the Articles of Organization. An Operating Agreement may be either be oral or in writing.

The Articles of Organization must be legally drafted and filed with the state office with the initial fees being paid at the same time.

A Limited Liability Company is a combination of the best aspects of a partnership and a corporation. Limited Liability Companies provide liability protection for member/owners, establishing a separate entity from the individual member/owners. However, a Limited Liability Company does not require the formalities of its managers and members that are required for a corporation. In addition, many states allow the forming of single-member Limited Liability Companies.

Many states allow for creating a single-member Limited Liability Company, while other states require two or more members. It must be remembered that the IRS may apply different tax liabilities to a Limited Liability Company with only one member (taxed as a corporation or disregarded entity for tax purposes) than it would to a Limited Liability Company having more than one member (taxed as a partnership by default).

In a number of states, a Limited Liability Company is not required to hold the simple member/manager meetings to maintain the protection provided against liability as are required by officers/directors and shareholders of corporations. For example, the state of California does not require member/manager meetings unless the Limited Liability Company’s Articles of Organization specifically require them

In the majority of cases, voting rights are proportional to the percentage of membership (ownership) interests. On the other hand, the articles of organization or operating agreement may establish a different set of conditions for voting rights

Usually, member shares may be sold only upon approval of members who hold a majority in interest, unless otherwise stipulated by the articles of organization or the operating agreement.

This decision is dependent upon an individual business and financial structure and situation. It’s best to contact a financial professional or an attorney if there are any doubts. An S corporation avoids the “double taxation” inherent in other business organizations. However, it is not as flexible as a limited liability company. Only U.S. citizens and U.S. resident aliens may own an S corporation. There is a limit of 75 shareholders. A Limited Liability Company offers different levels/classes of membership while an S corporation may only offer one class of stock. There is not a limit to the number of people who can be owners in a Limited Liability Company. A Limited Liability Company can be owned by a U.S. citizen or foreign person, a corporation or another Limited Liability Company. However, S corporations cannot be owned by other corporations, most trusts, Limited Liability Companies, partnerships, or nonresident aliens. In addition, Limited Liability Companies have no restrictions on subsidiaries.

A Limited Liability Company can be taxed for federal income tax purposes as a partnership. A Limited Liability Company can choose partnership status in order to avoid taxation at the entity level. If a Limited Liability Company is not taxed as a partnership it is often taxed as a C corporation (as chosen on the IRS 8832 form). Some Limited Liability Company owners elect to choose their Limited Liability Company to be a “disregarded entity” for taxation purposes where the owner is fully responsible to report the taxes on his personal tax returns.

A Limited Liability Company is owned by its members. The business organization may resemble either a partnership or a corporation depending on who exercises managerial responsibility. A Limited Liability Company resembles a partnership if managers are not used. In this case members have a direct say in managing and day to day activities of the company. A Limited Liability Company would resemble a corporation if its members choose to use managers to administer to the day to day activities of the company because the members will not typically participate in the day to day management.

The main difference is that the partners in a partnership are held personally liable for the debts and obligations of the partnership. In contrast, Limited Liability Company members are not personally liable for the company’s debts and obligations. Also, the Limited Liability Company statute creates specific rules for forming, operating, and managing of Limited Liability Companies, which may not apply to partnerships. For example, since an LLC is created pursuant to a specific registration process set forth in the statute, failure to go through that process essentially means that no Limited Liability Company exists. In comparison, a partnership can be created informally, without having to go through the statutory partnership registration process. Lastly, a partnership requires two or more partners, while a Limited Liability Company can be formed with a single member.

In a Limited Partnership, the limited partners have limited liability. However, every

Limited Partnership has to have at least one general partner, and that general partner is held personally liable for partnership debts. A Limited Liability Company is not required to have a “general partner”, which means that no member has to accept personal liability for debts of the entity. Also, limited partners may not participate in managing the partnership, or they lose their liability protection. Members of a Limited Liability Company, however, may participate in management without losing their liability protection.

