Business Organizations: Limited Liability Companies

Limited Liability Companies

“I’m forming a business and I want it all!” This statement encompasses the thought behind the Limited Liability Company (or, as it’s often referred to, the LLC). LLCs combine many of the best aspects of the corporation and the partnership. It is a hybrid business entity that allows members to be taxed like a partnership but limits personal liability like a corporation. [1]

            Unlike corporations, sole proprietorships, and partnerships, LLCs are a relatively new business entity. By 1994 nearly every state had adopted LLC statutes, but they were not uniform. In 2006, the “Revised Uniform Limited Liability Company Act” was written to “identify the best elements of the myriad of first generation LLC statutes and to fuse those elements into a new, ‘second generation’ uniform act.”[2] This Act has been adopted by several states and is being considered by several more.[3] Even though the Act is still in the process of being adopted, it does provide a good overview of how LLCs typically operate.

Operating Agreements

LLCs are governed by their operating agreements, which are drafted at the time of the formation of the LLC and adopted by the members. Operating agreements may be amended by the members from time to time. The initial operating agreement may stipulate the vote that it necessary to amend the agreement. The Revised Uniform Limited Liability Company Act sets forth many default rules that apply to the governance of the LLC, though where they are contradicted by the operating agreement, the operating agreement controls.[4] For example, the operating agreement can eliminate the duty of loyalty that is normally owed by members to the company, allowing members to compete with the company. It can also set the standards of conduct against which the managers will be measured and can limit their liability.[5] Allowing members to modify these default rules makes the LLC a very flexible business entity. 

Management

The management structure of an LLC can vary. If there is only one member of an LLC, the LLC is a “single-member” LLC and that person has complete control of the company. Multiple member LLCs can be member-managed, which means that the owners operate the company’s business. Alternatively, the members can hire managers to operate the business, which makes the LLC manager-managed. By default, a multiple member LLC is presumed to be member-managed unless the operating agreement states otherwise.

A member-managed LLC operates like a partnership while a manager-managed LLC operates like a corporation. In the latter case, members do not have roles in the day-to-day running of the company, as those tasks are left to the managers, as in the case of directors and officers of a corporation. However, the members must be consulted on certain fundamental matters, such as whether the LLC should merge with another company, and the members’ consent is required for such an event to occur.

Members of an LLC owe duties of loyalty and care to the company. The duty of loyalty requires that the person not act against the best interest of the company. For example, opening a competing business would likely be considered a breach of this duty. The duty of care requires that the members take reasonable efforts to ensure that the company is successful. Negligently failing to take necessary steps to support the company’s business, such as failure to file appropriate tax returns or other regulatory paperwork, breaches this responsibility.

However, where the LLC is manager-managed rather than member-managed, because the managers are not vested with control of the company, they are also absolved of the duties of care and loyalty.[6]  The members of a manager-managed LLC may compete with the LLC. This may be an attractive feature to potential investors whose livelihood may not be entwined with the business of the LLC.

Taxation

            LLCs feature tremendous flexibility when it comes to income taxation. There is no specific series of tax laws that apply to LLCs in the Internal Revenue Code. Instead, the IRS allows LLCs to elect to be treated as corporations or as partnerships. [7] In the case of the single-member LLC, the company can choose to be treated as a corporation or a sole proprietorship. This election is made by the filing of a Form 8832 with the IRS.[8] The election can also be changed during a subsequent year by filing the same form.

            When the LLC elects to be treated as a partnership (or sole proprietorship), it is considered a “pass-through” tax entity. This means that the entity does not pay its own income tax. Rather, its income (and losses) pass through proportionately to its owners. In the case of a multiple member LLC, the company files an informational Form 1065 (Return of Partnership Income) with the IRS to explain how its income and losses are allocated, just as would a partnership.[9] In the case of the single-member LLC, the sole member treats the company’s income as his or her personal income and reports it on Schedule C of the standard personal income tax return (Form 1040), which is used to report profits or losses from business activities.[10]

            If the LLC elects to be treated as a corporation, it files a Corporation Income Tax Return (Form 1120).[11] Corporations are subject to double taxation. That is, the corporation pays income tax on its income. Then, when it’s profits are distributed to its shareholders as dividends, the shareholders pay income tax on those dividends. For this reason, most LLCs will naturally select to be treated as pass-through entities. Nevertheless, where, for whatever reason, it is advantageous to the LLC to be treated as a corporation for tax purposes, it may do so.

Limited Liability

Another important advantage of an LLC is that the members have limited liability. In this way, the LLC is like the corporation. In a corporation, shareholders are not personally liable for the actions or debts of the corporation. In an LLC, the members have comparable protection. This means that the members of the LLC can only lose a maximum of the amounts of their contributions to the business. In fact, the LLC has an advantage over corporation in that this liability shield does not require the members to observe corporate formalities, which are required to maintain the liability shield in the case of the corporation.[12]

However, it is important to remember that the members and managers can be held responsible for their individual actions. If a member commits a tort or signs a contract in his personal capacity, he is not absolved of liability merely because he was engaging in behavior or transacting business on behalf of the company.

Moreover, if a court believes that the LLC was, in fact, a “sham” and that the operations were really those of its member who used the LLC strictly as a liability shield, the court can “pierce the corporate veil” and impose personal liability on a member.[13] This is likely to occur where a member commingled assets or businesses between herself and the company, establishing, by behavior, that she did not consider the company a separate entity from herself.

            Still, piercing the corporate veil is unusual, as the LLC liability shield will generally be respected by courts. In Ogea v. Merritt, for example, the single member of an LLC that operated a construction company contracted with the plaintiff to build her house. The plaintiff claimed that the company did not properly level the dirt pad that her home’s foundational slab sat on. She sued both the LLC and the sole member. The court held that the LLC was the entity that had contracted with the plaintiff and that the member did not act in a way that would justify piercing the veil. Thus, the plaintiff could only recover from the LLC.[14]

            LLCs provide limited liability for members, tax flexibility and have flexible management structures. For these reasons, the LLC is quickly becoming an extremely popular business entity for new businesses.