Limited Liability Companies



Chapter 13

Limited Liability Companies

Introduction

The limited liability company (LLC) is fast becoming the “entity of choice” in American business. LLCs offer business owners the limited liability protections of incorporation with the benefit of partnership taxation. While LLCs are often compared to the limited liability partnership, they offer their members more extensive personal liability protections. They combine the best of corporations (liability protections) with the best of partnerships (taxation benefits).

Lecture Notes

□ Limited Liability Company Defined

An LLC is an unincorporated entity that offers its members:

management rights

limited personal liability

pass-through taxation of partnerships

Advantages

limited liability for all members, including managers

pass-through taxation

flexibility of management

Disadvantages

limited duration (depending on state statute)

limited transferability of interests

lack of interstate uniformity

□ Liability

Members of an LLC are not personally liable for the debts or obligations of the LLC, in the absence of fraud. In this manner, they look very much like a corporation.

Note: State statutes generally require LLCs to carry appropriate insurance coverage to protect the public from the negligence or malfeasance of the LLC or its members.

□ Management

All members of an LLC have the right to participate in management. If the LLC members “opt out” (i.e., waive their management rights), they can elect a board of managers.

Board of Managers

An LLC board of managers operates like a corporate board of directors.

□ Taxation

An LLC may elect to be taxed by the IRS as a partnership, thus avoiding the double taxation suffered by corporations.

□ Formation

An LLC is formed much like a corporation:

1. Register business name, with “LLC” designation, with the secretary of state.

2. File articles of organization with secretary of state.

3. Obtain required business and professional licenses and permits.

4. Review Taxation Filings.

a. Apply for sales tax permit, if goods will be sold.

b. Apply for tax identification number with the IRS and state.

c. File IRS Form 8832 electing partnership or corporate taxation.

5. If employees will be hired

a. Establish employee withholding accounts.

b. Establish unemployment and workers’ compensation coverage.

6. Draft comprehensive operating agreement.

□ Name

As with all businesses that offer its members personal liability protections, the LLC must notify the public of its status and the limited liability protections of its members with the appropriate designation “LLC” or “Ltd. Liability Co.”

□ Purpose

Most states prohibit insurance companies, banking institutions, and some professions (e.g., accountants) from forming an LLC. The main purpose is to protect the public from the unlimited liability protections of these types of businesses, and hold companies and their agents accountable for the services they render.

□ Registration

An LLC must file articles of organization with the secretary of state. This filing provides contact information about the LLC (registered agent, registered office), as well as information about management of the LLC.

□ Operating Agreement

An LLC operating agreement is similar to a partnership agreement. While it is not mandatory, it is recommended and should be drafted for all LLCs.

The operating agreement should include

voting and management rights of members

capital contributions of members

profit sharing

duration

signatures of all members

□ Termination

Termination of an LLC is a two-step process:

1. dissolution

2. winding up

Step One: Dissolution

An LLC is generally dissolved due to

termination per operating agreement

statutory duration period expired

death, bankruptcy, etc. of member

agreement by members

court order

Step Two: Winding Up—Turning Assets into Cash

The LLC must turn its assets into cash (liquid assets) and distribute the “profits” as follows:

• Creditors’ Claims

Creditors are paid the amounts due before profits can be distributed to members.

• Distributions to Members

After the debts of the LLC are paid, any remaining profits will be distributed to the members.

➢ File Articles of Termination

An LLC is not legally dissolved until it notifies the secretary of state that it has dissolved and liquidated its assets.

Note: As a practical matter, most businesses fail to complete this step. However, it is advisable that the paralegal make sure that the articles of termination are filed. This avoids embarrassment when the client receives a letter from the secretary of state stating that the LLC has not been formally terminated with the state (yet the client paid your firm handsomely to take care of the dissolution process).

Answers to Study Questions in Review

1. What is a limited liability company (LLC)?

An LLC is like a corporation with its expansive personal liability protections; however, it provides partnership taxation to its members. LLCs offer all members management rights, limited personal liability, and the pass-through taxation of a partnership.

2. Who are the managers of a LLC?

All members of an LLC have management rights.

3. Do LLCs offer more liability protections than a limited liability partnership (LLP)?

Yes. Generally LLPs protect partners only from liability for the negligence and malfeasance of other partners; individual partners remain liable for their own negligence and malfeasance and that which they participated in, supervised, or had knowledge of. In contrast, an LLC generally offers its members absolute immunity for the debts and obligations of the LLC, including those arising from tort.