In a C corporation, the income tax applies at both the entity level and the owner level. In a Limited Liability Company, generally partnership taxation rules apply, and therefore the income tax will apply only at the owner level (although the entity must still file a partnership information return). Furthermore, corporate statutes generally provide less flexibility in structure and governance than the Limited Liability Company law does.

In an S corporation, the double taxation that is inherent in a C corporation can be avoided, but various other restrictions apply (e.g., the “one class of stock” rule, and limits on the number and type of stockholders). A Limited Liability Company

normally offers more flexibility than an S corporation.

A member in a Limited Liability Company is shielded from vicarious liability, i.e., liability arising out of the acts of others. The member is not shielded from liability that arises out of his own acts or omissions. For example, two doctors (A and B) form a Limited Liability Company to practice medicine. Doctor A treats patient Darby, and commits malpractice. Doctor B is not involved in the treatment of patient Darby. Therefore, Doctor B will not be jointly liable to Darby simply because Doctor B is a co-member of the Limited Liability Company with Doctor A. But, Darby can sue Doctor A, and Doctor A will not be protected by the LLC structure from liability. The Limited Liability Company only protects against explicit liability, not against liability for one’s own acts.

Normally, a single-member Limited Liability Company is a “disregarded entity” for tax purposes – i.e., the existence of the Limited Liability Company is ignored, and for tax purposes the business is treated as conducted by the member. For an individual, a Limited Liability Company’s operations would be included on the individual’s tax return, usually on Schedule C. If the member is a corporation or other entity, the Limited Liability Company’s operations would be included in the tax return of the corporation or other entity. The disregarded entity treatment applies unless the Limited Liability Company positively elects to be taxed as a corporation instead. That election can be made by filing IRS Form 8832.

Although a single-member Limited Liability Company is generally disregarded for the purpose of taxing the income generated by it, the IRS recognizes that, under state law, the Limited Liability Company is a separate and distinct entity, with liabilities distinct from the liabilities of the sole member. Therefore, for purposes of liens, levies, and collections, assets held by the Limited Liability Company are not treated as if they were owned directly by the sole member, nor are assets held by the member treated as if they were owned by the Limited Liability Company.

A Limited Liability Company having two or more members is a partnership for tax purposes unless the Limited Liability Company elects (by filing IRS Form 8832) to be treated as a corporation.

In IRS Publication 541 and in Rev. Proc. 2002-69, the IRS takes the position that a husband and wife owning a Limited Liability Company as community property count as a single owner for purposes of the disregarded entity rule. Should they choose to file a partnership return for the Limited Liability Company the IRS will accept the position that the company is a partnership for tax purposes. If the Limited Liability Company interest is not community property, the husband and wife constitute two owners. However, in Publication 541, the IRS says that a husband and wife can choose to classify the Limited Liability Company as a sole proprietorship by filing a Schedule C (Form 1040) listing one spouse as the sole proprietor.

A Limited Liability Company can be managed by designated managers, who do not necessarily have to be members. In a manager-managed Limited Liability Company, the managers are specifically identified in documents which are public records, and only the managers have the power to bind the Limited Liability Company contractually. Consequently, a contract signed by a member who is not a manager would not be binding on the Limited Liability Company. This is similar to a corporation, where usually only officers (managers) have the power to bind the corporation, and a contract signed by a stockholder who is not an officer would not be enforceable against the corporation. Alternatively, a Limited Liability Company can be member-managed, with all members having the power to act for the entity. This is comparable to a partnership, where any partner can bind the partnership contractually. A Limited Liability Company’s registration (which is a public document) must indicate whether it is manager-managed or member-managed.

A Limited Liability Company can be established for a fixed period of time (after which it is dissolved), or it can have an at-will existence, whereby any member has the power to dissolve it at any time, with or without the consent of the other members. In most cases, an at-will Limited Liability Company is not desirable, since it puts the existence of the entity at the mercy of any member who may be temporarily troubled. However, an at-will Limited Liability Company might be useful if the members want to make sure that they each have an absolute right to get out at any time.

