Limited liability companies are a newer form of business entity. Like S corporations, limited liability companies combine the liability protection traditionally associated with corporations with the flow-through taxation of partnerships. But because limited liability companies are not subject to the stringent rules that apply to S corporations, they are usually the preferred form of entity for small businesses.
A limited liability company is recognized as a legal entity separate from its owner for state law purposes. To form a limited liability company, the owner(s) must file documents with the state. The documents usually include, at a minimum, a Certificate of Formation (also called Articles of Organization). The owner(s) should also adopt an Operating Agreement to govern the affairs of the limited liability company.
The taxation of limited liability companies depends on how many members are involved and whether the limited liability company elects to be treated as a corporation. A single-member limited liability company is generally disregarded for Federal tax purposes unless it elects to be taxed as a corporation. Its income is reported on the owner’s personal income tax return, without any need for a separate tax return for the limited liability company.
A multi-member limited liability company is treated as a partnership for Federal tax purposes unless it elects to be treated as a corporation. This provides the flow-through taxation benefits normally associated with partnerships. For more information on taxation of limited liability companies, see Taxation of LLCs and Partnerships, Tax Consequences of Contributions to LLCs and Partnerships, and Tax Consequences of Distributions from LLCs and Partnerships.
Capitalization and Contributions
A limited liability company is initially capitalized by transferring property to the limited liability company in exchange for a membership interest in the limited liability company. A limited liability company can have different classes of membership interests, each with their own right to voting and distributions.
Owner Liability for Entity Obligations
Members of a limited liability company are generally protected from liability for obligations of the limited liability company. The limited liability company is treated a separate entity and is solely responsible for its own debts and obligations. This veil of protection may be pierced, however, if the members commingle personal and company funds, engage in fraudulent behavior, or inadequately capitalize the limited liability company to the detriment of creditors. Members are also personally liable for any loans or other obligations that they personally guarantee.
Protection of Entity Assets from Owner’s Personal Creditors
State law permits creditors of a member to obtain a charging order against that member’s membership interest. A charging order, which is issued by the court, directs that distributions of income or profits that would otherwise be paid to the debtor-member should instead be paid to the creditor.
In most states, a charging order confers only the right to receive distributions. It does not give the creditor the right to vote or otherwise participate in the management of the limited liability company. As a result, the creditor cannot force the company to make distributions. If the company makes no distributions, the creditor receives no payments. This makes the charging order an unattractive remedy for creditors.
In almost half of the states, the charging order is the only remedy to creditors of the limited liability company. This means that, as a general rule, limited liability companies generally offer a higher degree of protection of company assets from an owner’s personal creditors.
Control of a limited liability company is determined primarily by the limited liability company’s Certificate of Formation (also known as Articles of Organization) and Operating Agreement, as well as any agreements between the members. State law provides a default system of rules that apply in situations that are not governed by these organizational documents.
State law generally allows for two types of limited liability companies. A member managed limited liability company is managed by the members as a whole. Each member has the right to act on behalf of the company and most company affairs are decided by vote of the members. In contrast, a manager managed limited liability company is managed by one or more designated managers, which may or may not be members. The non-managing members are treated like passive investors in the company, with either limited or no rights to manage the day-to-day affairs. Some states require the type of limited liability company to be selected on the formation documents.
While the laws of most states have similar provisions regarding control of the limited liability company, there are some state-by-state variations that should be considered.
Continuity, Transferability, and Dissolution
In some states, limited liability companies exist until they are affirmatively dissolved by the members, either by unanimous or majority consent. Other states treat withdrawal of a member as an event that triggers an automatic dissolution, even if the remaining members agree to continue to operate the company.
Members are generally free to transfer their membership interests unless restricted by the formation documents or by agreement between the members. State law may prohibit an absolute restriction on transferability.
A limited liability company’s formation documents and annual reports are filed with the state and can generally be viewed by third parties. The limited liability company’s Operating Agreement, minutes, resolutions, and other books and records are not publicly accessible, but may be obtained and reviewed by members of the limited liability company in some circumstances.
Transition to Other Entity Form
In some circumstances, a limited liability company may be converted to another form of entity. This could involve a distribution of assets to the members followed by a contribution of those assets to the new form of entity, or through some other form of cross-entity merger or reorganization.