A limited liability company ("LLC") is a private company with specified limitations to operate in the United States. This business structure combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation.
An LLC has the option to form an Operating Agreement which provides the rules for all ownership transfer, voting rights, business activities, management structure, management authority and any other questions important to the success of the business.
Limited Liability Company
A limited liability company is a corporate structure whereby the members of the company cannot be held personally liable for the corporation's debts or obligations. Limited liability companies differ slightly from one country to the next. However, it is essentially a hybrid entity that combines the characteristics of a corporation and a partnership or sole proprietorship. While the limited liability feature is similar to that of a corporation, the availability of flow-through taxation to the members of an LLC is an element of partnerships. An LLC has to be dissolved upon the death or bankruptcy of a member, unlike a corporation, which can exist in perpetuity. Also, an LLC may not be a suitable option when the objective of the founder is to become a publicly listed company eventually.
Limited Liability: This is one of the features of an LLC in which it resembles the corporations. LLC provides its owners a protective shield against business debt and responsibility. Let’s take an example; there is a shoe store “boot & boot” owned by Jimmy which loses its customers to one of the most fancy stores around the corner. The business is not doing well, and the company hasn’t paid rent for last eight months and bills for three shipments of shoes. Thus “boot & boot” owes approximately $75,000 to its creditors who have filled a lawsuit against the company. The creditors have full right to claim the money owed from the company but have no right to Jimmy’s personal assets (bank deposits or gold or real estate). In an LLC, only the company’s assets can be liquidated to repay the debt and not the owners. This is a significant advantage which is not provided by a sole proprietorship or partnership where owners and the business are legally considered the same adding vulnerability of personal assets
Taxation: The company is not taxed directly by IRS as an LLC is not considered a separate tax entity. Instead, the tax liability is to the members who pay through their personal income tax. Let’s look at an example. Say “boot & boot” has two members and has made net profits to the tune of $60,000 in a year. The net profits will be divided into two (number of members) and this amount will be taxed as their personal income depending upon their overall tax liability. Because of nonrecognition of LLC as a business entity for taxation purposes, the tax return has to be filed as a corporation, partnership or sole proprietorship. Remember that individual LLCs are automatically classified by IRS as a corporation for tax purposes, so be sure to know if your business falls into this category. Those LLCs which not automatically classified as a corporation can pick the business entity of choice by filing the Form 8832. The same type of form is used in case the LLC wants to change the classification status. Click here for more details.
Less Hassles: Among all forms of companies, start-up of an LLC is easier with lesser complexities, paperwork, and costs. This type of company comes with a lot of operational ease with less record keeping and compliance issues. LLCs also provide a lot of freedom in management as there no requirement of having a board of directors, annual meetings or maintaining strict record books. These features reduce unnecessary hassles and help save a lot of time and effort. The formation of an LLC broadly requires filing the “articles of organization” which is a document including basic information like business name, address, members. The filing is done with the Secretary of State for most states and has an associated filling fee. Next, comes creating an Operating Agreement which though is not mandatory in most states but is recommended especially for multi-member LLCs. On registration of the business, other licenses and permits have to be obtained. Additionally, some states like Arizona and New York require publishing about the LLC formation in the local newspaper.
Flexibility in Allocation: LLC provides a lot of flexibility when it comes to investing as well as profit sharing. In an LLC, members can opt to invest in a different proportion than their ownership percentage i.e. a person who owns 25% of the LLC, need not contribute money in the same proportion for the initial investment. This can be done by creating an operating agreement which states percentages of company profits (and losses) for each member regardless of the amounts of their initial investments. So, it’s possible to have an outside investor put money in the business without ownership. The same applies to the distribution of profits where LLC members have the flexibility to decide the allocation of profits. The division of profits can be in a different proportion than ownership. A certain member may take a bigger chunk of profits by consensus for the extra hours or effort he/she has put in carrying out the business.
While a limited liability company (LLC) offers an edge over some of the other forms of business entity, there are also some drawbacks which need to be looked at before selecting an LLC as the corporate structure.
Limited Life: The life of an LLC is limited by the tenure of its members. While there can be variations across states, in most of them the business is dissolved or ceases to exist when a member departs an LLC further requiring the other members to complete the remaining business or legal obligations needed to close the business. The rest of the members can choose to set-up a new LLC or part ways. This weakness of an LLC can be overcome by including appropriate provisions in the operating agreement.
Self-Employment Taxes: The members of an LLC have to pay the self-employed tax contributions towards Medicare and Social Security as they are considered as self-employed. Due to this, the net income of the business is subject to this tax. To avoid this, depending upon the business turnover and tax burden, the entity can choose to be taxed as a corporation if it works out more beneficial. Consult an accountant before making this choice.
