Nolo’s Quick LLC: All You Need to Know About Limited Liability Companies
by Anthony Mancuso
“The limited liability company (LLC) is a relatively new business ownership structure that combines the best features of the corporation and the partnership. It gives small business owners corporate-style protection from personal liability while retaining the pass-through income tax treatment enjoyed by sole proprietorships (the legal term for one-person businesses) and partnerships.” LLC owners are called members.
To determine if an LLC is the best fit for your business, the author explains the advantages and disadvantages of various business structures in comparison to LLCs, including sole proprietorship, general partnership, limited partnership, C corporation, S corporation, RLLP, Series LLP, L3C, and benefit corporations.
- Sole proprietorship is the simplest way to do business. “A freelance proofreader who works at home and doesn’t ever anticipate needing a loan to run his or her business probably doesn’t need the limited liability that an LLC offers. Making a profit is hard enough—there is no sense in further complicating your life if you don’t need to.”
- C Corporation. “LLCs don’t issue stock, so there can be no stock options. (LLC membership options are tricky and expensive to set up). For these reasons, the small minority of small businesses that want to issue options to employees or sell shares to venture capitalists will find that organizing as a corporation makes the most sense.” On the downside, “when a corporation is sold or dissolved, both the shareholders and their corporation must pay tax on any increased value (appreciation) of the corporation’s assets… For businesses that regularly make investments, hold real estate, or buy other types of property that are likely to increase in value, this [double taxation] can be a big disadvantage.”
- S Corporation. “LLCs have largely replaced S corporations… That’s because the LLC provides substantially the same benefits of an S corporation without several of the significant restrictions.” However, “converting a corporation to an LLC… can be costly, because there’s often a substantial tax bite… Allowing owners of existing C corporations to obtain pass-through tax status is one of the few remaining practical uses of the S corporation.”
- RLLP. An LLC may not protect professionals from personal liability for the malpractice of other professionals in the firm. This is known as vicarious liability. For this reason, law firms, CPA firms, and medical practices would be better off with a registered limited liability partnership (RLLP). “An RLLP is essentially a partnership in which all of the owners remain personally liable for their own acts (malpractice), but receive limited liability for the malpractice of other partners in the firm.”
- The Series LLC. “A new type of LLC is taking shape under state laws… The defining characteristic—and main advantage—of the series LLC (SLLC) is that it allows business owners to form one LLC to run separate businesses or properties… For example, each series can have separate owners and managers, a separate operating agreement that specifies a separate division of profits and losses associated with the series, and other separate formation and operation characteristics.” The main advantage is to avoid paying formation and annual fees for each separate business. “However some states may not be willing to forgo those filing fees so easily… The California Franchise Tax Board “has said that it will treat each individual series of an out-of-state SLLC as a separate LLC… And there are other uncertainties. For example, it is not clear that a federal bankruptcy court will respect the separation of each series within an LLC. If one series in a LLC files for bankruptcy, the court might reach out and grab the assets of the other series in the LLC to satisfy claims filed by creditors of the bankrupt series.”
- Do-good entities. “A growing number of states allow the formation of hybrid entities… that can make a profit yet also do good.” Wyoming has introduced the low-profit limited liability company (L3C) while California law allows social purpose corporations and benefit corporations. The purpose is to prevent shareholder lawsuits accusing management of not trying to maximize profit. “These hybrids are sometimes loosely referred to as B corporations, but, in fact, ‘B corporation’ status is a separate, private (not state-law sanctioned) classification, which can be attained by any type of entity (not just a corporation).”
Member’s Capital and Profits Interests. “When LLC members receive a capital interest in an LLC in exchange for cash, property, or services, they also get a share of its profits and losses, called their distributive share. You’ll see the term ‘distributive share’ a lot in IRS publications and tax forms: It refers to how much of the LLC’s profits and losses will be allocated to each LLC owner at the end of the year. It is a bit of a misnomer, because under the pass-through tax rules an LLC’s owners are taxed on all of the profits allocated to them at the end of each LLC tax year, even if these profits are not actually distributed… An owner’s distributive share in sometimes also referred to as his or her ‘profit interest’ in the LLC.”
Note: “Whenever LLC members sign an operating agreement that issues a capital interest to a member in exchange for services, that member must pay income tax for the value of those services as recorded on the LLC’s books.”
“When it comes to actually paying out profits to the members, LLCs do have to pay attention to a few legal rules… In general, a distribution is valid if, after the distribution: the LLC remains solvent—that is, the LLC will be able to pay its bills as they become due in the normal course of business, and LLC assets remain equal to or exceed LLC liabilities (in some states, a statute sets out higher asset-to-liability ratio that the LLC must be able to satisfy after distributing profits)… Courts may ignore limited liability if these standards are ignored and the company is later sued. Members or managers who approve a distribution in violation of statutory standards can be held liable for the amount of the invalid distribution.”
