The limited liability company (LLC) is the most common business entity for new and small businesses. Even growth-based, startup ventures often spend part of their lifecycle organized as an LLC. The reason it is such a common business entity regards its versatility. The ownership and control structure of the entity can be organized very simply (similar to a general partnership) or more formally (similarly to a corporation).
In this article we discuss the primary characteristics of an LLC and the formation process.
Formation & Maintenance
State law controls the process and requirements for forming an LLC company. The LLC is a recognized business entity form in every state. To begin the process, the organizer must file articles of organization with the appropriate state office. State secretary of state offices are generally responsible for entity formation. The information required in the articles include:
- Name of Entity
- Business Purpose
- Duration of Entity
- Organizer Information
- Representative for Service of Process
- Registered Office for Records
- Member-Managed or Manager-Managed Control Structure
- Names of Members
- State-specific Declarations
If the articles are accepted, the state will issue a certificate of organization recognizing the existence of the business entity. At this point, the business entity exists and may begin carrying on business. The members of the company should at this point consider adopting a governing document known as an “operating agreement”. This document will lay out the rights of members, the obligations of managers, the procedures for controlling the company (such as meeting and voting rights, and member authority), and the ownership percentages of members. These are the steps in organizing a business and forming an LLC.
The default rule in many states is that an LLC dissolves when a member leaves the company. In other states, the opposite applies. If the company has an operating agreement, this document should include provisions concerning what happens when a member of the company leaves. This is known as “buy-sell” agreement. It outlines the process for cashing out a member.
Ownership & Control
When forming an LLC, the organizer will choose whether the entity will be managed by all members (member-managed) or managed by manager (manager-managed). In many cases, the members will hire or appoint one or more of the members to serve as the company’s executives or managers. A member-managed LLC is very similar in nature to a partnership. The members, like general partners, have equal authority and control in the company. Of course, this default rule can be changed within the operating agreement. A manager-managed LLC is more similar to a corporation. In this situation, the members assume the role of shareholders (and maybe directors). The members will meet to discuss company issues and may make decisions through voting. The managers are charged with running the daily affairs and operations of the company. A member who is not a manager does not have authority to represent the company as employee or agents unless she has the approval of the other members. A manager-managed LLC share responsibility for managing the company.
Personal Liability of Owner
The LLC provides limited personal liability for the members. This means that the LLC members are not personally liable for the debts or obligations of the company. This is particularly a concern if the LLC is sued and becomes subject to a legal judgment. The judgment holder would be able to reach or collect against the assets of the company; but, she would not be able to collect against the persona assets of the members outside of the company.
Compensation and Corporate Taxation
Another area in which an LLC is flexible is its form of taxation. The LLC can elect to be taxed as either a partnership or a corporation. Generally, this election is made at the time of formation or within a few months thereafter. The business entity can generally only change its election in this regard one time.
If taxed as a partnership, the members working in the business cannot receive a salary. They must receive any compensation in the form of distribution of profits. This may require uneven distribution or “special allocations” above members who are not employees of the company. Any company profits or losses flow through straight to the members in their respective ownership percentages (absent a special allocation). The LLC itself does not pay taxes. It is, however, required to file an informational tax return. This return tells the IRS how profits or losses were calculated and what portion of company profits or losses were allocated to the members.
If the LLC elects to be taxed as a corporate taxation, it may choose whether to be taxed under subsection C or subsection S of the Internal Revenue Code. To qualify for S corporate taxation, all members must be human beings and US citizens. There can be no more than 100 members. Further, there can only be one class of company ownership interest. Taxed as an S-Corp, the members who also work for the company can receive a salary. This prevents the company from having to make special allocations. Like the partnership, any profits or losses flow directly through the entity to the company owners. The LLC does not pay taxes. It must still file an informational return with the IRS to demonstrate how profits and losses were calculated and distributed to owners.
Law Trades and Business Formation
Organizing a business as a business entity is an essential part of a company’s formation and growth. There are many factors to consider when choosing the appropriate business entity. The experts at LawTrades can help you determine the correct business entity form for your business and help you through the formation process.