Limited liability company

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A limited liability company (LLC) is the United States-specific form of a private limited company. It is a business structure that can combine the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. [1] An LLC is not a corporation under the laws of every state; it is a legal form of a company that provides limited liability to its owners in many jurisdictions. LLCs are well known for the flexibility that they provide to business owners; depending on the situation, an LLC may elect to use corporate tax rules instead of being treated as a partnership, [2] and, under certain circumstances, LLCs may be organized as not-for-profit. [3] In certain U.S. states (for example, Texas), businesses that provide professional services requiring a state professional license, such as legal or medical services, may not be allowed to form an LLC but may be required to form a similar entity called a professional limited liability company (PLLC). [4]

Contents

An LLC is a hybrid legal entity having certain characteristics of both a corporation and a partnership or sole proprietorship (depending on how many owners there are). An LLC is a type of unincorporated association, distinct from a corporation. The primary characteristic an LLC shares with a corporation is limited liability, and the primary characteristic it shares with a partnership is the availability of pass-through income taxation. As a business entity, an LLC is often more flexible than a corporation and may be well-suited for companies with a single owner. [5]

Although LLCs and corporations both possess some analogous features, the basic terminology commonly associated with each type of legal entity, at least within the United States, is sometimes different. When an LLC is formed, it is said to be "organized", not "incorporated" or "chartered", and its founding document is likewise known as its "articles of organization", instead of its "articles of incorporation" or its "corporate charter". Internal operations of an LLC are further governed by its "operating agreement". An owner of an LLC is called a "member", rather than a "shareholder". [6] Additionally, ownership in an LLC is represented by a "membership interest" or an "LLC interest" (sometimes measured in "membership units" or just "units" and at other times simply stated only as percentages), rather than represented by "shares of stock" or just "shares" (with ownership measured by the number of shares held by each shareholder). Similarly, when issued in physical rather than electronic form, a document evidencing ownership rights in an LLC is called a "membership certificate" rather than a "stock certificate." [7]

In the absence of express statutory guidance, most American courts have held that LLC members are subject to the same common law alter ego piercing theories as corporate shareholders. [8] However, it is more difficult to pierce the LLC veil because LLCs do not have many formalities to maintain. As long as the LLC and the members do not commingle funds, it is difficult to pierce the LLC veil. [9] [10] Membership interests in LLCs and partnership interests are also afforded a significant level of protection through the charging order mechanism. The charging order limits the creditor of a debtor-partner or a debtor-member to the debtor's share of distributions, without conferring on the creditor any voting or management rights. [11]

Limited liability company members may, in certain circumstances, also incur a personal liability in cases where distributions to members render the LLC insolvent. [12]

History

The first state to enact a law authorizing the creation of limited liability companies was Wyoming in 1977. [13] The law was a project of the Hamilton Brothers Oil Company, which sought to organize its business in the United States with liability and tax advantages similar to those it had obtained in Panama. [14]

From 1960 to 1997, the classification of unincorporated business associations for the purpose of U.S. federal income tax law was governed by the "Kintner regulations", which were named after the prevailing taxpayer [15] in the 1954 legal precedent of that name. [16] As promulgated by the Internal Revenue Service (IRS) in 1960, the Kintner regulations set forth a complex six-factor test for determining whether such business associations would be taxed as corporations or partnerships. [16] Some of these factors had equal significance, so that the presence of only half of them would result in classification as a partnership. Accordingly, the Wyoming Legislature tailored its statute to grant LLCs particular corporate features without exceeding this threshold. [13]

For several years, other states were slow to adopt the LLC form because it was unclear how the IRS and courts would apply the Kintner regulations to it. After the IRS finally decided in 1988 in Revenue Ruling 88-76 that Wyoming LLCs were taxable as partnerships, [16] other states began to take the LLC seriously and enacted their own LLC statutes. [13] By 1996, all 50 states and the District of Columbia had LLC statutes. [17] In 1995, the IRS came to the conclusion that the widespread enactment of LLC statutes had undermined the Kintner regulations, and in 1996 it promulgated new regulations establishing a so-called "check the box" (CTB) entity classification election system that went into effect throughout the United States on January 1, 1997. [16]

Flexibility and default rules

LLCs are subject to fewer regulations than traditional corporations, and thus may allow members to create a more flexible management structure than is possible with other corporate forms. As long as the LLC remains within the confines of state law, the operating agreement is responsible for the flexibility the members of the LLC have in deciding how their LLC will be governed. [18] State statutes typically provide automatic or "default" rules for how an LLC will be governed unless the operating agreement provides otherwise, as permitted by statute in the state where the LLC was organized.

