A Limited Liability Company (“LLC”) is a form of business organization created under state law that combines the corporate advantages of limited liability with the partnership advantage of pass-through tax treatment.
Often considered a “hybrid” of a partnership and corporation, a LLC is similar in structure to a partnership but subjects its Members to no personal liability for the entity’s debts or liabilities.
The LLC is owned by its “Members.” They are analogous to partners in a partnership or shareholders in a corporation, depending on the manner in which the Members choose to “manage” the affairs of the LLC.
- Members will more closely resemble Shareholders if the LLC selects the “Manager” method of management, because the Members will not participate in the day-to-day operation of the company.
- Members will more closely resemble Partners if the LLC selects the “Member” method of management, because the Members will have direct decision-making authority in day-to-day decisions of the company.
A Member’s ownership of an LLC is represented by their “interests,” just as Shareholders have stock in a corporation and partners hold interests in a partnership.
The LLC is an entity formed under state law by filing with Office of the Secretary of State an organizing document typically called the “Articles of Organization” in most states or the “Certificate of Organization” as in Delaware. The LLC does not come into existence until the Articles or Certificate is filed with the Office of the Secretary of State. It must also obtain a Federal Employer Identification Number and state tax identification if it expects to be taxed other than at the personal level.
The rights, obligations and authority of the owners of the company (i.e., the Members), the Managers, and the Officers are established in a document called either an “Operating Agreement” or “Member Control Agreement.” This Agreement can address a variety of critical decisions about the existence of the LLC, such as what events will trigger dissolution. Unless all Members wish to be involved in day-to-day operations, the Members will elect Managers, who act like the Board of Directors of a Corporation, and are responsible for managing the business, property and affairs of the company, including the hiring and firing of Officers who run company operations.
Many state laws require at least the following issues to be addressed in the Operating Agreement:
- The names and membership interests of all the members;
- The amount of cash and the agreed upon value of other property or services contributed for each membership interest identified above;
- The amount and value of any cash contributions under a contribution agreement and the events that require further contributions from members;
- A description of rights regarding distributions of cash or property to the members; and
- The events that will cause the LLC to dissolve.
Courts are generally very strict about the formal requirements of LLC status, so Members must strictly comply with the requirements of the state statute. If Members stray too far from those requirements, Courts will “pierce the corporate veil” and impose personal liability for the LLC’s debts and obligations among all the Members. In other words, “Owners expecting to enjoy the limited liability provided by the statute should comply with the demands of the statute.” (See footnote i.)
The Members of an LLC can elect the manner in which the entity will be taxed – as a Sole Proprietorship, a Partnership or a Corporation. If the LLC elects not to be taxed as a corporation (that is, as a separate legal entity), the profit earned by the LLC flows through to the Member(s) who report it as income on their personal tax return – IRS Form 1041. The LLC is a “pass-through” entity for federal tax purposes. The Member(s) make their tax treatment election using IRS Form 8832, Entity Classification Election. For the individual member, income and expenses are reported on Schedule C, “Profit or (Loss) from Business,” of the owner’s Form 1040. Since the Member is taxed at the individual level, her “tax bracket” applies to her share of the profit. (See footnote ii.)
The LLC represents an extremely progressive movement in the evolution of business entities: it eradicates the age-old requirement that, in order to have limited liability for the debts and obligations of the business, owners had to sacrifice any rights to manage day-to-day affairs. Personal liability is limited to the amount of investment, regardless of involvement.
The common link in each of the LLC statutes, however, is either presumptive or optional management by the owners. The concept of separating management authority and structure from limited liability is gone. The LLC exemplifies a crossroads in the development of business organization law. No longer is managerial passivity the price that must be paid for limited liability. (See footnote iii.)
No matter the direction the Members take in organizational decisions, they are no longer subject to jeopardy if they both invest and manage the business affairs of the LLC. In this light, the LLC form of business organization exalts the mutual concepts of flexible management and flexible ownership. Like GPs, LLCs are absolutely free to establish any organizational structure agreed upon by the Members. Among other things, the right to vote in the affairs of the LLC may be separated from the rights to share in profits.
With respect to tax treatment, the LLC offers the tremendous advantage of being eligible for a single level of federal income tax. (See footnote iv.) In 1997, the IRS issued regulations that clarified the options for one or more taxation treatments for the LLC. Commonly referred to as the “check the box” regulations, an LLC may be classified for federal income tax purposes as if it were a sole proprietorship, a partnership or a corporation. If the LLC has only one Member, it will automatically be treated as if it were a sole proprietorship, unless an election is made to be treated as a corporation. If the LLC has two or more Members, it will automatically be considered to be a partnership, unless an election is made to be treated as a corporation. Finally, if the Member(s) fails to elect a preferred method of taxation treatment, the IRS will impose a default classification of a sole proprietorship for the single-member LLC and a partnership for a multi-member LLC.
The primary disadvantage of the LLC as a form of business organization is that it requires a more formal definition of Member rights and obligations than other types of entities. The LLC must prepare an Operating or Member Control Agreement that must be tailored to the company and the needs of its Members. Often, Members will need the professional advice of attorneys and accountants to properly structure the company and obtain the most favorable tax treatment. All of this advice comes at a financial cost to the Members that usually is avoided with a GP.
The lack of restrictions on the make-up of owners and the ability to have more than one class of stock makes the LLC form of business organization an enticing one in comparison to its cousin, the “Subchapter S” Corporation.
[i] Matheson and Eby, supra, at 175. See also, Fredric J. Bendremer, Delaware LLCs and Veil Piercing: Limited Liability Has Its Limitations, 10 Fordham J.Corp. & Fin.L. 385 (2005).
[ii] Please note that the state income taxation treatment of LLC profits and losses may or may not mirror that of the IRS, depending on the state of jurisdiction.
[iii] Id. at 167.
[iv] See IRS Publication 3402.