LIMITED LIABILITY COMPANIES (Llcs)

LIMITED LIABILITY COMPANIES (LLCs)

From West's Encyclopedia of American Law

Note: LLC's are commonly used by CDCs as an alternate way to set up their wholly owned for-profit subsidiaries. A big advantage is that they are simplier to maintain (no board of directors, bylaws, etc.). They are also commonly being used by CDCs as the preferred vehicle to attract private investors to their Low Income Housing Tax Credit Deals

LLCs are noncorporate businesses whose owners actively participate in the organization's management and are protected against personal liability for the organization's debts and obligations.

The limited liability company (LLC) is a hybrid legal entity that has characteristics of a corporation and a partnership. An LLC provides its owners with corporate-like protection against personal liability. It is, however, usually treated as a noncorporate business organization for tax purposes.

HISTORY

The LLC is a relatively new business form in the United States, although it has existed in other countries for some time. In 1977 Wyoming became the first state to enact LLC legislation: it wanted to attract capital and created the statute specifically for a Texas oil company (W.S. 1977 §17-15-101 et seq., Laws 1977, ch. 158 §1). Florida followed with its own LLC statute in 1982 (West's F.S.A. §608.401, Laws 1982, c. 82-177 §2). At this point states had little incentive to form an LLC because it remained unclear whether the Internal Revenue Service (IRS) would treat an LLC as a partnership or as a corporation for tax purposes. In 1988 the IRS issued a ruling that an LLC in Wyoming would be treated as a partnership for tax purposes. This allowed the taxable profits and losses of an LLC to flow through to the LLC's individual owners; unlike a typical corporation, an LLC would not be taxed as a separate business organization. After the 1988 IRS ruling, nearly every state in the United States enacted an LLC statute, and the LLC is now a widely recognized business form. Many legal issues concerning the LLC are still developing.

FORMATION

State law governs the creation of an LLC. Persons form an LLC by filing required documents with the appropriate state authority, usually the secretary of state. Most states require the filing of articles of organization. These are considered public documents and are similar to articles of incorporation, which establish a corporation as a legal entity. The LLC usually comes into existence on the same day the articles of organization are filed and a filing fee is paid to the secretary of state.

The minimum information required for the articles of organization varies from state to state. Generally, it includes the name of the LLC, the name of the person organizing the LLC, the duration of the LLC, and the name of the LLC's registered agent. Some states require additional information, such as the LLC's business purpose and details about the LLC's membership and management structure. In all states an LLC's name must include words or phrases that identify it as a limited liability company. These may be the specific words Limited Liability Company or one of various abbreviations of those words, such as LLC or Ltd. Liability Co.

STRUCTURE

The owners of an LLC are called members and are similar in some respects to shareholders of a corporation. A member can be a natural person, a corporation, a partnership, or another legal association or entity. Unlike corporations, which may be formed by only one shareholder, LLCs in most states must be formed and managed by two or more members. LLCs in those states are therefore unavailable to sole proprietors (Florida, however, is one of the states that allows single member LLCs). In addition, unlike some closely held, or S, corporations, which are allowed a limited number of shareholders, LLCs may have any number of members beyond one.

Generally, state law outlines the required governing structure of an LLC. In most states members may manage an LLC directly or delegate management responsibility to one or more managers. Managers of an LLC are usually elected or appointed by the members. Some LLCs may have one, two, or more managers. Like a general partner in a limited partnership or an officer in a corporation, an LLC's manager is responsible for the day-to-day management of the business.

A manager owes a duty of loyalty and care to the LLC. Unless the members consent, a manager may not use LLC property for personal benefit and may not compete with the LLC's business. In addition, a manager may not engage in self-dealing or usurp an LLC's business opportunities, unless the members consent to a transaction involving such activity after being fully informed of the manager's interest.

OPERATING AGREEMENT

Nearly every LLC maintains a separate written or oral operating agreement, which is generally defined as the agreement between the members that governs the affairs of the LLC. Some states call an operating agreement regulations or a member control agreement. Although some states do not require an operating agreement, nearly all LLCs create and maintain a written document that details their management structure.

The operating agreement typically provides the procedures for admitting new members, outlines the status of the LLC upon a member's withdrawal, and outlines the procedures for dissolution of the LLC. Unless state law restricts the contents of an operating agreement, members of an LLC are free to structure the agreement as they see fit. An LLC can usually amend or repeal provisions of its operating agreement by a vote of its members.

