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Limited Liability Company (LLC)

A limited liability company (abbreviated L.L.C. or LLC) in the law of the vast majority of the United States is a legal form of business company offering limited liability to its owners. Often incorrectly called a “limited liability corporation” (instead of a company), it is a hybrid business entity having characteristics of both a corporation and a partnership. It is often more flexible, the owners have limited liability for the actions and debts of the company, and it is suitable for smaller companies with a single owner. The primary corporate characteristic is limited liability, while the primary partnership characteristic is the availability of pass-through income taxation.

Management

LLCs may be either member-managed or manager-managed. A member-managed LLC may be governed by a single class of members (in which case it approximates a partnership) or multiple classes of members (in which case it approximates a limited partnership). Choosing manager management creates a two-tiered management structure that approximates corporate governance, with the managers typically holding powers similar to those of corporate officers and directors. The LLC’s operating agreement (the LLC version of a partnership agreement or a corporation’s bylaws) determines how the LLC is managed. Corporations, S-corporations, Limited Liability Partnerships, Limited Partnerships, Limited Liability Limited Partnerships, and LLC’s lie along a spectrum of flexibility, with LLC’s being the most flexible, and thus preferable, for many businesses.

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Flexibility and Default Rules

The phrase “unless otherwise provided for in the operating agreement” (or its equivalent) is found throughout all existing LLC statutes and is responsible for the flexibility of the LLC.

In contrast, the phrase “unless otherwise provided for in the bylaws” is also found in all corporation law statutes, but usually only refers to relatively minor matters.

Terminology

Member

All LLCs must have at least one member. LLC members are the owners of the LLC, much as shareholders are the owners of a corporation or the partners of a partnership. Like shareholders, a member’s liability to repay the LLC’s obligations is limited to his or her capital contribution. Members may be natural persons, corporations, partnerships, or other LLCs.

Membership Interest

A member’s ownership interest in the LLC is called a membership interest. Membership interests are often divided into standardized units, which, in turn, are often called shares. Unless otherwise provided for in the operating agreement, a member’s right to control or manage the LLC is proportionate to their membership interest.

Manager

LLCs are, by default, managed by their members in proportion to their membership interests. Many LLC operating agreements, however, provide for a manager or board of managers to run the day-to-day operations of the LLC. The managers are elected or appointed by members and may also be removed by members. A member may also be a manager, often called the managing member (similar to the managing partner of a partnership).

Articles of Organization or Certificate of Formation (State Dependent)

All LLC’s must file evidence of their existence with the Secretary of State (or some governmental office) of the state where they choose to be organized. The Articles of Organization serve this purpose and are the LLC version of a corporation’s articles of incorporation. Although the specific information that must be included in the Articles of Organization vary by state, all LLC’s must disclose their company name (which must conform to rules set forth by the state of the organization), appoint a statutory agent, and disclose their valid business purpose. The fees associated with filing the Articles of Organization, or Certificates of Formation, also vary by state.

Operating Agreement

The Operating Agreement of an LLC is the document most important to its success because it determines, defines, and apportions the rights of the members. Because the various LLC statutes offer so much flexibility (see discussion below) and the default statutory rules do not fit most LLCs' needs, Operating Agreements must be drafted carefully and with much discussion and agreement between the prospective members.

Income Taxation

LLCs use IRS Form 1065 (if taxed as a partnership) and Schedule SE (Self-Employment Tax). LLC’s are organized with a document called the “articles of organization” or “the rules of organization” specified publicly by the state; additionally, it is common to have an “operating agreement” privately specified by the members. The operating agreement is a contract among the members of an LLC governing the membership, management, operation and distribution of the company.

Under some circumstances, however, the members (the LLC version of shareholders or partners) may elect for the LLC to be taxed like a corporation (taxation of the entity’s income prior to any dividends or distributions to the members and then taxation of the dividends or distributions once received as income by the members).

Operating as an LLC form of partnership does not mean that appropriate US federal partnership tax forms are not necessary, or not complex. As a partnership, the entity’s income and deductions attributed to each member are reported on that owner’s tax return.

LLC’s can lose their tax advantage without the partnership structure. The possible label “disregarded entity” for income tax purposes singles out the one-member owner of an LLC as actually earning income and deductions directly. It is the owner, then, who reports as a business proprietor rather than as an LLC operating an active trade or business. An LLC passively investing in real estate and owned by a single member would have its income and deductions reported directly on the owner’s individual tax return on a Schedule E tax form. An LLC owned by a corporation—in other words, an LLC with a single corporate member—would be treated as an incorporated branch and have its income and deductions reported on the corporate tax return, creating double taxation.

