An Introduction to the Limited Liability Company (LLC)
What is a limited liability company (LLC)?
A limited liability company is a relatively new form of business organization that has emerged during the past 40 years. The main idea of the LLC is to combine aspects of two older forms of business entity: the corporation and the partnership. The limited liability company is now a recognized type of business entity in all 50 U.S. states and many other countries. An LLC is not the same as an LP (limited partnership), an LLP (limited liability partnership), or an LLLP (limited liability limited partnership), each of which are separate and distinct forms of business with their own advantages and disadvantages. An LLC may be managed by its owner/members or by one or more managers who may or may not be owner/members.
What are the main advantages of LLCs compared with other business entities?
The three main advantages of the limited liability company are: (i) protection of the LLC owner/members from liabilities that arise from the companies business operations; (ii) protection of the LLC owner/members from the creditors of other owner/members; (iii) the option to have “pass-through” tax treatment, meaning that the business entity pays no income tax and its profits or losses are treated as profits or losses of its members; (iv) extreme flexibility regarding management structure, business formalities (such as meetings and record-keeping), and income allocation; and (v) in most places, the ability to have only one owner/member.
Is the liability protection provided by an LLC absolute? Are there circumstances when limited liability company creditors can “pierce the veil” of the LLC and reach an owner/member’s personal assets?
It is difficult, but not impossible, for the creditors of a limited liability company to successfully reach the personal assets of an LLC owner/member. The two most common ways that an LLC owner/member can become personally liable for company debts is when the owner/member commingles company and personal funds, and when the company distributes income without making adequate provisions for paying its bills.
Unlike with a corporation structure, the failure of a limited liability company to hold regular meetings, elect officers, or keep proper records, will not expose the LLC member/owners to personal liability. However, LLCs are required to keep their assets separate from those of the owner/members. This means that company assets, including title to real estate, must be held in the name of the LLC, and not in the name of one or more of the owner/members. Similarly, cash or securities must be held in accounts set up in the name of the LLC. Owner/members must take care not to commingle LLC and personal funds (meaning that all company income must be deposited in company accounts, and all company bills must be paid from these accounts).
Limited liability companies are also required to retain enough of their income to cover the bills and other liabilities they reasonably expect to incur. This means that the company must plan ahead before making distributions to owner/members. Creditors who are not paid because LLC money was distributed to the owner/members can reach the owner/members’ personal assets to satisfy the LLC’s debts; however, no individual owner/member can be required to pay more to creditors than he/she received in distributions from the LLC.
How does an LLC protect each of its owner/members from the creditors of the other owner/members?
The laws that govern limited liability companies prevent the creditor of an LLC owner/member from seizing his/her debtor’s full interest in the LLC. Instead, creditor can only obtain a “charging order” that entitles him/her to the money or other assets that the LLC distributes to the debtor owner/member. The creditor cannot force dissolution of the LLC, require sale or distribution of any LLC asset, or exercise voting or management rights.
Why would anyone choose not to take the liability protection offered by the LLC structure?
The liability protection created by using a limited liability company structure is not cost-free. In most jurisdictions, a limited liability company must pay an annual franchise tax or fee to maintain its legal existence and, with some exceptions as discussed below, is also required to file annual tax returns. Use of an LLC may also deprive its owner/members of income tax deductions or other benefits that they would have had if they owned an asset, such as a home, directly, or may increase the difficulty and/or cost of obtaining financing. Because there are costs and disadvantages of using a limited liability company structure, it is important to consider the true value of the liability protection in the context of the type of business the LLC will undertake. Some activities do not create a high level of liability exposure; other activities can be insured at relatively low cost. In the end, the costs and inconveniences of creating and maintaining an LLC must be weighed against the true level of liability exposure and the availability and cost of alternative forms of protection such as insurance.
What is “pass-through” tax treatment?
Pass-through tax treatment means that a business entity, such as a limited liability company that chooses this tax treatment, does not pay income tax on its profits. Instead, each of its owner/members reports a percentage share of the profits or losses on his/her individual tax return. Any profits reported this way are taxed based on the owner/member’s tax rate. Limited liability companies have a choice between pass-through tax treatment and corporate tax treatment. In general, if the LLC chooses corporate tax treatment, it will pay tax on its profits and then, if and when it pays dividends to its owner/members, they will have to pay tax on those dividends (a phenomenon often referred to as “double taxation”). However, under certain circumstances, an LLC can qualify to be taxed as an “S corporation”, in which case the double taxation effect is avoided.
Why would an LLC choose corporate (i.e. non-pass-through) tax treatment?
The most common reason an LLC chooses corporate tax treatment is to protect the member/owners from having to pay income tax on profits that are not distributed. This is important in situations where the company wants to retain its profits for future business needs. Another common reason why an LLC might choose corporate tax treatment is particular to small LLCs whose owner/members provide services to the company or its customers. In this situation, if the LLC qualifies to be taxed as an S corporation, electing corporate tax treatment might diminish self-employment tax liability for the owner/members providing these services.