MEMBERSHIP INTERESTS

A member of an LLC possesses a membership interest, which usually includes only an economic interest. A membership interest is considered personal property and may be freely transferred to nonmembers or to other members. The membership interest usually does not include any right to participate in the management of the LLC. Accordingly, if a member assigns or sells a membership interest to another person, that other person typically receives only the right to the assigning member's share of profits in the LLC. Persons who receive a membership interest are not able to participate as voting members or managers unless they are admitted as new members.

State law and an LLC's operating agreement or articles of organization provide the circumstances under which a person may be admitted as a new member. These circumstances vary. Usually the admission of a new member requires the consent of existing members, and in most cases the consent must be unanimous. In some cases the articles of organization do not allow for admission of new members. In others the recipient of a membership interest may be automatically admitted as a new member.

MEMBER CONTRIBUTIONS

Members of an LLC contribute capital to the LLC in exchange for a membership interest. There is no minimum amount of capital contribution, and members usually can contribute cash, property, or services. By default, the total amount of a member's capital contribution to an LLC determines the member's voting and financial rights in the LLC. In other words, unless an LLC's operating agreement provides for a different arrangement, the profits and losses of the LLC are shared proportionally in relation to the members' contributions to the LLC. For example, if a member's capital contributions constitute 40 percent of an LLC's capital, that member typically has a 40 percent stake in the LLC and has more voting power than a member with a 20 percent interest.

A member may promise a future contribution to an LLC in exchange for a membership interest. If the member later fails to make the contribution, the LLC generally may enforce the promise as a contract or sell the member's existing interest to remedy the failure.

Distributions of profits or assets to members are usually governed by an LLC's operating agreement. Most state LLC laws do not require distributions to members other than when a member withdraws or terminates membership. Members vote to determine all aspects of distributions to members, including amount and timing. Because a member's share of any distribution or loss depends on the member's share of all capital contributions to an LLC, the LLC maintains records of each member's capital contribution.

LIABILITY

State LLC statutes specifically provide that members of an LLC are not personally liable for the LLC's debts and obligations. This limited liability is similar to the liability protection for corporate shareholders, partners in a limited partnership, and partners in a limited liability partnership. Under certain circumstances, however, a member may become personally liable for an LLC's debts.

An individual member is generally personally liable for her or his own torts and for any contractual obligations entered into on behalf of the member and not on behalf of an LLC. In addition, a member is personally liable to a third person if the member personally guarantees a debt or obligation to the third person. A person who incurs debts and obligations on behalf of the LLC prior to the LLC's formation is jointly and severally liable with the LLC for those debts and obligations.

Members may also become personally liable for an LLC's debts or obligations under the "piercing-the-corporate-veil" theory. This doctrine imposes personal liability upon corporate shareholders and applies primarily if a corporation is undercapitalized, fails to follow corporate formalities, or engages in fraud. Although the law of LLCs is still developing, piercing the corporate veil is likely applicable to an LLC that fails to follow the legal formalities required to manage the LLC. LLC statutes in Colorado, Illinois, and Minnesota specifically apply the corporate veil-piercing theory to LLCs.

A member is generally considered an agent of an LLC and thus may bind the LLC for the debts and obligations of the business. When a member has apparent or actual authority and acts on behalf of an LLC while carrying on the usual business of the LLC, the member binds the LLC. If a third person knows that the member is not authorized to act on behalf of the LLC, the LLC is generally not liable for the member's unauthorized acts. Some states also limit a member's authority to act as an agent of an LLC.

RECORDS AND BOOKS

Many LLC statutes require an LLC to maintain sufficient books and records of its business and management affairs. This requirement varies from state to state. The books and records generally detail the members' contributions to the LLC, the LLC's financial and tax data, and other financial and management information. Like a partnership's books, an LLC's books generally must be kept at the LLC's principal place of business, and each member must have access to and must be allowed to inspect and copy the books upon reasonable demand.

TAXATION

The IRS generally treats an LLC as a partnership for federal income tax purposes. The LLC's members are taxed only on their share of LLC profits. Any gains, losses, credits, and deductions flow through the LLC to the members, who report them as income and losses on their personal tax return. The LLC is not taxed as a separate entity unless it fails to qualify as a partnership for tax purposes.

