On March 4, 1977, the Wyoming state legislature passed a statute that authorized the creation of the United States’ first limited liability company. The statute presented one of the most sweeping changes in business organization law in the country’s history. The LLC offers the taxation benefits of a partnership with additional flexibility and the liability protection benefits of the corporation, without many of the corporation’s burdensome formalities.
A simple Internet search of “why form an LLC” reveals statements such as “Make Business Changes Easily”, “Protect Your Assets”, and “Avoid Double Taxation.” In this module, we’ll examine why such phrases are associated with LLCs, why it’s a popular business form for smaller companies and discuss how entrepreneurs form and operate LLCs.
An LLC is the offspring of both a partnership and corporation and shares traits from both. There are four common reasons to form an LLC.
First, the LLC can avoid double-taxation, but can also elect to be treated as a C Corporation if that makes more sense for the organization. Neither the Internal Revenue Code nor the tax regulations promulgate tax laws specific to an LLC. Instead, an LLC has the option to determine how it is taxed. If it is a single member LLC, it can choose to be treated as a sole proprietorship or as a C Corporation. If there are multiple members of the LLC, it can opt to be treated as a partnership or as a C Corporation.
The LLC makes this election by filing an “Entitle Classification Election” form with the IRS (Form 8832). This election remains in effect until the LLC changes it by filing a new form. If the LLC elects to be treated as a partnership, it must report its income on a Form 1065 and allocate income through schedule K-1’s to its members. If it elects to be treated as a sole proprietorship, the single-member simply reports the company’s income on schedule C of his personal Form 1040. If it elects to be treated as a corporation, its income is reported on a Form 1120, like any other corporation.
An LLC provides a business owner with more flexibility with membership additions and subtractions than an S Corporation. For example, assume that Will and Chris are interested in forming an email marketing service business. This segment of the marketing industry is characterized by rapid changes, inconsistency in staffing, and a constant need for adaptability. Should Will and Chris need to entice potential employees to join their business by offering them ownership stakes in the LLC, they can do so. If they had formed an S corporation, they would have been limited to 100 or fewer owners who all must be U.S. citizens or permanent residents. With an LLC, Will and Chris can issue as many membership shares as they want to as many people as they want, regardless of a prospective member’s residency status.
Another LLC advantage is the LLC’s perpetual existence even if there are changes in membership. If Will or Chris decide to exit the email marketing service industry, their business won’t dissolve. As with a corporation, many states presume that an LLC continues perpetually. In many jurisdictions, a partnership will dissolve if one partner dies or leaves the partnership and the partners don’t specify otherwise in the partnership agreement. In industries characterized by high employee turnover rates, if any LLC member decides to leave, the LLC does not terminate.
The third benefit to forming an LLC is right in its name: limited liability. An LLC’s members are not held personally liable for business obligations. An LLC member participates in the company’s growth and her liability is limited to the amount that she invested in the company, even if the LLC declares bankruptcy after incurring a lot of debt.
Fourth, LLC formation doesn’t require the LLC’s founders and members to follow a checklist of formal requirements. Generally, states impose minimal requirements when a business decides to form an LLC. Nevada has earned a pro-business reputation and many LLCs choose to incorporate in Nevada, even if they primarily do business elsewhere. There, the LLC must file articles of organization with the Nevada Secretary of State and pay a one-time filing fee of $75. There are no publication requirements and furthermore, Nevada doesn’t require the LLC owners to prepare an operating agreement.
There are, of course, some drawbacks to the LLC. First are the filing costs. An LLC is more expensive to form than a sole proprietorship or general partnership, which do not have start-up or annual fees.
The second disadvantage is that an LLC’s owners may have a difficult time finding investors and raising money from venture capitalists. First, venture capitalists don’t like an LLC’s tax implications. Unless it elects to be treated as a C corporation, it is a pass-through entity. A venture capitalist’s personal tax situation may become complicated as he becomes liable for the LLC’s taxes, even in years when he receives no cash distributions. Additionally, a state’s stockholder rules may prevent a venture capitalist from investing in an LLC. Venture capital funds sometimes have tax-exempt partners and states will prevent these partners from even receiving business income due because of their tax-exempt status. LLCs trying to draw venture capital funds or other large-scale investments might therefore consider re-incorporating as a corporation.
