Limited Liability Companies: Overview
What is an LLC?
One of the choices available to persons who wish to conduct a business is to operate as a limited liability company (LLC). Compared to corporations and partnerships, the LLC is a relatively new business entity. The name of an LLC conveys the most important feature: the LLC itself, and not its members, have liability for the LLC’s debts and losses. The key to achieving this limited liability is to form and operate the LLC properly.
Formation of LLC Governed by State Law
Every state has a statute that applies specifically to limited liability companies. The rules are usually found in the section for corporations or business organizations. The state laws do vary, so it is important to form an LLC pursuant to the applicable state’s law. To give the reader a general idea of the characteristics of an LLC, this discussion contains rules that are common to many, but not all, states’ LLC provisions.
Naming your LLC
The name of an LLC must contain the words “limited liability company,” “L.L.C.” or “LLC” as the last words. The purpose of this requirement is to put those who do business with the LLC on notice that they may look only to the company itself for satisfaction of any liabilities.
Articles of Organization
The first step in forming an LLC is to prepare the articles of organization, which contain the most basic information about the company. The articles of organization are the counterpart of the articles of incorporation of a corporation. The articles of organization must contain:
- Name of the LLC
- Mailing and street address of the company’s principal office
- Name and street address of the company’s registered agent
- Other information that the members elect to include
Other matters that may be contained in the articles of organization are the names of the initial members of the LLC, the purpose for which the LLC is formed, or the form of management of the LLC.
The articles must be signed by at least one member or authorized representative of the LLC and filed with the secretary of state or other designated state official. A filing fee is payable when the articles of organization are filed.
Management of an LLC
The management of an LLC is vested in all the members, unless the articles of organization or operating agreement provide otherwise. Typically, a person or entity is named to manage the LLC. The manager does not have to be an LLC member. The members also adopt an operating agreement which spells out all the relevant issues about the company, about the relationship of the company and the members, and about the relationships of the members with each other.
Although an operating agreement is not required by law, the operating agreement is very important because it governs the operation of the LLC. The operating agreement may address:
- Persons who have authority to act on behalf of the LLC
- Matters pertaining to the specific business of the company
- Division of the LLC’s profits and losses
- Procedures for death or withdrawal of a member
- Mergers and consolidations with other business entities
- Dissolution of the LLC
Limited Liability of Members
As a general rule, the members of an LLC do not have personal liability for the LLC’s debts or other liabilities. Thus, if a creditor sues an LLC for payment of a debt, the creditor must look only to the LLC for satisfaction of the liability. There are some exceptions to the rule of non-liability for members. First, a member is liable for his or her own negligence. Also, a member who personally guarantees a liability for the LLC is personally liable to the extent of the guarantee. As a practical matter, many small or start-up LLCs cannot borrow funds unless the indebtedness is guaranteed by one or more members.
A doctrine called “piercing the corporate veil” was developed in connection with regular corporations and also applies in the context of LLCs. The veil is the demarcation between an LLC and the member that shields the member from personal liability for the LLC’s liabilities. When the doctrine applies, the LLC is treated as a sham, i.e., not a separate and distinct entity but rather the alter ego of the member. The doctrine often applies when there is a single member. If a member’s personal identity is not kept completely separate from the corporate identity, then there is a danger that a court might allow a creditor to “pierce the corporate veil” and reach the member’s personal assets. Some of the questions that a court will raise in determining whether to pierce the corporate veil are:
- Is the company substantially under-financed for the business in which it engages?
- Does the member treat the LLC’s assets as his or her own assets, e.g., pays personal bills from the corporate account?
- Does the LLC clearly represent that it is an LLC on checks, business cards, signage, etc.?
- Does the LLC observe the required customary formalities, such as maintaining corporate books and records, filing an information tax return, and maintaining a separate bank account?
- Does the member use the LLC’s assets to advance his or her own personal interests?
Income Tax Treatment
For federal income tax purposes, an LLC is disregarded; income, losses, deductions, and credits of the LLC flow through to the members, usually in proportion to their percentage interests in the LLC. Thus, using an LLC avoids double taxation at both the company and member levels. If an LLC’s sole member is an individual, its income and expenses are reported as profit and loss from a business on the owner’s Form 1040, Schedule C. If the LLC’s only member is a corporation, the income and expenses of the LLC are reported on Form 1120, U.S. Corporation Income Tax Return, or Form 1120-S, U.S. Income Tax Return for an S Corporation. An LLC with multiple owners files as a partnership, using Form 1065, U.S. Return of Partnership Income. If an LLC wishes to be taxed in any other manner, it must file Form 8832, Entity Classification Election.
Choosing the form of a new business is one of the most important decisions a new owner makes. Also, businesses operating in one format sometimes decide that it would be advantageous to change to a different format. The LLC is certainly worth considering for either a new business or a change of format. An LLC, which avoids double taxation and protects the members from the company’s liabilities, has numerous advantages to offer.