The limited liability company has grown to become one of the most prevalent business forms in the United States. Even the use of a single member LLC affords greater protection for the assets of the member, as compared to operating as an unincorporated entity. [19]

Effective August 1, 2013, the Delaware Limited Liability Company Act provides that the managers and controlling members of a Delaware-domiciled limited liability company owe fiduciary duties of care and loyalty to the limited liability company and its members. Under the amendment (prompted by the Delaware Supreme Court's decision in Gatz Properties, LLC v. Auriga Capital Corp), [20] parties to an LLC remain free to expand, restrict, or eliminate fiduciary duties in their LLC agreements (subject to the implied covenant of good faith and fair dealing). [21]

Under 6 Del. C. Section 18-101(7), a Delaware LLC operating agreement can be written, oral or implied. It sets forth member capital contributions, ownership percentages, and management structure. Like a prenuptial agreement, an operating agreement can avoid future disputes between members by addressing buy-out rights, valuation formulas, and transfer restrictions. The written LLC operating agreement should be signed by all of its members. [22]

Like a corporation, LLCs are required to register in the states they are "conducting (or transacting) business". Each state has different standards and rules defining what "transacting business" means, and as a consequence, navigating what is required can be quite confusing for small business owners. Simply forming an LLC in any state may not be enough to meet legal requirements, and specifically, if an LLC is formed in one state, but the owner (or owners) are located in another state (or states), or an employee is located in another state, or the LLC's base of operations is located in another state, the LLC may need to register as a foreign LLC in the other states it is "transacting business". [23]

Income tax

For U.S. federal income tax purposes, an LLC is treated by default as a pass-through entity. [24] If there is only one member in the company, the LLC is treated as a "disregarded entity" for tax purposes (unless another tax status is elected), and an individual owner would report the LLC's income or loss on Schedule C of his or her individual tax return. Thus, income from the LLC is taxed at the individual tax rates. The default tax status for LLCs with multiple members is as a partnership, which is required to report income and loss on IRS Form 1065. Under partnership tax treatment, each member of the LLC, as is the case for all partners of a partnership, annually receives a Form K-1 reporting the member's distributive share of the LLC's income or loss that is then reported on the member's individual income tax return. [25] On the other hand, income from corporations is taxed twice: once at the corporate entity level and again when distributed to shareholders. Thus, more tax savings often result if a business formed as an LLC rather than a corporation. [26]

An LLC with either single or multiple members may elect to be taxed as a corporation through the filing of IRS Form 8832. [27] After electing corporate tax status, an LLC may further elect to be treated as a regular C corporation (taxation of the entity's income prior to any dividends or distributions to the members and then taxation of the dividends or distributions once received as income by the members) or as an S corporation (entity level income and loss passes through to the members). Some commentators have recommended an LLC taxed as an S-corporation as the best possible small business structure. It combines the simplicity and flexibility of an LLC with the tax benefits of an S-corporation (self-employment tax savings). [28]

Some legal scholars argue that corporate income taxes are intended to limit the power of corporations and to offset the legal benefits corporations enjoy, such as limited liability for their investors. [29] There is concern that LLCs, by combining limited liability with no entity-level taxation, could contribute to excessive risk-taking and harm to third parties. [30] [31]

Advantages

Disadvantages

Although there is no statutory requirement for an operating agreement in most jurisdictions, members of a multiple member LLC who operate without one may encounter problems. Unlike state laws regarding stock corporations, which are very well developed and provide for a variety of governance and protective provisions for the corporation and its shareholders, most states do not dictate detailed governance and protective provisions for the members of a limited liability company. In the absence of such statutory provisions, members of an LLC must establish governance and protective provisions pursuant to an operating agreement or similar governing document.