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Advantages

Check-the-box taxation. An LLC can elect to be taxed as a sole proprietor, partnership, S corporation or C corporation, providing much flexibility.
Limited liability, meaning that the owners of the LLC, called “members,” are protected from some liability for acts and debts of the LLC but are still responsible for any debts beyond the fiscal capacity of the entity.
Much less administrative paperwork and record-keeping than a corporation.
Pass-through taxation (i.e., no double taxation), unless the LLC elects to be taxed as a C corporation.
Using the default tax classification, profits are taxed personally at the member level, not at the LLC level.
LLC’s in most states are treated as entities separate from their members, whereas in other jurisdictions case law has developed deciding LLC’s are not considered to have separate juridical standing from their members (see recent D.C. decisions).
LLCs in some states can be set up with just one natural person involved.
Membership interests of LLCs can be assigned, and the economic benefits of those interests can be separated and assigned, providing the assignee with the economic benefits of distributions of profits/losses (like a partnership) without transferring the title to the membership interest (see, for example, the Virginia and Delaware LLC Acts).
Unless the LLC has chosen to be taxed as a corporation, the income of the LLC generally retains its character, for instance, as capital gains or as foreign-sourced income, in the hands of the members.

Disadvantages

Although there is no statutory requirement for an operating agreement in most states, members who operate without one may run into problems.
It may be more difficult to raise financial capital for an LLC, as investors may be more comfortable investing funds in the better-understood corporate form with a view toward an eventual IPO. One possible solution may be to form a new corporation and merge into it, dissolving the LLC and converting into a corporation.
Many states, including Alabama, California, Kentucky, New York, Pennsylvania, Tennessee, and Texas, levy a franchise tax or capital values tax on LLCs. (Beginning in 2007, Texas has replaced its franchise tax with a “margin tax”.) In essence, this franchise or business privilege tax is the “fee” the LLC pays the state for the benefit of limited liability. The franchise tax can be an amount based on revenue, an amount based on profits, or an amount based on the number of owners or the amount of capital employed in the state, or some combination of those factors, or simply a flat fee, as in Delaware. Effective in Texas for 2007, the franchise tax is replaced with the Texas Business Margin Tax. This is paid as: tax payable = revenues minus some expenses with an apportionment factor. In most states, however, the fee is nominal, and only a handful of states charge a tax comparable to the tax imposed on corporations.
Some creditors will require owners of up-and-starting LLC’s to cosign for the LLC’s loans, thus making the owners equally liable for the debt as the LLC is and effectively removing the very purpose of forming an LLC: Limited Liability
Some people, such as new business people, may not be familiar with the governance of LLCs. Unlike corporations, they are not required to have a board of directors or officers.
Taxing jurisdictions outside the US are likely to treat a US LLC as a corporation, regardless of its treatment for US tax purposes. For example, if a US LLC does business outside the US or a resident of a foreign jurisdiction is a member of a US LLC.
The LLC form of organization is relatively new, and as such, some states do not fully treat LLCs in the same manner as corporations for liability purposes, instead treating them more as a disregarded entity, meaning an individual operating a business as an LLC may in such a case be treated as operating it as a sole proprietorship, or a group operating as an LLC may be treated as a general partnership. This defeats the purpose of establishing an LLC in the first place, to have limited liability (a sole proprietor has unlimited liability for the business; in the case of a partnership, the partners have joint and several liabilities, meaning any of the partners can be held liable for the business’ debts no matter how small their investment or percentage of ownership is).
The principals of LLCs use many different titles — e.g., member, manager, managing member, managing director, chief executive officer, president, partner or authorized person. As such, it can be difficult to determine who actually has the authority to enter into a contract on the LLC’s behalf.

Variations

A Professional Limited Liability Company (PLLC or P.L.L.C.) is a limited liability company organized for the purpose of providing professional services. Usually, professions where the state requires a license to provide services, such as a doctor, chiropractor, lawyer, accountant, architect, or engineer, require the formation of a PLLC. The exact requirements of PLLCs vary from state to state. Typically, a PLLC’s members must all be professionals practicing the same profession. In addition, the limitation of personal liability for members does not extend to professional malpractice claims.
A Series LLC is a special form of a limited liability company that allows a single LLC to segregate its assets into separate series. For example, a series LLC that purchases separate pieces of real estate may put each in a separate series, so if the lender forecloses on one piece of property, the others are not affected.

Diversified Corporate Services can efficiently and cost-effectively form your LLC in all 50 states, as well as in the District of Columbia. If you have more questions regarding LLCs, be sure to speak with an attorney, CPA, or financial advisor.

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