BUSINESS LAW: Limited Liability Companies

WHAT IS A LIMITED LIABILITY COMPANY?

A Limited Liability company is similar to a corporation, in that it protects the owners from personal liability for certain debts of the company, but is taxed more like a partnership, can be owned by non US citizens and non US residents, and may have an unlimited number of members. This article applies only to California Limited Liability companies. Other states may have different requirements.

A California limited liability company (LLC) is generally an entity having two or more members that is organized under the California limited liability company provisions. Two members required in some jurisdictions - but not in California, where an LLC may have just one member, unless the member is a trust.

A member of a limited liability company may be an individual, partnership, limited partnership, trust, estate, association, corporation, another limited liability company, or other domestic or foreign entity. For tax purposes, an LLC is a pass-through entity.

WHAT ARE SOME OF THE RULES AND BENEFITS
OF A LIMITED LIABILITY COMPANY?

• An LLC is not subject to federal taxation at the entity level. Instead items of income, deduction, loss, and credit are passed through to the individual member.

• A member of an LLC ordinarily is not liable for the debts and obligations of the LLC solely by virtue of that membership, however, personal liability may arise only under the same or similar circumstances, and to the same extent, as for a shareholder in a corporation. Even then, the failure to hold meetings of members or to follow formalities with respect to meetings does not tend to establish personal liability for members of an LLC, as it does in the corporate context. Members of LLCs are, however, liable for participation in tortuous or criminal conduct.

• Unless the articles of organization or operating agreement provide otherwise, the members of an LLC cannot be required to make additional contributions to the entity.

• Managers and officers of LLCs are not personally liable for debts and obligations of those entities solely by virtue of their positions, but they may agree to be personally obligated.

• Managers do owe the same fiduciary duties to the LLC as partners owe to a Partnership, and officers owe to a Corporation and may be held liable for breach of that duty.

• An LLC may have unlimited continuity of existence. Although a specified date of dissolution of an LLC must be stated in its articles of organization, and an LLC must be dissolved at that time, an LLC does not lack continuity of existence because the termination date can always be amended.

• An LLC may specify in its articles of organization or a written operating agreement that any particular event will cause its dissolution. The vote of a majority in interest of the members (or a greater percentage voting interests of members as may be specified in the articles of organization or written operating agreement) dissolves an LLC, as does an entry of a decree of judicial dissolution.

• Unless otherwise provided in the articles of organization or written operating agreement, an LLC must dissolve on the death, bankruptcy, retirement, resignation, expulsion, or dissolution of any member who is a manager (for LLCs managed by managers who are members), or any member (for LLCs managed by their members or by managers who are not members). Even this requirement does not prevent continuity of existence, however, because a majority in interest of the remaining members may vote to continue the business of the LLC within 90 days of the dissolving event.

• An economic interest in an LLC (as distinct from a membership interest) is freely assignable, and an assignment of an economic interest does not of itself dissolve the LLC. Unless otherwise provided in the articles of organization or operating agreement, however, a membership interest in an LLC may be assigned only with the consent of a majority in interest of the members not transferring their interests. Without that approval, the assignment entitles the assignee only to receive distributions and allocations of income, gains, losses, deductions, credit or similar items from the LLC to which the assignor was entitled.

• If an individual member of an LLC dies or is adjudged incompetent, that member's legal representative may exercise all of the member's rights for purposes of settling the member's estate or administering the member's property. Management and control of an LLC may be vested in a manager or managers, or may be conducted by the members themselves. Managers may, but need not be, members of the LLC.

• The articles of organization or operating agreement may also restrict or enlarge the management rights and duties of any member or class of members.

• Any person acting as a manager has the same fiduciary duties to the LLC and its members as a partner has to a partnership and other partners of the partnership. An LLC may also provide for the appointment of various officers, who may or may not be members or managers of the LLC.

• Limited liability companies must comply with various statutory record keeping and compliance formalities, but are normally less stringent and less costly than those incurred by corporations.

• Limited liability companies must maintain specified records of members and managers, and keep books and records as required by statute. Meetings of members and managers must be noticed, conducted, and adjourned in a manner prescribed by statute.

Advantages of forming an LLC . . .

• An LLC is a hybrid between a partnership and a Corporation in that it combines the "pass-through" treatment of a partnership with the limited liability accorded to corporate shareholders. The assistance of a qualified tax professional is recommended, as the area of taxation is complex and changes often.
  
  
• In an LLC, the profits and losses can be specially allocated in any manner agreeable to the parties. Another major difference is how appreciated assets are treated in a liquidation. Partnerships, and consequently LLCs, will almost always offer the best tax results on the sale of assets or complete liquidation. For this reason, LLCs are often recommended for enterprises where assets will be obtained, or created (e.g. intellectual property) and subsequently sold after they have appreciated.
  
  
• Unlike a corporation which can have as few as one shareholder, most states require that an LLC consist of two or more members (owners). Recently, however, more states, including California, are allowing single-member LLCs.

Please note, however, that the IRS may treat a single-person LLC differently than an LLC with more than one member. The assistance of a qualified tax professional is recommended, since the area of taxation is complex and changes often.

Separate Legal Entity . . .

Like Limited Partnerships and Corporations, an LLC is recognized as a separate legal entity from its "members." Limited Liability: Ordinarily, only the LLC is responsible for the company's debts thus shielding the members from individual liability. However, there are some exceptions where individual members may be held liable:

Guarantor Liability . . .