Fees: The fee which is typically paid by an LLC as initial costs or ongoing charges is more than that for business entities like a sole proprietorship or general partnership but less than what a C-corporation has to pay. The various types of fees include - applicable state filing fees, ongoing fees, annual report fees, etc.
Precedent is Less: LLC is a relatively newer business structure, and thus there have not been many law cases related to them. For this reason, there is not much legal precedent or case law for LLCs as there is for the older forms. Having a certain legal precedence helps to act accordingly in the same given case scenario. There is more vulnerability as there are few established laws.
LLC is a good combination of protection with flexibility and tax benefits. It provides an array of taxation alternatives while shielding individual members from personal liability. LLCs are seen as apt for small businesses as there are less hassle and complexity in its functioning. However, consulting an accountant or lawyer for expert opinion is advisable before taking the final call.
An LLC member is an owner of the company. All owners of LLCs are classified as members. Just as the owners of a partnership are members of the company, LLC owners are legally members of the LLC. The rights and responsibilities of LLC members are specified in the operating agreement but also defined by state LLC regulations. Since LLCs state, not federal, creations, each state can have their specific regulations, but owners in all LLCs are members.
Managing members are those owners who are also empowered to manage the LLC. They are differentiated from "passive" members, who are investors only. Should the owners choose to have one or more of their group manage the day-to-day LLC operations, they are called managing members. They are authorized to make purchases, sign contracts, and obligate the LLC to binding agreements.
The owners of an LLC are called members. While corporations have shareholders, LLCs have members. There is no limit on the number of members in an LLC and most states allow single-member LLCs. In single-member LLCs, one member may perform most, if not all, of the positions in the company. In larger companies, some members are involved in the day-to-day running of the company and other members are investors. The level of involvement members have -- or don't have -- in an LLC must be specified in the LLC's Articles of Organization. This document, which members must file with state authorities, states the company's operating rules, who the founding members are, and the purpose of the LLC.
LLC members have two management choices. These options are called "member managed" or "manager managed" LLCs. In most states, the owners must select one option at the formation of the company. LLC managers are like CEOs in corporations. They are employees, but not members. Their authority level to manage the LLC is granted by the members. An LLC manager may have the total authority of a managing member or may have specific responsibilities that are somewhat less than those of a managing member.
Managers are elected representatives of an LLC's members. They have the authority to make the day-to-day decisions necessary to operate the business. However, managers are optional within an LLC. If the members of an LLC manage the company, there is no need for managers. However, if the owners of a company are not involved in the day-to-day operations of a company, they must appoint managers to represent them. They can choose to appoint a single manager or several. How many will depend on the nature of the business, the number of owners and the size of the company. The specific powers and responsibilities of managers are set by state law and the LLC's Articles of Organization.
LLC Members Like Partners
LLCs are hybrid organizations, having some of the characteristics of corporations and partnerships. While members are owners, like corporation stockholders, their rights and responsibilities are more like the partners in a partnership. For example, unless modified by the LLC operating agreement, all members must agree on major decisions, for example, asset purchases. Requiring unanimous agreement is more akin to a partnership than simply having Corporation stockholders vote on issues with the majority making major decisions.
What Members Do
As owners, LLC members may participate in the day-to-day management or simply be passive investors. Managing members act as CEOs of the LLC with authority to execute purchases and contracts, binding the LLC to legal agreements. At year's end, the LLC will "pass through" all profits to members, to be included in their personal income for tax purposes. The amount of profit/income members will match their ownership percentage. For example, a member owning 40 percent of the LLC will receive the same percentage of net profit to be taxed as personal income.
Officers are employees appointed by the LLC managers -- or members if it's a member-managed LLC. The powers and responsibilities of LLC officers are set in the LLCs Article of Organization. Unlike corporations, which are required to appoint at least one officer, such as a president, secretary or treasurer, most states do not require LLCs to have officers. However, certain institutions such as banks require LLCs to appoint an officer with the power to represent the company. If an LLC is to have officers, members must include an operating agreement in the Articles of Organization of the LLC that authorizes their appointment.
The size, complexity and managerial style of an LLC will determine how many officer positions are created. Typical positions include the chairman, who presides over managers' meetings; a president in charge of the day-to-day operations, a secretary that maintains the necessary LLC records and supervises meetings and elections and a treasurer to keeps the accounts and manages financial and tax information. Larger LLCs may require the appointment of more positions, such as vice presidents, assistant secretaries, and assistant treasurers.
The Operating Agreement
The Operating Agreement serves as the equivalent of an LLC's bylaws, providing the rules for all ownership transfer, voting rights, business activities, management structure, management authority and any other questions important to the success of the business.