The third disadvantage relates to Social Security and Medicare taxes. LLC members are considered self-employed and are subject to self-employment taxes for Social Security and Medicare on their respective shares of the net income of the LLC.
The first step to create an LLC is to choose the state of formation. LLC owners will decide where to form it after examining where members hail from, as well as formation costs and formalities. Every state is different, and each state may impose its own requirements.
Once the owners choose the state of formation, the next step is filing required documents. A person known as the “organizer” handles this process. Like an incorporator for a corporation, the organizer handles all paperwork and keeps track of filing requirements. The organizer is typically an LLC member over the age of 18, or an attorney. The organizer’s primary role is to affirm that everything provided for in the LLC application is honest and accurate.
The organizer’s next step is to file the articles of organization with the Secretary of State. Like the articles of incorporation for a corporation, the articles of organization provide basic details about the LLC and act like a “birth certificate” for it. States may impose different requirements for what must be included, but the articles must have:
- the LLC’s name: must include the words ‘Limited Liability Company’ and be distinguishable from other LLC names;
- a description of the LLC’s business
- county where the LLC’s office main is located; and
- the LLC’s address
State LLC statutes typically contain no rules that govern the issuance of ownership interests, creation of classes of interests, or the allocation of equity contributions in the articles of organization. It’s a hands-off approach that allows all members to determine the LLC’s operating structure.
In some states there is a publication requirement. For example, New York requires the LLC to publish a copy of the articles of organization or a notice related to the formation in two newspapers for six consecutive weeks. The information in the published notice must include the name of the LLC and match the Department of State’s records exactly as set forth in the initial articles of organization.
Once the organizer files all forms and pays all fees, the secretary of state then either accepts or rejects the articles of organization. Assuming the articles of organization are accepted, the LLC may operate.
Organizational Structure and Internal Governance
Even though an LLC’s owners may not be required to draft an operating agreement, they may do so to avoid future conflict. An operating agreement, a document that sets out the rights and obligations of the members and determines the LLC’s operating rules, governs an LLC. The operating agreement is like a partnership agreement or a shareholder’s agreement.
The operating agreement will include provisions detailing key information such as:
- who the initial members are;
- a description of member ownership and voting interests;
- how LLC profits will be allocated to members;
- how membership interest can be transferred and;
- procedures for bringing in new members
Furthermore, the operating agreement provides operating procedures relating to scheduling meetings, giving notice, what constitutes a quorum and how voting at meetings will be conducted.
In a member-managed LLC, all members participate in the decision-making process. Each member is an LLC agent and each member votes in business decisions. Each member can make decisions on behalf of the company, but contracts and loan agreements must still be approved by a majority. Other decisions by member-managed LLCs are statutorily required to have unanimous member approval and these decisions relate to the LLC’s operation. They include votes on dissolution, merger, admission of new members, or amendments to the articles of organization or operating agreement.
If drafted, the operating agreement must provide how a member’s vote will be counted. For example, New York’s LLC statute provides.
Except as provided in the operating agreement, in managing the affairs of the limited liability company, electing managers or voting on any other matter that requires the vote at a meeting of the members pursuant to this chapter, the articles of organization or the operating agreement, each member of a limited liability company shall vote in proportion to such member’s share of the current profits of the limited liability company.
While this voting structure will make sense for many LLCs, some may wish to designate different classes of members and assign to each class differing voting rights.
Though a member-managed LLC is different than a partnership and a corporation, certain things are common to all three business forms. In a member-managed LLC, each member owes fiduciary duties to both other members and to the LLC. Most states have statutory provisions defining the applicable fiduciary duties: the duty of loyalty and the duty of care.
The other type of management structure is the “manager managed” LLC, which means that an outside manager is hired to run the company. Members relinquish the authority of the members to the manager or managers, who are the LLC’s agents. An entrepreneur may choose to form a manager-managed LLC when some members want to be passive investors in the business. These owners often feel more comfortable if the LLC delegates management responsibilities to others.
The manager-management structure is also preferable when the LLC is too large, diverse, or complex to efficiently allow for sharing management among all members or when some of members are not particularly skilled at management. For example, Chrysler LLC, one of the United States’ largest private companies, has over 70,000 employees and thousands of members. It’s unfathomable to think how business would be conducted if Chrysler were a member-managed LLC. Here, delegating management is an effective way of balancing the varied skills and interests of multiple LLC members and can ensure more competent management of the business.