Where an LLC member has personally guaranteed an obligation of the LLC, just as with corporation, he or she will be liable on that guaranty. For example, where an LLC is relatively new and has no credit history, a prospective landlord about to lease office space to the LLC will most likely require a personal guarantee from the LLC members before executing such a lease. In fact, in California, all closely held corporations can expect a landlord to require the owners to guaranty the rent.

Alter Ego Liability . . .

Very similar to the judicial doctrine applied to corporations where a court may hold the individual shareholders liable where the business entity is merely the "alter ego" of its shareholders, a member of an LLC may also be held liable for the LLCs debts if the court imposes its "alter ego liability" doctrine. Please note that although a corporation's failure to hold shareholder or director meetings may subject the corporation to alter ego liability, this is not the case for LLCs in California. An LLCs failure to hold meetings of members or managers is not usually considered grounds for imposing the alter ego doctrine where the LLCs Articles of Organization or Operating Agreement do not expressly require such meetings.

Management and control . . .

Management and control of an LLC is vested with its members unless the articles of organization provide otherwise. Voting Interest: Ordinarily, voting interest directly corresponds to interest in profits, unless the articles of organization or operating agreement provide otherwise.

Transferability . . .

No one can become a member of an LLC (either by transfer of an existing membership or the issuance of a new one) without the consent of members having a majority in interest (excluding the person acquiring the membership interest) unless the articles of organization provide otherwise.

Duration . . .

Although many states now allow an LLC to have a perpetual existence, LLCs traditionally were required to specify the date on which the LLCs existence will terminate. In most cases, unless otherwise provided in the articles of organization or a written operating agreement, an LLC is dissolved at the death, withdrawal, resignation, expulsion, or bankruptcy of a member, unless within 90 days a majority in both the profits and capital interests vote to continue the LLC.

Formalities . . .

The existence of an LLC begins upon the filing of the Articles of Organization with the Secretary of State. The articles must be on the form prescribed by the Secretary of State. Among the required information on the form is the latest date at which the LLC is to dissolve and a statement as to whether the LLC will be managed by one manager, more than one manager, or the members.

To complete the formation of the LLC, members must enter into an Operating Agreement. This Operating Agreement may come into existence either before or after the filing of the Articles of Organization and may be either oral or in writing. A carefully drafted written Operating Agreement is recommended, since it will assist in preventing differences of recollection in the event of later disagreements between the LLCs members.

The Law Offices of David D. Murray can form a Limited Liability Company or Corporation in any state in the United States and can can also advise on the formation of Offshore Companies.

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FAQ's ABOUT LIMITED LIABILITY COMPANIES

QUESTION: What is a Limited Liability Company?

ANSWER: California adopted a Limited Liability Company law in late 1994. An LLC is an entity which offers its owners limited liability, but is taxed more like a partnership. The liability of the individual members can be protected, except for personal tort or criminal conduct.

QUESTION: Isn't that what a corporation that has elected to be treated
for tax purposes under Subchapter "S" of the Internal Revenue Code is?

ANSWER: Subchapter "S" corporations are taxed in their own unique way. An LLC, if set up in a certain way, are taxed on the federal level just like partnerships. Before we get to the tax implications, there are non-tax differences between the "Sub-S" corporation and an LLC. "Sub-S" corporations may have only 75 shareholders, and the holders must be individuals or certain trusts. Other business entities, like corporations, and nonresident aliens may not be shareholders of a "Sub-S" corporation. There are no such limitations on the owners of a LLC. Sub-S corporations may only have one class of stock, so all of the owners must have the same rights and privileges. In an LLC you have flexibility in fashioning the relationship among the owners.

QUESTION: What are the tax differences between an LLC and a
Corporation that has elected for tax treatment under IRC Subchapter "S"?

ANSWER: First, both entities pass the business' profits and losses through to the owners, but in the "Sub-S" tax election, all allocations must be made strictly according to ownership interests. In an LLC the profits and losses can be specially allocated in any manner agreeable to the parties. Another major difference is how appreciated assets are treated in a liquidation. Partnerships, and consequently LLCs, will almost always offer the best tax results on the sale of assets or complete liquidation. For this reason, LLCs are often recommended for enterprises where assets will be obtained, or created (e.g. intellectual property) and subsequently sold after they have appreciated. The assistance of a qualified tax professional is recommended, as the area of taxation is complex and changes often.

QUESTION: Are LLCs difficult to form?

ANSWER: Yes and no. The filing requirements are not complicated, and are accomplished using forms from the Secretary of State. However, LLCs do require an agreement among the members, and those agreements can be very complex.

QUESTION: Is there any easy way to determine the best entity
for a particular business?

ANSWER: Not really. Everything depends on the individual situation. First, think about what your goals are. It is not enough to know what kind of business you are operating, you also need to think about whether you are going to use the business to defer income; are you going to bring in other investors?; are you planning on selling the business or some or all of its assets? You should meet with your attorney and your tax accountant to review both the legal and the tax issues of forming a business entity.

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CONCLUSION . . .

Chosing a business entity must be made through a careful weighing and balancing of all the interrelated tax and non-tax factors involved in the formation and conduct of a business venture. It cannot be overemphasized that this choice must be made on a case-by-case basis and must be tailored to the specific tax, legal, and financial objectives and expectations of the principals involved in the venture. Both short-term and long-term objectives must be determined. The choice of the proper business entity need not be made at the inception of a venture. It is an ongoing decision that requires review and reconsideration at least yearly in the light of changing tax laws and the changing circumstances of the business and its principals. Changes can always be made when the circumstances require.

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