The choice to attach the Operating Agreement to the Articles of Organization has the effect of publishing the document and making it publicly available. While this is often not a problem, privacy reasons may warrant avoiding publication. The benefit of publication is that any future purchaser of LLC interests is aware of the Operating Agreement, and cannot claim ignorance because it is a publicly available agreement.
In the absence of an Operating Agreement, state law provides the rules under which the business is conducted. Because LLCs are a much more recent legal development than corporations, there are far greater variations in the laws from state to state and many fewer legal cases explaining these laws. The effect is to make the disputes that arise under LLCs much harder to solve than corporation disputes - if there is no Operating Agreement. In contrast, a well drafted Operating Agreement provides the answers to the situations which arise within the LLC, greatly reducing the ability for confusion and dispute to arise as well as discouraging lawsuits among LLC members.
A well drafted Operating Agreement provides the answers to potential LLC problems, greatly reducing confusion and discouraging lawsuits among LLC members. This requires that the LLC be drafted to take advantage of the law in the state of formation of the LLC and to adjust the provisions to the significant personnel, financial, and operational aspects of the enterprise.
In an LLC, members are the owners of the LLC, while managers have the right, power and duty to conduct the business of the LLC. "Ownership" in this case means that the member has both an equity interest in the LLC and the authority to vote on limited aspects of the LLC. In the typical LLC, managers are also members, having both the ownership interest and the business authority. However, members can employ managers who have no ownership interests.
The managers work together as the officers and directors of the LLC, depending on the LLC provisions. In the start-up business, the entrepreneur may be the only manager, or there may be more than one manager. In companies based on inventors, the inventor, key investor and business chief executive may serve as the managers together.
One of the primary benefits of the Operating Agreement is the ability to draft the management clauses to give different managers different powers. In the case of an inventor-based company, for example, the LLC could provide that the inventor is a manager with primary responsibility for product research and development, while the business executive is the manager with primary responsibility for all marketing and financial decisions. The key investor under this hypothetical is a manager but has no duties. The voting rights of the managers could be distributed at 35% to the inventor, 35% to the business executive and 30% to the investor — meaning that so long as the inventor and business executive agreed, the investor would not affect decisions, but if they disagreed, the investor had a tie vote. Such a model can be used to overcome many business roadblocks and is much more easily achieved in an LLC compared to a corporation. The parties can also design any other varying construction of voting rights and authority.
The LLC can also specify the extent to which managers can act with individual authority as officers and the extent to which they must act as a group with formal meetings. The need to formalize the operation will be a function of the size of the management team and the degree to which there are disagreement and poor communication among the group.
In a manager-run LLC, members vote on only a few key decisions. They can vote to dissolve the LLC, replace the managers if the managers have resigned, amend the Operating Agreement, raise additional capital investments, and admit additional members. Most or all of the operational decisions are left to the managers.
For smaller companies, the managers can be eliminated entirely, and the members can serve as member-managers. Over time, however, ownership is often transferred by will, managers need to retire and other life-cycle changes occur. As a result, it may be preferable to plan ahead with separate provisions in the LLC for members and managers, even if initially there are no members who are not also managers.
Setting up the decision-making authority of the managers and members is the most crucial aspect of the LLC. This is where the primary disputes are likely to develop, and because of the limits placed on the members, these provisions are most important to the non-manager members.
Another important provision related to authority flows from the ability of the members to remove the managers of the LLC. Ultimately the members, as owners of the company, have the legal right to remove the managers. The LLC will provide rules for exercising this power. Members vote based on their membership interests rather than the number of members. This voting is the same as the corporation model of "one share, one vote," designed to protect the ownership interests tied directly to the proportionality of ownership.
Membership power to elect and remove managers can vary depending on the need for independent managers or membership control. At one extreme, a simple majority vote of the membership interests, excluding the manager's interests, may remove managers without cause. Such a provision would provide strong membership oversight of the managers. More commonly, however, managers draft the LLC to limit severely the members' ability to remove managers. In these Operating Agreements, the members may be required to prove that the managers acted improperly.
Alternatively, the Operating Agreement may require that a high percentage of the members vote for removal. To avoid the tremendous difficulties of establishing appropriate standards and methods of determining when a manager has acted improperly, the super-majority voting provision, which requires a high percentage of membership voting interests to remove the Managers, may be more practical.
State law will provide the ultimate limit on managers. Regardless of the LLC provisions, a manager who has breached the duty of loyalty to the company by stealing from the company or committing fraud can be terminated by the membership for cause. Theft and fraud are extreme examples of impropriety, however, so the LLC should always provide the members with some ability to remove managers when the conduct can be proven to be improper.