A Limited Liability Company’s Articles of Organization are similar to a corporation’s Articles of Incorporation. The Articles identify the initial members, the initial managers (if any), the address of the Limited Liability Company’s principal office or place of business, and other basic information. The Articles do not have to state the formula or method of sharing income among the members, nor do they have to state the terms (or even the existence) of buy-sell agreements. Accordingly, the real economic terms of the deal among the members do not have to be publicly disclosed.

An Operating Agreement is a written agreement among the Limited Liability Company’s members which sets forth the deal regarding governance and money. By statute, an operating agreement (if it exists) must be in writing. Therefore, by definition, there is no such thing as an oral operating agreement. An Operating is not public unless the parties choose to make it public. A Limited Liability Company is not required to have an Operating Agreement. In the absence of an Operating Agreement, various statutory default provisions will apply.

Limited Liability Company law allows a great deal of flexibility, but it includes a number of default provisions that apply unless there is an agreement to the contrary. It should be noted that since an Operating Agreement must be in writing (if it exists at all) an oral agreement to do something different from the default provisions is presumed to be both void and unenforceable. The default provisions include some rules that you may not want. For example, unless there is an agreement to the contrary, distributions to the members must be equal. Thus, if A puts in 80% of the capital and B puts in 20%, they each get 50% of the money distributed unless the Operating Agreement says otherwise. Most clients will neither expect nor want this result. It is therefore important to have a written agreement to deal with these issues.

There is no minimum amount of capital required to become a member, and the voting power of a member does not have to be related to his or her capital contribution. A member’s contribution to the capital of an LLC can be in cash, property (real or personal, including intangibles), or in the form of services. A member’s obligation to contribute capital is not excused by the member’s death; it becomes an obligation of his estate. Generally, creditors of the entity can enforce the obligations of the members to make capital contributions, but only to the extent that the entity itself could enforce such obligations. For example, assume that A agrees to pay $10,000 as his capital contribution, payable at the rate of $2,000 per year for five years. A has only paid $6,000 at the time that X obtains a judgment against the LLC. X can compel A to put in the remaining $4,000 according to the original schedule, but cannot compel him to accelerate the payments or to put in any more than $10,000, even if the judgment remains unsatisfied.

In general, a transfer of property to a partnership (including an Limited Liability Company that is treated as a partnership) in exchange for a partnership interest will not result in the recognition of gain or loss. The tax basis of the contributor in the property becomes the partnership’s basis. The partner’s basis in the partnership interest acquired is also equal to the partner’s pre-contribution basis in the property.

Although the default provisions provide for equal distributions, almost any system or formula can be agreed upon. For tax purposes, the distribution system may need to have some economic basis, but as a matter of state law the members can agree on anything they want. The allocation of profit or loss and the actual distribution of money or property are separate matters, and do not have to be either simultaneous or equal.

Default provisions give each member one vote (regardless of the size of their

own capital interests), but again this can be changed in the Operating Agreement. Voting power can be made proportional to ownership or completely unconnected to ownership. With certain exceptions, most decisions require a simple majority vote.

Members performing services for the entity are not automatically entitled to wages,

salaries, or any other compensation, although compensation can be agreed upon. Members advancing funds for legitimate expenses of the entity are entitled to reimbursement.

Generally, a third party dealing with a Limited Liability Company will want to determine whether the Limited Liability Company is member-managed or manager-managed, as this determines who is empowered to act on behalf of the entity.

In a manager-managed Limited Liability Company, only the named managers have the power to bind the company. For example, a deed conveying property from the Limited Liability Company, a mortgage, or a written contract is invalid unless signed by a manager. In general, any one manager can bind the Limited Liability Company, even if there are multiple managers. Managers are normally recognized to have authority to act on behalf of the Limited Liability Company. However, if the third party dealing with a manager knew or had notice the manager lacked authority to do a particular act, then the manager does not bind the Limited Liability Company by doing that act. In a member-managed LLC, any member has the power to bind the Limited Liability Company in carrying on in the ordinary course of business of the type carried on by the Limited Liability Company.

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