Does an LLC that chooses pass-through tax treatment need to file tax returns?
An LLC is required to file Federal and state tax returns every year even if it opts to be treated as a pass-through entity. The only exception to this rule applies to a “single-member LLC” which can opt to be treated as a “disregarded entity” for income tax purposes. A disregarded entity is not required to file federal tax returns; instead, its member/owner reports the single-member LLC’s income and expenses on his/her personal federal return. In addition to saving time and money, disregarded entity tax treatment allows the member/owner to take advantage of tax benefits not generally available in connection with assets held by an LLC, such as mortgage interest deductions and capital gain exclusions on a home held by a single-member LLC and occupied as a personal residence by the LLC’s owner/member. Note, however, that many states (including California) require single-member LLCs to file state tax returns even if they are not required to file Federal returns.
What is a single-member limited liability company?
A single-member LLC is a limited liability company with only one owner/member, or a company with two members who are spouses. The single member may also be another entity, such as a trust (including a living trust), a partnership, a corporation, or another LLC. All 50 U.S. states now allow limited liability companies to have only one member, but many other jurisdictions do not. A single-member LLC can be managed by a manager who is not the owner/member.How does one create an LLC?Forming a limited liability company requires filing an organizational document, often called the “Articles of Organization” or the “Certificate of Organization”, with a state government office, and paying a filing fee. The name of the organizational document, required content, filing procedure, and fee, varies from state to state, but each state’s requirements are readily available online. The organizer of the LLC can create an original document provided it satisfies state requirements; however, all states offer simple, one-page, fill-in-the-blank forms that require no special knowledge or expertise. Many states now have procedures under which the entire LLC creation process can be completed in minutes online, with fee payment by credit card.
Although filing an organizational document is the only legally required step in LLC formation, two other steps are desirable for practical reasons. The first is obtaining a federal tax identification number (or “EIN”), which allows the LLC to fulfill its tax filing obligations and to open a bank account. Anyone with a U.S. social security number can get an EIN instantly by completing an online application process on the IRS website. The second is creating an LLC Operating Agreement as described in the next section.
What is an LLC Operating Agreement, and is it necessary to have one?
An LLC Operating Agreement describes how the limited liability company will be managed and operated, and covers issues such as original capital contributions, obligations for future contributions, decision-making rights and procedures, profit allocations, admission of new owner/members, and dissolution. An Operating Agreement is obviously useful for resolving future disputes; but there are other, less obvious benefits such as establishing who is authorized to sign contracts on behalf of the company, and how many signatures are necessary to bind the company. In practice, it is often impossible for an LLC, even a single-member LLC, to conduct business, open a bank account, acquire real estate, or obtain financing, without showing an Operating Agreement that establishes who is authorized to sign on the company’s behalf.
Can LLC owner/members remain anonymous?
Some jurisdictions allow a limited liability company to form without identifying any of its owner/members. Depending on the jurisdiction’s rules, the LLC may be able to maintain the anonymity of some or all of the owner/members indefinitely, or may have to identify them within a specified period after formation. Anonymity rules applicable to a particular company will depend both on where the company is formed and where it is doing business. Many jurisdictions require “foreign LLCs” (meaning those formed in another jurisdiction) to register prior to doing business and/or acquiring assets, and registration may entail identifying one or more of the owner/members.
Even jurisdictions that do not require LLC owner/member identification do require each LLC formed or doing business there to designate either a natural person, or a licensed company, to act as its “agent” within the jurisdiction. The role of the agent is to receive legal documents on the company’s behalf, including lawsuits, but the agent need not be an owner/member. Some jurisdictions also require that the company have a local business address. Company owner/members can preserve anonymity by hiring a person or service to satisfy both agent and address requirements for a relatively low annual fee.
How does one choose the best U.S. state in which to form an LLC?
Choosing the best state for a limited liability company requires analysis of filing requirements, filing fees, annual fees, tax policies, and the type and location of business to be conducted by the LLC. We have prepared a chart that provides a state-by-state comparison of LLC filing fees, annual fees, franchise tax, and tax return requirements ( view LLC Cost Comparison Chart ). But consideration of only these issues is too limited for most businesses. It is also important to remember that most states require LLCs formed in other jurisdictions to register prior to conducting business and/or acquiring assets within the state, and satisfying these registration requirements may involve paying fees and taxes, and disclosing information, not required by the state where the company was formed.
About the Author
Since 1984, Andy Sirkin’s law practice has focussed on developing and documenting creative and practical approaches to real estate investing. He is known for his ability to help his clients evolve general concepts and business model ideas into fully developed and detailed business plans by quickly identifying hidden issues and solving seemingly complex problems. He favors reasonable and cost-effective solutions to regulatory challenges, and simple, short, plain-English legal documents. In addition to over 30 years of legal practice experience in the US and overseas, including work with numerous web-based and non-technology startups, he brings extensive experience as a real estate builder/developer, syndicator, brokerage manager, income-property owner, and passive investor.