Limited liability companies (“LLC”) were first allowed in 1977 when Wyoming passed a statute allowing their creation. Now every state and the District of Columbia allow business people to form LLCs. The main advantages to an LLC are the protection the LLC owners receive from business creditors and the fact that, unlike a limited partnership, the owners can still participate in the management of the business. We discuss these interesting entities in this section and conclude with a brief discussion of the taxation issues involved in an LLC.
An LLC is formed by submitting articles of organization with the Secretary of State of a state. There is a fee usually associated with the formation of the LLC, the size of which varies depending on the state.
After the parties submit the articles of organization, the owners of the LLC (called “members”) usually enter into a written agreement about how the LLC will be run, who is in charge of running it, how profits will be divided up, etc. This agreement is called the operating agreement and it is similar to a limited partnership agreement. If there is no operating agreement, then the “default” rules for running an LLC kick in. These default rules are found in the LLC statutes of the state where the articles of incorporation are filed. Generally speaking, it is better to have an operating agreement than it is to rely on the default rules, if only because it forces the members to think about many practical aspects of running a business at the outset and then agree about such matters before real money is at stake.
The people who actually run the LLC for the members are usually called the managers. The managers can be, but do not have to be, members of the LLC. The managers can be set up to resemble a board of directors if that is what the members want.
LLC Advantage Over Partnership Entities
The LLC has one very large advantage over the general partnership: members of an LLC do not take on any personal liability for the obligations of the LLC and they are only liable for debts of the LLC to the extent of their ownership interest in the LLC. (And there is no requirement that there be a general partner who retains personal liability for the LLC debts that one finds in limited partnership entities.) Moreover, unlike a limited partnership, there is little chance that members will somehow lose the LLC’s liability protection through involvement in the business affairs of the LLC.
As mentioned earlier, an LLC can opt for a management structure that allows certain people called “managers” to control the LLC. These managers usually possess the same scope of powers as a general partner would have in a standard general partnership: they can sign contracts, sell assets, and make other important business decisions for the business. The actual powers are spelled out in the state statute or, more often, in the LLC operating agreement.
But managers are not required for an LLC. The members may simply retain all managerial authority for themselves. Or they can grant partial or limited powers to certain members and/or managers. In fact, almost any practical division of power among members and/or managers is possible with an LLC. This flexibility of control by the owners is one of the very best features of the LLC.
Continuity of Existence
The death, retirement, withdrawal, or bankruptcy of a member or manager may, in some states, end the existence of the LLC. But the laws concerning this issue are currently changing, so we cannot tell you the state of the law in general. The operating agreement will usually cover this topic and your attorney should know whether the state where the articles of organization are filed allows continuity of existence in such instances. (If he does not, find a more sophisticated attorney!)
Apart from the death, retirement, bankruptcy or withdrawal of a member or manager, an LLC usually only ends upon the date of expiration (often set at 25-30 years from the date of formation) or, if there is no expiration date, then upon mutual agreement of a majority of the members.
Why use it?
The LLC is often attractive to entrepreneurs because they can retain control of the business by acting as the manager or controlling member while still being able to enjoy the tax benefits of a tax flow-through entity. It is rapidly becoming the preferred entity over limited partnerships and S-Corporations (both of which provide similar tax benefits) because the LLC does not need a general partner and does not require the legal (i.e., costly) “maintenance” associated with a S-Corporation.
The LLC enjoys the same “flow-through” tax treatment that partnerships and S-Corporations do. The rules concerning capital accounts, contributions and other basic partnership taxation principles apply to LLCs as well. So you may want to jump to our discussion of partnership taxation if you haven’t reviewed it already.
In short, this means that although the LLC must file a tax return, the LLC owners report income and pay the taxes owed on such income using their personal returns. The LLC itself does not pay taxes on its income. (At this time, the IRS has not developed a separate tax return form for LLC, so the same form used for partnerships is used, Form 1065.) The owners will each file a Schedule K-1 with their personal income tax return, which will show their “share” of the LLC income. While this structure avoids the double taxation dilemma of the C-corporation, there is a downside. The taxation downside is that, unlike a C-corporation, an LLC (like the partnerships and an S-Corporation) cannot retain earnings without the owners of the business having to pay income taxes on those earnings anyway.
One of the very best features of the LLC is the fact that you can divide up the ownership interests differently from the rights to distribution of profits (and losses). For example, suppose you went into business with another person and both of you wanted to own 50% of the business. But you were going to work at for LLC all the time while the other person was going to keep her full-time job and work for the business part-time. Well, you could each still own 50% of the ownership will dividing the profits interests into a 75%-25% split or some other ratio to reflect your different levels of effort. While you can still technically do this with a partnership, it is more difficult from a tax compliance point of view.
You should also be aware that some states impose a tax on LLC income tax (for no clear reason other than a simple money grab). So you should check with the state tax authority of each state in which your LLC will earn income to make sure that you are not going to have to pay an additional amount of money in LLC income taxes.
We recommend this structure, it really is a good entity. But it is one where you need the advice of a very good business attorney if you want to implement some of the more sophisticated LLC ownership options. As ever, we would be happy to guide you to local competent counsel in your area who could help you.