The limited liability company (LLC) is perhaps the most popular business entity form for small and midsize businesses within the United States. The reason for its popularity is the combination of characteristics similar to those of a partnership while allowing for some of the benefits of the corporate entity form. This article explains everything you need to know to fully understand the LLC entity form.
Creation and Maintenance
LLCs are state-recognized business entities. When forming an LLC the organizer must file articles of organization with the appropriate state office. In most states, the state secretary of state controls this process. Most states allow for these documents to be filed online. The articles of organization include the name of the company, registered agent, primary business location, names of members, management structure (member managed or manager managed), and a filing fee. Most states allow an LLC to have as few as one members, known as a single-member LLC. The governing document of an LLC is the operating agreement. In the absence of an operating agreement, default state laws govern the entity. The operating agreement lays out the rights and obligations of the owners. It will outline things such as the management structure, voting rights, meeting rights, etc. Outside of the specific requirements that the members elect to include in the operating agreement, LLCs have very few formal maintenance requirements. Basically, the only requirement is to update the secretary of state’s office when there is a change of membership or other change to the information in the articles of organization. The LLC must also pay annual registration dues.
The LLC operating agreement will generally include what is known as a buy-sell agreement. This outlines what happens when a member of the LLC seeks to exit the business. Most often, the business must purchase the interest of the exiting LLC member at the fair market value. The LLC agreement will sometimes lay out the process for determining fair market value. If no, the parties must work that out themselves. Any unresolved disputes over the value will generally result in litigation. If the operating agreement is silent on the exit of members from the business, state law is the default rule. In most states, a member leaving the LLC is grounds for the dissolution of the entire business entity. In other states, the default rule is that the business continues and there is no event of dissolution. If the business dissolves, the assets must be sold and the operating wound up. Even in dissolution states, the existing members will generally buy out the interest of exiting member and reorganize the business to continue operations.
The LLC owners are known as members. Each member holds a percentage ownership of the LLC. The percentage ownership is generally recorded in the operating agreement. In some case, the LLC will award membership units of the LLC – these are similar to shares of stock of a corporation. The LLC can even print certificates to represent these units. If an LLC does not have an operating agreement outlining the specific ownership interest or percentage, the default rule is equal ownership among all members. This is rarely the desire of the LLC members, so it is advisable to record the ownership interest in some form or fashion. It is also important to note that, when distributions are made from the LLC, this can alter the ownership interest if the distribution is made based upon ownership percentage.
LLCs are controlled by the members. The extent of the control, however, is limited by the company’s election to be member-managed or manager-managed. A member-managed LLC means that all members have authority and control over the LLC. The default rule is equal control, but the operating agreement can limit responsibilities of any member. In a manager-managed LLC, the members appoint managers to run the daily affairs of the business. The members retain control through the ability to vote upon major decisions affecting the LLC.
Limited Personal Liability
The LLC protects the members from personal liability for the debts or obligations of the business. So, if the business takes out loans that it cannot repay, the members of the LLC will not be liable for those loans unless they provided a personal guarantee of repayment. Employees of a business act as agents of the business. If an employee enters into a contract for the business, the business will be bound by that contract. If a party to the contract sues the business and obtains a judgment, the business will be liable to pay the judgment. Likewise, if an employee commits a tort while working in the scope of their employment, the business could be sued and subject to a judgment. In these scenarios, the plaintiffs can recover from the business and all of its assets. The LLC entity status protects personal assets of the members from the judgment creditors. That is, the members do not risk losing their personal assets for company debts. An important thing to remember is that a member may be personally liable if she commits a tort personally. The LLC entity status does not protect individuals from their own actions.
Compensation & Taxation
The method by which members of an LLC receives compensation is based upon the tax election of the business. The LLC may choose to be taxed as a partnership or as a corporation. If the entity chooses corporate taxation, it may choose S-corporation (assuming it meets the requirements) or C-corporation status. If taxed as a partnership, the members of the business cannot receive a salary for working in the business. Instead, they can allocate a specific percentage of profits, known as a partnership draw. Any other profits of the LLC flow through and are taxed to the members based upon their ownership percentage. In some instances, the company can make a special allocation, but it cannot have the purpose of avoiding taxation. If the company chooses to be taxed as a corporation, the members can receive a salary for working the LLC. If taxed as an S-corporation, any profits of the LLC flow through (as dividends) and are taxed to the members based upon their ownership percentages. If taxed as a C-corporation, the profits of the business do not automatically flow through to the members. Rather, the corporation pays taxes on any profits. The members can then vote on whether to distribute the profits as dividends or retain those profits in the business. If the dividends are distributed, the LLC members receiving a dividend are taxed on the dividend.
If you decide to organize your business as an LLC, talk to the professionals at LawTrades about how they can assist you.