Limited Liability Companies

Chapter 6

A limited liability company is a cross between a partnership and a corporation, owned by members who may manage the company directly or delegate to officers or managers who are similar to a corporation’s directors.

Introduction

A limited liability company is a hybrid between corporations and partnerships, with all of the advantages of limited partnerships and none of its disadvantages.

The limited liability company was designed as a vehicle to keep the attractions of a limited partnership while avoiding its downside: liability for the general partners.

Under a limited liability company arrangement, none of the owners face the specter of unlimited liability.

Their personal assets are not in danger.

"In general, the purpose of forming a limited liability company is to create an entity that offers investors the protections of limited liability and the flow-through tax status of partnerships" (Jonathan R. Macey, The Limited Liability Company: Lessons for Corporate Law, 73 Wash. U. L.Q. 433, 434 (1995)).

Organization of a Limited Liability Company

Limited liability companies do not have general partners.

Instead, the persons responsible for the day-to-day management of the business are referred to as managers.

The investors in the business are called members.

The members have voting rights about business decisions and are permitted to take an active role in the operation of the business.

Managers may also be members.

They all enjoy the protection of limited liability, so there is no practical reason to bar managers from also investing in the business as members.

A limited liability company has at least one member who has membership interest in the company. Managers control the business and are permitted to be members.

Members of a limited liability company retain the

right to vote on changes in the operating agreement and to set limits on the addition of new members into the company.

Members own a percentage of the company, but the company itself has a separate existence.

In other words, limited liability companies can act like individuals.

For example, limited liability companies can own property.

In limited liability companies, an individual member’s liability is again restricted to the amount of his or her contribution to the business.

Like limited partnerships, contributions to limited liability companies can come in the form of cash or services.

Members of limited liability companies face no personal liability for the company's debts, judgments, or other assessments.

Unlike limited partnerships, managers are also protected by limited liability.

Advantages of Limited Liability Companies

Limited liability companies enjoy certain advantages over the corporate model.

The way that taxes are assessed against limited liability companies is different from the method used to assess taxes against corporations.

Limited liability companies offer great flexibility to their owners and protection for everyone involved in the enterprise.

Tax Advantages of the LLC

The best advantage of a limited liability company structure is the tax benefit.

Similar to limited partnerships, a limited liability company has the pass-through feature of tax treatment.

Members can deduct business losses on their personal income taxes.

In 1988, the IRS ruled that limited liability companies should be taxed like limited partnerships rather than as corporations, which legitimized limited liability companies as a business structure.

As long as a limited liability company meets certain prerequisites, it is taxed in exactly the same way as a limited partnership.

In 1996, the IRS again revisited the issue of limited liability companies and corporations.

Under the new rules, business organizers can choose their business type and as long as it qualifies under state law, the IRS will treat it by its own classification.

Under this rule, a company that calls itself a limited liability company and is organized and registered under state law as a LLC will be taxed as one.

IRS Entity Classifications

Factors to ensure that a business will be considered a limited liability company by the IRS:

Does the business have a fixed date for termination?

Will the business terminate on the death, retirement, or bankruptcy of a member?

Are there limitations on the power of the business to transfer ownership interests to others?

(con’t)

IRS Entity Classifications (con’t)

Are there provisions that provide limited liability for managers and members?

Has the business filed with the state as a limited liability company?

Has it filed articles of organization? Does it have an operating agreement?

If the answer to all of these questions is yes, the IRS will probably rule that the business is a limited liability company.

Creation of a Limited Liability Company

Depending on the state, the regulations concerning the creation, day-to-day operation, and dissolution of limited liability companies can vary considerably.

Many states enacted tax legislation to encourage companies to form their limited liability companies in their states.

Creating a limited liability company is a relatively simple process involving filing appropriate documentation, such as the articles of organization and name reservation forms.

In addition, the parties will also draft an operating agreement.

Limited Liability Companies as Creatures of Statutes

This business structure derives exclusively from state statutes, and the statutes must be closely followed in order to create a viable limited liability company.

There is no common law of limited liability companies.

The Uniform Limited Liability Company Act

The Uniform Limited Liability Company Act grew out of a need for a uniform system of creating, maintaining, and dissolving a limited liability company.