4. What is the disadvantage of including an expansive purpose clause that allows a company to transact “any and all lawful business,” in an LLC’s articles of organization?

It grants the members and managers authority to act on behalf of the LLC in any lawful business. Thus a member or manager may bind the LLC to transactions that have not been properly approved.

5. How would a professional limited liability company designate its status in its name?

By including “PLLC” in its partnership name

6. What document can be drafted for an LLC that establishes the operating procedures and the rights and duties of LLC members?

The operating agreement

7. Is an LLC taxed as a partnership or as a corporation? Explain.

An LLC is taxed as a partnership as long as it does not share more than two of the four corporate characteristics (continuity of life, centralization of management, limited liability, free transferability of interests).

8. Have all states adopted LLCs as a business form?

No. A state that has not adopted LLCs as a business form may treat a foreign LLC as either a corporation or a partnership. This lack of uniformity is a major disadvantage of the LLC.

9. What is centralization of management, and do LLCs have centralized management? Under what conditions is a board of directors appointed to manage an LLC?

Centralized management occurs when a limited number of individuals have the authority to participate in the management of a business. LLCs are generally considered to have decentralized management because all members have the right to manage. A board of directors may be appointed to manage an LLC if the members waive their management rights.

10. What fiduciary duties do members of an LLC owe to the company and to each other?

The ULLCA impose the duty of care and loyalty on members of an LLC.

11. Members of LLCs are generally granted immunity from personal liability for the obligations of the LLC. What are the exceptions to this general rule?

1. Members are liable for the capital contributions that they agree to make to the LLC.

2. Members, managers, and officers may be held personally liable for violations by the LLC of environmental laws.

3. Members, managers, and officers may be personally accountable for unpaid federal and state tax obligations of the LLC.

4. If the LLC is formed for an improper or fraudulent purpose, its members may be held personally liable for the obligations of the LLC resulting from improper or fraudulent acts.

Answers to Case Studies in Review

1. Cathy, Don, and Steve own “T-shirts à GoGo, LLC.” They produce T-shirts with personalized logos for local businesses, sports teams, and other organizations. Steve is in charge of marketing for the company, and during one of his recent rainmaking trips, he discovered that many businesses want to have their business name and logo imprinted on pencils, pens, and other business-related items. Steve is excited about the prospect of this area of expansion and signs contracts with three companies to provide imprinting of their business name and logo on several business supplies. Steve did not receive Cathy or Don’s approval for the contracts, and the business does not have the equipment to produce the products Steve contracted for. The purpose clause of the company’s articles of organization allows the company to transact “any and all lawful business” and the operating agreement does not restrict the members’ authority. Did Steve have the authority to bind the LLC to the new contracts?

Yes. The use of the boilerplate “any and all lawful business” grants members and managers expansive authority to bind an LLC to unexpected business arrangements.

2. The Riley family owns and operates a local religious bookstore for profit. The bookstore is an LLC, and all the members of the family participate in management of the business, including the parents and four children. While the family generally works well together, it is difficult for everyone to meet for the weekly management meetings. Everyone is offered the opportunity to speak on the management issues at each meeting; thus, the meetings usually take two to three hours. The family finally decides that it makes sense to appoint a board of managers, which they do. What are the advantages and disadvantages to appointing a board of managers?

A board of managers centralizes the management of an LLC and generally simplifies the management’s decision-making process. However, if a board of managers is elected to operate an LLC, the LLC has centralized its management (a corporate characteristic) and therefore jeopardizes its status as a partnership for tax purposes (because an LLC must avoid “looking like” a corporation for tax purposes).

Project Applications

1. Does your state impose annual reporting requirements on LLCs? (Hint: Contact the secretary of state to research this issue).

2. Obtain the documents necessary to register an LLC with the secretary of state of your state. Prepare the documents for the following company:

Joann and Melissa have been partners in an accounting firm for five years. They work mainly with small businesses. They recently received a letter from their attorney notifying them that the state has adopted a new business form—limited liability companies. Joann and Melissa like the extensive liability protections of the LLC. They ask the firm to draft the registration documents.

Their file contains the following relevant information:

Joann Dollars Melissa Cents

100 South West 340 Bend Drive #6

Somewhere, (your state) 55555 Somewhere, (your state) 55555

Business Address: Dollars and Cents

400 Brooks Street

Somewhere, (your state) 55555

County: Any County

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