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. An LLC is typically so flexible it is considered a design-your-own-entity.
LLC management types vary. In member-managed LLCs, every single member has a right to participate in management (decision-making). In manager-managed LLCs, designated managers carry out executive decision-making, while certain decisions may be reserved to the members. The operating agreement typically spells out who makes which decisions, who carries out conduct, and a number of other matters applicable to the entity and the parties’ rights, roles, and responsibilities.
LLC owners are called members. Membership is represented interest, which may be divided into units similar to shares or referenced as a percentage. LLCs may have multiple classes of ownership with different rights.
LLC ownership interests would generally be freely transferable unless restricted by the terms of the operating agreement, which is common. 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.
Depending on its membership, an LLC may generally select from among various forms of federal taxation. A single member LLCwill be taxed as a disregarded entity (sole proprietorship taxation) by default, but may elect to be taxed as a C-corporation (C-corp) or an S-corporation (S-corp). An LLC with two or more members will be taxed as partnership by default, but may elect to be taxed as a C-corp or an S-corp.
WHO CAN DO THIS
Any individual or entity may be an LLC member. Certain states may have additional qualifications.
Every LLC must have at least one member.
WHO HANDLES WHAT
In a member-managed LLC, members share ownership, management, and business conduct according to state law and 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, subject to applicable statutes.
In a manager-managed LLC, designated managers control decision-making and, generally, business conduct. Certain decisions are reserved to the members by the applicable statute and the operating agreement. Generally, only managers may act to bind the business.
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.
The duty of loyalty likely includes a responsibility to:
- 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;
- Act fairly in dealing with the company as or on behalf of a party with an adverse interest;
- 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 participants 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, when properly formed and maintained, 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.
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, responsibilities, roles, and duties.
LLCs generally allow member-managed or manager-managed structures, each of which may vary greatly from one entity to another.
HOW LONG YOUR BUSINESS LASTS
An LLC may generally exist in perpetuity, regardless of changes in ownership or management.
HOW YOU GET PAID
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 LLCs would generally receive self-employment income, just as partners do. In contrast, members in an LLC taxed as an S-corp would receive W2 wages at what would be the officer level of the S-corp and profit distributions at what would be the shareholder level of the S-corp.
ACCOUNTING
Accounting methods must correspond to those required under the LLC’s federal tax status.
TAXES
LLCs may be taxed as single member disregarded entities, multi-member entities taxed as partnerships, or as C-corps or S-corps.
To be taxed as a disregarded entity, single-member LLCs make no tax election. Disregarded entity taxation is the default.
To be taxed as a partnership, multi-member LLCs make no tax election. [3] Partnership taxation is the default.
To elect to be taxed as a C-corp, LLCs use Form 8832. [4]
To elect to be taxed as an S-corp, LLCs use Form 2553. [5]
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. The LLC also has many tax benefits. That said, certain investors’ tax needs may conflict with the LLC’s often-elected pass through tax treatment.
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. It is important to consider all relevant factors when contemplating Choice of Entity.
[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.