Special Allocations. “Your operating agreement can provide that profits and/or losses be distributed in a manner that is not proportionate to capital interests. For example, an LLC member with a 30% capital interest could receive 40% of the yearly profits. The ability to mete out allocations of profits and losses in different ways is one of the special advantages of setting up an LLC (or a partnership)… Allocating profits and losses in a way that is disproportionate to members’ capital interests is called making special allocations under the tax law. Such divisions are subject to IRS tax rules.” The author explains the safe harbor rules for special allocations. One of these requirements is, “when an owner sells his or her interest, or the LLC is sold or liquidated, members with a negative capital account balance must restore their account to a zero balance….If you adopt this type of provision in your operating agreement, however, you have waived your limited liability protection, because you are personally agreeing to repay any deficit.”
Pass-through taxes. “Like partnerships and sole proprietorships, an LLC is automatically recognized by the IRS as a pass-through tax entity.” This means that all of the business’s profits and losses pass through to the owners’ individual tax returns, thus avoiding the double taxation experienced when a corporation is taxed on profits and then shareholders are taxed again when any of those profits are distributed as dividends. “Many new businesses lose money in their first year or two. Fortunately, LLC members (like owners of partnerships) can subtract their LLC losses from their taxable income (assuming IRS rules are met).”
Single-member LLCs file a Schedule C with their Form 1040, the same as a sole proprietorship. Multiple-member LLCs file IRS Form 1065, the same form as a partnership. “If you are an active owner in your LLC (that is, you manage or work for it), your tax adviser will probably recommend that you pay self-employment (Social Security and Medicare) taxes on any profits paid to you.”
“LLC members who receive a share of LLC profits are not normally treated as employees, but the LLC must withhold income tax on any guaranteed payments made to members. Ask your tax adviser if you have questions.”
Corporate tax option. Although most LLC owners will stick with pass-through tax status, they have the option of being taxed as a corporation. The reason to do this is that “income splitting” could reduce overall taxes, particularly in companies where a significant portion profits are retained to fund growth of the firm. Members will pay personal income tax on any salary and bonuses they are paid. These are business expenses that will reduce the LLC’s taxable earnings. Any remaining profits would be taxed at the corporate rate, which is often lower than the marginal rate of the individual owners.
“If you form an LLC and decide that you want your LLC to be taxed like a corporation, you must file IRS Form 8832, Entity Classification Election… Once a business makes a corporate tax election, it normally cannot change its tax status back to pass-through treatment for at least five years.”
“Corporate capital gains tax treatment, corporate loss carryover treatment, and other technical corporate tax provisions are different from the rules that apply to pass-through LLCs. For example, corporations often must pay double taxes when they are liquidated. Also, corporations typically can’t pass tax losses through to owners—these losses normally stay with the corporation. You will want to thoroughly review these issues with a knowledgeable tax advisor before electing corporate income tax status.”
Filing Fees. “One disadvantage to forming an LLC rather than a partnership or sole proprietorship is that you‘ll have to pay a filing fee when you file your articles to create your LLC. But in most states, the fees are modest (although the states of Massachusetts, Illinois, and Texas, among a few others, sock it to new LLCs)… Some states do, however, have larger recurring annual fees… California, for example, charges an annual minimum franchise tax of $800, plus an additional ‘total income’ fee (calculated on gross income plus the cost of goods sold, paid, or incurred in connection with the trade or business) that can reach up to $12,000 per year for high-income LLCs.”
LLC Management. “Under most states’ legal rules, all LLC members are automatically equally responsible for managing the LLC… In LLC legal jargon, this arrangement in called member management. But there is another possible LLC management approach—manager management—by which LLC members can choose one or more members and/or nonmembers to manage their LLC. In most states you must specify whether your LLC is member- or manager-managed in the organizational paperwork (your LLC articles or certificate) you file with the LLC filing office… A few states call the managers governors.” Examples of scenarios in which manager-management makes sense include: some members are investors with no active role in managing the firm; LLC members hire a CEO; an outsider is willing to loan the LLC money in exchange for a say in management decisions; the sole member gives membership interests to nonmanaging family members.
Keep in mind, “any member of a member-managed LLC, or any manager of a manager-managed LLC, can legally bind the LLC to a contract or business transaction. In other words, each of these people is an agent of the LLC, and can single-handedly commit the entire LLC to a contract or business deal.”
“In a co-owned LLC, the managers (either its members in the case of a member-managed LLC or its specially appointed managers in the case of a manger-managed LLC) have a legal obligation to manage the LLC in good faith and in the best interests of the LLC and its members. This is known as their ‘duty of care,’ and is similar to corporate directors’ and officers’ duty to their corporation. If a member or manager of an LLC violates this duty of care, he or she can be held personally liable for any money damages that result.”
