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Limited Liability Company (LLC)

What it is:

An LLC is a limited liability business vehicle with a combination of corporate and partnership entity characteristics, and multiple alternative tax treatment options.  LLCs are flexible entities that are structured largely by their operating agreements, rather than by extensive statutory rules.  The operating agreement is a legal document; a contract created by the members to govern the business.  In general, LLCs are more flexible business forms than are corporations.  Members have great power to design the business’s structural parameters and the parties’ rights, duties, and obligations.  The entity generally has fewer state formalities with which to comply.

LLC management types vary by state.  Some states allow only member-managed LLCs, with management structures similar to partnerships in which members share ownership, management, and conduct.

Other states allow LLCs to elect to create either member-managed or manager-managed structures in which members’ ownership is separated from managers’ management; more like a corporation.

LLC owners are called members.  Ownership is represented by units of interests, similar to shares.  LLCs may have multiple classes of ownership with different rights.

Ownership interests are generally freely transferable.  A purchaser of an LLC interest generally receives only the right to the transferring member’s economic distributions, not the right to participate in LLC management.  An operating agreement should address members’ rights to transfer interests and, if any, rights to transfer membership.

There is no distinct federal LLC tax scheme.  Depending on its membership, an LLC may generally select from among various forms of federal taxation.  A single member LLC may be taxed as a disregarded entity (sole proprietorship taxation), a C-corporation (C-corp), or an S-corporation (S-corp).  An LLC with two or more members may opt for partnership, C-corp, or S-corp taxation.

LLCs are newer entities.  Their case law is still developing, and as indicated above, they are treated differently in different states.

Who can do this:

Any individual or entity may be an LLC member.  Your state may require that persons organizing an LLC meet an age or other such requirements.

Every LLC must have at least one member.

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Who handles what:

In a member-managed LLC, members share ownership, management, and business conduct according to state law or any operating agreement.  State law often provides that all members share equally in the ability to act on behalf of and bind the LLC, and that all members have equal management rights.  These provisions may generally be altered through an operating agreement.

In a manager-managed LLC, members own the company and elect or appoint managers, while managers control decision-making and business conduct.  Generally, only managers may act to bind the business (but it may be difficult for outside parties to discern which participants are authorized LLC agents).

To Whom You Are Responsible:

LLC members have rights to company information, and the LLC is responsible for keeping records and providing members access to that information.

Members of member-managed LLCs generally owe similar fiduciary duties of loyalty and care to the company and each other as would be required of general partners in a partnership.  Check your statute in this regard.

The duty of loyalty likely includes a responsibility to:

  • 1. Account to the company and hold as trustee for it any property, profit, or benefit derived from the member’s use of company property, including appropriating a company opportunity;
  • 2. Act fairly in dealing with the company as or on behalf of a party with an adverse interest;
  • 3. Refrain from competing with the company prior to dissolution.

The duty of care generally includes refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or knowing violation of law.

Members in member-managed LLCs also often owe an obligation of good faith and fair dealing in exercising company rights and duties.

Generally, only managers in manager-managed LLCs owe the fiduciary duties of loyalty and care and the obligation of good faith and fair dealing outlined above.  Members who are not managers owe no such duties.

In most states, all LLC parties owe an obligation of good faith and fair dealing in carrying out the terms of any agreement into which they enter.

LLCs are limited liability vehicles.  Thus, neither members nor managers in LLCs of either management type are personally liable for the LLC’s obligations.

The LLC is liable for its obligations and liabilities to clients, customers, creditors, and anyone who incurs injury as a result of its goods or services, or wrongful or negligent actions.

The LLC and all participants are responsible for complying with any and all applicable laws, rules, regulations, procedures.

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Your power to affect the business structure:

An LLC is a flexible business vehicle subject to applicable statutory law, which generally provides that only a handful of statutory provisions may not be altered or waived. [1]  As a result, a member-created operating agreement may almost wholly design by contract the company’s ownership structure, along with member/manager/company relationships, rights, and duties.

Where state law allows, you may choose between a member-managed and manager-managed company.