The IRS will examine a state's LLC statute and an LLC's operation to determine whether the LLC qualifies as a partnership for tax purposes. Essentially, if the IRS determines that the LLC resembles a corporation more than a partnership, the LLC may not qualify as a partnership for tax purposes. Under IRS regulations, an LLC must lack two of four recognized corporate characteristics before it will be treated as a partnership for tax purposes. These characteristics are limited liability, centralized management, free transferability of interests, and continuity of life. Because every LLC protects its members' liability, an LLC almost always possesses the characteristic of limited liability. Therefore, the IRS's analysis usually focuses on the last three characteristics.

CENTRALIZED MANAGEMENT

A business organization has centralized management when one or more persons have exclusive authority to manage its day-to-day conduct. Most LLCs lack the corporate characteristic of centralized management because most state LLC statutes provide that members manage the LLC directly, and LLCs that do not have separate managers lack the corporate characteristic of centralized management. However, some states require LLCs to have one or more managers to manage the LLC. If an LLC's operating agreement or articles of organization require each and every member to be a manager, the LLC likely lacks the corporate characteristic of centralized management. If, on the other hand, the members designate nonmembers to manage the LLC or designate member-managers who do not own a substantial portion of the LLC's membership interests, the LLC may possess the corporate characteristic of centralized management.

FREE TRANSFERABILITY OF INTERESTS

A business form possesses free transferability of interests when one of its owners essentially has the power to substitute another person as a new owner of the business. Most corporate shareholders, for example, may sell their shares freely and thereby transfer their ownership interest to another person, without the consent of other shareholders. A member in an LLC, however, generally may not substitute another person as a new member unless the existing members agree to the substitution. A member typically has the power only to assign his or her economic rights in an LLC. Thus, members of an LLC lack the ability to freely transfer substantially all of their interest in the LLC.

CONTINUITY OF LIFE

Continuity of life essentially means perpetual continuation without regard to the withdrawal, expulsion, or death of any member. Most state LLC statutes provide for the dissolution of an LLC upon the death, disability, bankruptcy, or withdrawal of a member. Accordingly, most LLCs lack the corporate characteristic of continuity of life, unless their operating agreement substantially changes the effect of a member's withdrawal upon the continued existence of the LLC. Many state LLC statutes also limit the duration of an LLC to thirty years, but this limitation does not affect the IRS's determination of whether an LLC lacks continuity of life.

MEMBER WITHDRAWAL

Members may withdraw from an LLC unless the operating agreement or articles of organization limit their ability to do so. A member must usually provide to the LLC written notice that she or he intends to withdraw. If a withdrawal violates the operating agreement, the withdrawing member may be liable to the other members or the LLC for damages associated with it. State law frequently sets forth the circumstances under which a member may withdraw from an LLC. In many states a member may withdraw only if she or he provides six months' written notice of the intent to withdraw. In a few states, an LLC cannot prevent a member's withdrawal.

A member who withdraws is usually entitled to a return of his or her capital contribution to an LLC, unless the withdrawal is unauthorized. Some LLCs instead pay a withdrawing member the fair market value of his or her membership interest. The operating agreement typically provides for the method and manner of payment of a withdrawing member's interest. State law also governs those issues.

DISSOLUTION

Dissolution means the legal end of an LLC's existence. In most states an LLC legally dissolves upon the death, disability, withdrawal, bankruptcy, or expulsion of a member. These occurrences are generally called disassociations. Other circumstances that bring about dissolution include bankruptcy of the LLC, a court order, or the fulfillment of the LLC's stated period of duration.

Most states provide for the continuation of an LLC after the disassociation or withdrawal of a member. Continuation after a member's disassociation usually requires the remaining members' unanimous consent. Some states require that the articles of organization or operating agreement allow for the continuation of the business after a member's disassociation. Some states allow an LLC's articles of organization or operating agreement to require the continuation of the business after a member's dissociation even if the remaining members do not provide unanimous consent.

If an LLC dissolves, state law and the LLC's operating agreement usually outline the process for winding up the LLC's business. In this process the LLC pays off its remaining creditors and distributes any remaining assets to its members. The LLC's creditors receive priority. Although members may be creditors, they are not creditors in determining the members' distributive shares of any remaining assets. After the LLC pays off its creditors, and only then, it distributes the remaining assets to its members, either in proportion to the members' shares of profits or under some other arrangement outlined in the operating agreement. After an LLC winds up its business, most states require it to file articles of dissolution.