Filing Requirements

Limited liability companies are formed first by filing the appropriate documentation with the state secretary of state office.

One piece of this documentation is the application to reserve a specific name.

In addition to that filing, most states require limited liability companies to file a copy of their articles of organization.

Reserving a Company Name

All states have provisions that allow a prospective company to reserve a company name before they officially file for limited liability company status.

This application reserves the name and prevents others from using it before the company has completed its application process.

Naming Restrictions on a Limited Liability Company

The official name must contain the words "limited liability company" or the abbreviation “LLC.”

This is to put the public on notice that it is dealing with a company that enjoys the protections of limited liability.

Articles of Organization Similar to the Certificate of Limited Partnership,

the Articles of Organization set out the details of the limited liability company.

The articles of organization will list the name of the agent for service of process, the mailing address of the principal office of the company, the style of management, and any other matters that the owners feel they wish to make a part of the public record.

Operating Agreement

The operating agreement forms the entire framework for all interactions between members in a LLC.

The agreement sets out the many issues involved in creating, running, and eventually dissolving the business.

Any operating agreement should address the following issues:

Finance and management Members’ percentage of interest in the LLC Members' rights and responsibilities Members' voting power Allocation of profits and losses Rules for meetings and votes Transfer issues

Judicial Interpretation of Operating Agreements

Courts are often called upon to interpret the language in operating agreements in the same way that they must interpret the language in contracts and partnership agreements.

When an operating agreement contains

ambiguous or contradictory terms, courts must attempt to resolve these conflicts in order to keep the company functioning.

Unwritten or NonexistentOperating Agreements

Given the importance of the operating agreement, it might seem odd to consider the fact that the laws authorizing limited liability companies do not actually require one.

Most states opt for an approach that takes a very liberal view of what constitutes an operating agreement.

Transfer of Interests

Modern law allows members to freely transfer their interests to others.

Dissolution of a Limited Liability Company

Limited liability companies can be dissolved by a number of actions:

A limited liability company might have a specific life span. The company may have been created with a specific time period in mind. When that time period is up, the company will automatically dissolve.

The company may have been formed with a specific purpose in mind, and when that purpose is satisfied, the operating agreement authorizes the termination of the company.

The withdrawal of a member will also trigger the dissolution of the limited liability company.

There are usually provisions in the operating agreement that allow the members to expel one of their own for a specific reason and thus keep the limited liability company functioning.

Members can be removed from the company by the votes of the other members. A member may lose his membership for any of the following reasons:

Filing a personal bankruptcy Death Declaration of mental incompetence

Consequences of Member Withdrawal

When a member withdraws from a limited liability company, he or she is entitled to a return of their original contribution.

Contribution consists of the monetary investment that the member made in the business.

Contribution can also come in the form of services provided, property transferred, or anything else of value.

Summary

Limited liability companies offer several advantages over other types of business structures.

In a limited liability company, there are no general partners.

Instead, all members are protected by limited liability.

Limited liability companies offer some of the same advantages as limited partnerships.

For instance, business profits and losses are "passed through" on the individual owner’s income tax returns.

This avoids the problem of double taxation, where the business and the individual owners must each file a separate income tax return.

Summary

Limited liability companies are organized with managers and members.

Managers run the day-to-day operation of the business, while members enjoy the profits from the business.

In limited liability companies, managers may also be members.

This means that all of the participants are protected by limited liability coverage.

Summary

Limited liability companies are organized in operating agreements that set out the rights and responsibilities of all members.

In order to be recognized as a limited liability company, the business must file appropriate documentation with the state.

This documentation includes not only a notice that the business intends to operate as a limited liability company, but also articles of organization.

These articles of organization are the bylaws for how the business will be run.

Summary

Limited liability companies can terminate in several different ways.

The operating agreement may set a specific date of termination of the business, or the company may terminate upon the death or bankruptcy of a member.

Limited liability companies have great flexibility in their day-to-day operation, but they do have some limitations.

For instance, the business must contain the words "limited liability company" or the abbreviation “LLC” in order to be considered a valid legal entity.

Summary