A limited liability company (“LLC”) is a business entity that functions as a distinct legal “person” separate from its owners. In that role, it offers the owners protection from personal liability for business debts. An LLC is typically a “pass-through” entity for tax purposes, meaning taxes are not paid at the company level, but rather, the profits and losses of the business pass through to its owners, who report them on their personal tax returns.
While certain aspects of an LLC are similar to a traditional corporation, formation and LLC management from a legal perspective provides more flexibility than a corporation, while also having less of a statutory burden.
To create an LLC, Articles of Organization—in some states called a Certificate of Formation or Certificate of Organization—-–are filed with the business division of the state government, which is usually, but not always, part of the secretary of state’s office. Filing fees typically range from about $100 to $800.
In most states, the state has a prescribed form that requires a few basic details about the LLC, such as its name, address and the contact information for a person who will receive legal papers on its behalf (usually called a “registered agent”). Some states also require a list of the names and addresses of the LLC members or managers. If the LLC will be conducting business in more than one state, then it must also register to transact business with the business division in each additional state. Usually, that entails filing a form and paying fees similar to the filing of the original Articles of Organization, but the original state of formation remains the “home” state.
While not required by most state statutes, it is a good idea to adopt and follow an operating agreement, also called a “limited liability company agreement.” The operating agreement typically addresses issues of company governance, ownership, economics and operations; furthermore, it lends credibility to the LLCs separate legal existence. The operating agreement is an internal company document that is not filed with the state, but is usually prepared by a corporate lawyer who tailors it to fit the business’ specific wants and needs.
LLCs may, but are not required to, issue certificates to evidence ownership of LLC membership interests (often called “units”). Most companies do not issue these certificates, and instead track ownership internally in the company’s records.
LLCs management is conducted in one of two fashions: directly by the owners, a system called “member-managed,” or by certain designated parties (known as managers) who are elected/appointed by the members (this is called “manager-managed”).
Once the LLC has been formed, most states require annual franchise tax filings, which essentially amounts to a tax for the privilege of being registered in that state. Also, while not required by statute, it is generally recommended that LLCs follow similar maintenance procedures as corporations—for instance, that they hold annual meetings of members and managers, and/or prepare annual consents that formally approve the actions of management over the prior year. Doing so will help in establishing the separate company existence (as discussed below), and is good company practice.
Similar to corporation shareholders, all LLC owners (referred to as “members”) are protected from personal liability for business debts and claims. That means if the business itself can’t pay a creditor (such as a landlord, supplier, or lender), the creditor cannot legally come after the personal assets of a member absent a personal guarantee or misconduct. As such, the members have limited liability, because their risk in connection with business debts is limited to the money they have invested in the LLC. Notwithstanding the foregoing, as in any type of business entity, a member can be held personally liable if they do one of the following:
The last exception could lead to what is known as “piercing the corporate veil,” where the owners may in fact become personally liable for business debts (notwithstanding the LLC’s separate legal existence). In order to prevent that from happening, it is essential that adequate capital is invested in the LLC, personal activities and funds are not mixed with business activities and funds, and that certain formalities are observed. For example, business funds should be separate from personal funds, meaning personal expenses should not be paid out of business accounts. The LLC should create, file and maintain proper documentation of its existence and operation; in other words, the LLC should make sure that all federal and state forms have been filed, and that all documents are signed in an official capacity on behalf of the LLC (e.g., as manager), rather than personally.
Finally, while also not required under statute, obtaining a comprehensive business insurance policy helps to protect personal and business assets. Such insurance will cover most business activities where they occur in the course of performance of the business. However, insurance won’t help if the LLC defaults on its financial obligations, as commercial insurance usually does not protect personal or LLC assets from unpaid business debts, whether or not they’re personally guaranteed.
Unless an election is made to be taxed as a corporation (which is rarely the case), an LLC is taxed as a “pass-through entity” like a partnership. That means the LLC itself doesn’t pay taxes, and instead, business income or losses pass through the business to the LLC members, who report their share of profits (or losses) on their individual income tax returns. However, multi-member LLCs do have to file yearly Form 1065s (an informational return) with the IRS. This form sets out each LLC member’s share of the LLC’s profits (or losses) that the IRS uses to make sure LLC members are correctly reporting their income. In the case of a single member LLC, the LLC is disregarded for federal tax purposes. As such, income or losses appear on a schedule to the owner’s return, and the LLC does not file any tax return.
Because of structural/organizational flexibility and favorable tax treatment, the LLC has become the most popular form of business organization in the United States. That being said, there remain instances where other forms of business enterprise may be more appropriate, and a discussion with your advisors is always warranted before forming any new company.
©All Rights Reserved. April, 2020. DailyDAC™, LLC d/b/a/ Financial Poise™
Jeremy Waitzman advises his clients on significant transactions and operational issues in their businesses. Described by clients as “an essential business advisor” and “a partner in the success of my business,” Jeremy has substantial experience representing businesses of all types and sizes from inception, guiding them through significant growth, and often through ownership’s exit. His…