Notes on Limited Liability Companies (LLCs)

UNIT FOUR | Business Entities

CHAPTER 29 | Limited Liability Companies

Learning Objectives

  • After studying this chapter, students will be able to:

    • Define what a limited liability company (LLC) is.

    • Identify the sources of laws that govern LLCs.

    • Explain the steps required to form an LLC.

    • Identify the primary methods for capitalizing LLCs.

    • Explain the function of an operating agreement.

    • Articulate the legal protections from personal liability afforded to the principals in an LLC.

    • Identify the tax treatment alternatives available to an LLC.

    • Compare and contrast dissolution and dissociation.

Overview of the LLC

  • A limited liability company (LLC) is a flexible type of business entity that offers:

    • Easy formation.

    • Flexible operation.

    • Limited legal liability of the owners (called members).

    • Pass-through taxation.

Definitions

  • Limited Liability Company (LLC): A business entity that combines elements of partnerships, sole proprietorships, and corporations, providing liability protection to its members while allowing flexible tax treatment.

Pros and Cons of LLCs

Pros:

  • Limits personal liability for business debts and agreements.

  • Pass-through entity for tax purposes to avoid double taxation.

  • Fewer requirements around corporate meetings and less formal paperwork.

Cons:

  • Not typically set up for raising venture capital.

Key Concepts

  • The owners of an LLC are referred to as members.

  • All states in the U.S. recognize LLCs; historically, Wyoming was the first state to do so in 1977.

Laws Governing LLCs

  • The Uniform Limited Liability Company Act (ULLCA) and the Revised Uniform Limited Liability Company Act (RULLCA) are important statutes designed to promote uniformity in state LLC laws.

  • Differences between state statutes can occur; however, both ULLCA and RULLCA provide a framework for the governance of LLCs.

  • As of 2022, twenty states and the District of Columbia adopted a version of RULLCA.

Key Points

  • LLCs must only file in one state, even if conducting business across state lines.

Formation of the LLC

  • Formation involves:

    • Filing the articles of organization with the designated public official in the state of entry (e.g., secretary of state).

    • Articles must include:

    • Name of the entity.

    • Location of the principal place of business.

    • Names of members.

  • Typical requirement: A contemporaneous filing with tax authorities.

  • Examples include original articles of organization from Facebook when it was an LLC.

Steps Required to Form an LLC

  • Relatively easy and inexpensive setup.

  • Basic information is crucial for the articles of organization.

Capitalization of the LLC

  • Unlike corporations, LLCs do not issue shares.

  • Mainly capitalized through:

    • Debt from private/commercial lenders.

    • Sale of equity ownership in the LLC itself.

  • The methods of capitalization are often controlled by the operating agreement.

Key Point

  • LLCs are mainly capitalized through debt or by selling equity, dictated by the operating agreement.

The Operating Agreement

  • An operating agreement governs how the members will operate the LLC. It details:

    • Structure of governance and voting rights (managing members vs. members).

    • Voting procedures and member responsibilities.

    • Procedures for admitting new members and handling death or incapacity.

    • Outline procedures for dissolution if majority members decide to cease operations.

  • Essential for specifying rights, responsibilities, and operational protocols within the LLC.

Importance of the Operating Agreement

  • It sets forth members' rights and duties, highlighting rules of management.

  • It may include penalties for noncompliance with its terms or particular events.

Types of LLC Management

  • Member-managed LLC: All members can manage; similar to general partnership.

  • Manager-managed LLC: A designated manager (or managers) runs daily operations, while other members are investors without authority to bind the LLC.

  • Decisions about management structure are made before filing articles of organization.

Fiduciary Duties

  • Managers owe fiduciary duties of care and loyalty to each other and cannot engage in self-dealing.

  • The RULLCA provides clarity that members cannot evade personal liability in cases of bad faith or misconduct.

Limited Liability of the Owners

  • LLC protects its members from personal liability for business debts and obligations.

  • Members may be personally liable if:

    • A personal guarantee is provided to creditors.

    • Courts determine that fairness demands compensation due to fraudulent activity.

  • Example: If a member signs a lease on behalf of the LLC, creditors can only claim against the LLC itself under most circumstances.

Taxation of the LLC

  • LLCs are often treated as pass-through entities for tax purposes:

    • Income is only taxed once at the member level, avoiding double taxation.

    • Members can elect to be taxed as a corporation if advantageous.

Benefits of Pass-Through Tax Treatment

  • Allows investors to utilize tax deductions and losses allowing for financial flexibility.

Dissolution versus Dissociation

  • Dissolution: Liquidation process triggered by events in the operating agreement or member majority vote to dissolve.

    • Possible due to expiring fixed terms or decision of a majority.

  • Dissociation: When a member withdraws from the LLC, remaining members may choose to continue or dissolve.

  • Cases highlight the significance of having clear agreements to avoid disputes regarding LLC operations and member exits.

Legal Cases and Concepts

  1. Kirksey v. Grohmann: A case exemplifying judicial dissolution where the court decided based on the inability to operate effectively due to deadlock among members.

Quick Quiz Regarding Limited Liability

  1. Is a sole member of an LLC personally liable for business debts?

  2. If multiple members in an LLC face a lawsuit for loan repayments, what is their level of responsibility?

Answers to the Quick Quiz

  • Personal liability questions were addressed, concerning whether liability falls back onto individual members under specific circumstances.