“Full and fair disclosure of all material facts is part and parcel of LLC managers’ and members’ duty of care to the LLC. As long as this duty is met, the business judgment rule will normally protect members and managers from personal liability for their management decisions.”
Member Voting Rights. “LLC members have the right to remove and replace managers. Also, nonmanaging members have the right to approve fundamental changes to the LLC and its membership, including (in many states) the power to amend the articles or operating agreement of the LLC, to merge or dissolve the LLC, to approve or deny the admission of new members, and to approve or deny the transfer of an LLC membership from an existing member to an outsider.”
The LLC operating agreement does not have to require annual meetings. “Instead, it can simply set up procedures to allow any LLC member or manager to call a special meeting when the need arises—typically, when an important legal, business, or tax decision needs to be made… LLCs with investors who are not involved in the business often do call a meeting at the end of each year to keep the nonmanaging investors aware of how well management is meeting the LLC’s financial goals and what the financial objectives are for the upcoming year.” The author lists some scenarios that may warrant a special meeting.
Articles of Organization. “In most states, the only legal step you must take to create an LLC is to prepare and file LLC articles of organization with your state’s LLC filing office… Your LLC articles will be rejected by the LLC filing office if the proposed name of your LLC is already in use by another LLC, corporation, or other type of registered business in your state.” You should also make sure your proposed business name is not similar to another business’s trademark.
Operating Agreement. “Even though it is not required by state law, you also should create an LLC operating agreement. This is the document where you set out the ownership rules for your business (much like a partnership agreement or the bylaws of a corporation). A typical operating agreement includes: the members’ capital interests; the rights and responsibilities of members; how profits and losses will be allocated; how the LLC will be managed; the voting power of all the members (and any managers); rules for holding meetings and taking votes; and buyout provisions, which lay down a framework for what happens when a member wants to sell his or her interest, dies, or becomes disabled.” Appendix A includes a Sample Operating Agreement.
The author warns, “I believe it’s a big mistake to run an LLC without an operating agreement.” Without an operating agreement, “state law, not the choices you and your business associates make, will dictate how the dispute is resolved. For example, many states have a default rule that LLC profits and losses must be divided up among the members equally, regardless of each members’ capital contribution.”
Maintaining Records. The author discusses the importance of LLC record keeping. “In a worst-case scenario, if an LLC keeps few or no records, a court might disregard the LLC’s legal existence and hold its members personally liable for business debts… Formally documenting key LLC actions is also a good way to keep any members who are not involved in the day-to-day management of your LLC fully informed of major LLC decisions. An even more important reason to document key LLC decisions is to reduce the possibility of future controversy and dissention among LLC members.”
Securities Filings. “If someone invests in a business with the expectation of making money from others’ efforts, federal and state statutes, as well as the courts, usually treat that owner’s membership as a security… If you set up a manager-managed LLC, it’s likely that the ownership interests of at least the nonmanaging members will be treated as securities under state and federal law… See a lawyer if one or more of your LLC members wants to be inactive. It’s no joke to be out of compliance with securities laws. It could even give rise to a lawsuit down the road by a disgruntled member.”
The author explains the private offering exemption and the Regulation D exemption, which is filed with the Securities and Exchange Commission. “Under federal case law… as well as securities laws of many states, a private sale of securities, without advertising or promotion, to a limited number of people (usually no more than 35) is often eligible for a ‘private offering’ exemption… In addition, your membership interests must not be freely transferable—that is, you must place restrictions on the further transfer of your LLC memberships… Tip: Make full disclosure your motto when taking money from investors.”
This book provides a wealth of insights and cautions. Anthony Mancuso has also written two other Nolo books about LLCs: Form Your Own Limited Liability Company and Your Limited Liability Company: An Operating Manual. Other books recommended by the author include: Trademark: Legal Care for Your Business & Product Name by Stephen Elias and Richard Stim; Business Buyout Agreements: Plan Now for All Types of Business Transactions by Anthony Mancuso and Bethany K. Laurence; Tax Savvy for Small Business by Frederick W. Daily and Jeffrey A. Quinn; The Employer’s Legal Handbook: Manage Your Employees and Workplace Effectively by Fred S. Steingold; Legal Guide for Starting and Running a Small Business by Fred S. Steingold; Negotiate the Best Lease for Your Business by Fred S. Steingold; and Federal Taxation 2017: Comprehensive.
Mancuso, Anthony. Nolo’s Quick LLC: All You Need to Know About Limited Liability Companies. Berkeley, California: Nolo, 2017. Buy from Amazon.com
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