While a corporation is primarily a statutory entity, an LLC is generally a contract entity.  Those who consider the corporation more complicated than the LLC are likely referencing required corporate formalities.  Those who consider the LLC more complicated are likely referencing the fact that the entire entity must be designed and created from the ground up through the operating agreement.  It is an open form.

How long your business lasts:

Your LLC may generally exist in perpetuity, regardless of changes in ownership or management.

How you get paid:

Because there is no federal LLC tax scheme, LLC member, manager, and employee income is characterized according to tax election.  Members, managers, and employees of LLCs may receive distributions and compensation as would sole-proprietors, partners, shareholders, directors, officers, or employees of correspondingly taxed entities.

For example, income derived by an LLC taxed as a partnership will be treated and characterized as is partnership income.  Such LLC members may generally allocate items of income and loss at their discretion, per the operating agreement. [2]  All members in partnership-taxed member-managed LLCs would generally receive self-employment income, just as partners do.  Arguably, in a similarly taxed manager-managed LLC, only the manager(s)/agent(s) would receive self-employment income.  In contrast, members in an LLC taxed as an S-corp would not receive self-employment income, and would not receive specially allocated distributions.

For income purposes, generally pretend that the LLC is whatever entity type you elect for tax purposes.  In states that allow manager-managed LLCs, please get help with characterizing member income versus manager income.

Accounting:

The LLC must keep accurate records, and maintain supporting evidence for accounting entries.

Accounting methods must correspond to those required under the LLC’s federal tax status.

Please consult an accountant regarding your LLC’s particular circumstances.

Taxes:

LLCs may be taxed as single member disregarded or multi-member partnership-taxed entities, or as C-corps or S-corps.

To be taxed as a disregarded entity, single-member LLCs should make no tax election.  Disregarded entity taxation is the default.

To be taxed as a partnership, multi-member LLCs should make no tax election. [3]  Partnership taxation is the default.

To elect to be taxed as a C-corp, use Form 8832. [4]

To elect to be taxed as an S-corp, use Form 2553. [5]

If you elect to be taxed as a C- or S-corp, you may generally specify that the election become effective between seventy-five (75) days before and twelve (12) months after the date you file the election.

Please consult an accountant or other tax professional regarding the applicability of LLC tax elections and requirements to your business circumstances.

Annual State Business Filings and Formalities:

LLCs must generally file annual reports with the Secretary of State, and pay corresponding fees and charges.

Noteworthy:

LLCs are popular business forms.  An LLC combines limited liability with flexible ownership and management, and choice of taxation.  There are also generally fewer required governing formalities than those required of corporations.

However, LLCs also present drawbacks.  In some states, LLC formation and annual filing costs are substantial.  LLCs are newer, and their case law is less developed than that of other entities.  Further, statutory LLC law differs throughout the states, and no distinct federal LLC tax scheme exists.  As such, a party dealing with the company cannot presume tax type, governing structure, or rights or duties of members or managers.  Additionally, certain investors’ tax needs may conflict with the LLC’s often-elected pass through tax treatment.

If your business will operate in multiple states, or if you want an array of investors to feel comfortable with your business form, the LLC may not be ideal.

If you seek to combine the benefits of your state’s non-tax LLC attributes with your choice of entity taxation, an LLC may be a good entity choice.


[1] For example, you generally cannot restrict members’ rights to information and access to records.

[2] Special allocations must have substantial economic effect.  I.R.C. § 704(b)(2) (1986).  For a discussion of the definition of “substantial economic effect,” see Matthew Cavitch, Substantial Economic Effect, Lexis Nexis Tax Law Community (2012), available at http://www.lexisnexis.com/community/taxlaw/blogs/federal/archive/2013/01/18/substantial-economic-effect.aspx.

[3] http://www.irs.gov/publications/p3402/ar02.html.  All members of member-managed partnership-taxed LLCs must generally pay self-employment tax.  Arguably, only the manager(s)/agent(s) in similarly taxed manager-managed LLCs would pay self-employment tax.

[4] http://www.irs.gov/pub/irs-pdf/f8832.pdf (instructions are included at the bottom of the form). 

[5] http://www.irs.gov/pub/irs-pdf/f2553.pdf; instructions available at:  http://www.irs.gov/pub/irs-pdf/i2553.pdf.