Under this structure, one or more members are designated to manage the LLC on behalf of all the members, but managers don’t necessarily have to be LLC members. The managers control all the LLC’s daily activities and all managers have equal rights of management. If there are disagreements between the managers, disputes are decided by a majority vote among managers. The other members do not, and aren’t entitled to, participate in the LLC’s governance, except as to matters that require a unanimous member vote.
The operating agreement of a manager-managed LLC not only includes information regarding membership and meetings, it will also spell out procedures for appointing managers and manager terms. In the absence of such a provision, managers may be appointed by members with a majority of the voting interests.
Absent limitations in the operating agreement, managers can act unilaterally with respect to the LLC’s activities. A manager has actual authority for actions taken in ordinary course of business, unless there are multiple managers and the manager taking the action has reason to know other managers would object. Actual authority is also lacking if the manager taking the action has reason to know that other managers must be consulted before doing so.
Managers may not commit any illegal acts on behalf of the LLC. Unanimous consent is still required for certain actions such as disposing of all or substantially all property, merger or conversion of the LLC, amending the operating agreement, or any matters outside ordinary course of the LLC’s business.
Like members in a member-managed LLC, managers owe certain fiduciary duties to both members and the LLC itself. In Delaware, for example, unless eliminated or restricted in the LLC agreement, LLC managers owe default fiduciary duties, such as a duty of loyalty to the LLC and the other members, and a duty to provide information about the activities and finances of the LLC to those on whose behalf they manage. There is also an obligation of good faith and fair dealing. This is not a fiduciary duty, but rather is implied in law as part of all agreements, including the LLC’s operating agreement, or the manager’s employment agreement.
An LLC can file claims against a member for his wrongful acts, misdeeds or breach of agreement. Similarly, while the LLC’s liability shield protects members from liability “solely by reason of” his status as a member, the member may voluntarily take on additional liability, such as by guaranteeing debts of the LLC. In addition, a member can be liable for taking actions for which the member lacks authority or engaging in tortious behavior that harms another party.
Unlike a corporation, the LLC doesn’t have a board of directors. Rather, an LLC is run by its managers or member, who may then employ people to run the business.
Membership Transferability and Dissociation
A member transfers his interest in an LLC much like a partner transfers his partnership interest. Most LLC statutes distinguish between membership interests and member rights. The most important difference between the two is that the member’s transferable interest includes only the member’s share in profits and losses and the right to participate in distributions and doesn’t include the right to participate in management and control. A member’s financial interest in an LLC is freely assignable, if there aren’t any restrictions in an operating agreement.
Most states won’t allow the assignee of a member’s membership interest in an LLC to participate in the LLC’s management unless the assignee is officially admitted as a new member of the LLC. Admission to the LLC requires the unanimous consent of other LLC members unless the operating agreement says otherwise.
A member can voluntarily leave the LLC at any time. A member’s management rights and fiduciary obligations end upon dissociation. In addition to voluntary dissociation, judicial dissociation or expulsion by other members is possible if a member has violated the operating agreement’s terms. If a member successfully claims that his dissociation is wrongful, he may claim damages, but cannot force the LLC to keep him as a member.
Unlike in some partnerships, member dissociation does not result in the LLC’s dissolution. The LLC will continue to exist with the remaining members.
An LLC terminates, barring judicial intervention, when the members vote to dissolve it. Like a vote to dissolve a partnership, a vote to dissolve the LLC begins the process of termination, rather than concludes it. Many states require the filing of an articles of dissolution after the vote to dissolve. The articles of dissolution state the LLC’s name, the formation date, and the event triggering the dissolution. Upon the effective date of this document the LLC is dissolved and must stop doing its regular business and start winding up affairs.
After the filing of the articles of dissolution, the LLC will go through a winding up process. During the winding up period, three tasks remain:
- settling and closing the LLC’s activities and affairs;
- discharging the LLC’s debts, liabilities and obligations; and
- distributing the remaining assets to remaining members
This concludes our program on business organizations. The decision as to which business entity to operate under is complex but important. This program set forth some of the factors that inform this determination. Thank you for your participation.