Variations

See also

Notes

  1. ↑ The rules contained in Treasury Regulation 1.704-1 must also be met. [32]
  2. ↑ An S corporation may have no more than 100 shareholders. [33] An individual, their spouse, and their family members within six common ancestors may typically be considered to be one shareholder for the purpose of this test. [34] [35]
  3. ↑ For purposes of U.S. tax law, residency is not the same as the location where a person lives.
    A U.S. citizen or U.S. national is always a U.S. tax resident.
    A lawful permanent resident of the U.S. at any time during a calendar year is typically a U.S. tax resident that year. [36] [37]
    In other cases, an individual is typically a U.S. tax resident if the individual was physically present in the U.S. on at least 31 days during the current year, and 183 days during the three-year period that includes the current year and the two years immediately before that, counting all the days present in the current year, and one-third of the days present in the first year before the current year, and one-sixth of the days in the second year before the current year. In some cases, an individual does not count days physically present in the U.S. while in certain visa statuses, such as F-1, J-1, M-1, Q-1. [38] Alternatively, an individual may not be a U.S. tax resident if the individual was present in the U.S. less than 183 days during the year, the individual had a closer connection to one foreign country in which the individual has a tax home than to the U.S., the individual maintained a tax home in that foreign country during the entire year, and the individual has neither pursued nor has a pending application for U.S. lawful permanent resident status. [39]

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References

  1. ↑ Schwindt, Kari (1996). "Limited Liability Companies: Issues in Member Liability". UCLA Law Review. 44: 1541.
  2. ↑ "Limited Liability Company (LLC)". Internal Revenue Service. Retrieved October 9, 2019.
  3. ↑ McCray, Richard A.; Thomas, Ward L. "Limited Liability Companies as Exempt Organizations" (PDF). Internal Revenue Service. Retrieved October 9, 2019.
  4. 1 2 Akalp, Neil (August 10, 2016). "Should You Structure Your Accounting Firm as an LLC, PLLC or PC?". Accounting Today. SourceMedia. Retrieved October 9, 2019.
  5. ↑ Bischoff, Bill (May 1, 2017). "The advantages of owning real estate in a single-member LLC". MarketWatch, Inc.
  6. ↑ Johnston, Kevin. "What Is the Difference Between a Shareholder Vs. a LLC Member?". Hearst Newspapers, LLC. Houston Chronicle. Retrieved October 9, 2019.
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  8. ↑ Macey, Jonathan R. (March 27, 2014). "The Three Justifications for Piercing the Corporate Veil". Harvard Law School Forum on Corporate Governance.
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  11. ↑ Adkisson, Jay (April 30, 2013). "The Misunderstood Charging Order". Forbes.
  12. ↑ See, e.g., "Delaware Code, Title 6, Chapter 18, Limited Liability Company Act". State of Delaware. Retrieved October 9, 2019.
  13. 1 2 3 Borden, Bradley T.; Rhee, Robert J. (2012). Limited Liability Entities: A State by State Guide to LLCs, LPs and LLPs, Vol. 1 (2022-3 supp. ed.). New York: Wolters Kluwer. p. 1-14. ISBN   9781454820208.
  14. ↑ Hamill, Susan P. (1998). "The Origins Behind the Limited Liability Company". Ohio State Law Journal. 59 (5): 1459–1522.
  15. ↑ United States v. Kintner , 216 F.2d 418 (9th Cir. 1954).
  16. 1 2 3 4 Field, Heather M. (January 2009). "Checking In on 'Check the Box'". Loyola of Los Angeles Law Review. 42 (2): 451–528. Retrieved September 22, 2020.
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  18. ↑ "Pros and Cons of a Limited Liability Company (LLC)". AllBusiness.com. Retrieved October 9, 2019.
  19. ↑ Miller, Shari P. "Single Member LLC Vs. Sole Proprietorship Liability". Houston Chronicle. Hearst Newspapers, LLC . Retrieved October 9, 2019.
  20. ↑ "Gatz Properties, LLC v. Auriga Capital Corp., 59 A. 3d 1206 (2012)". Google Scholar. Retrieved October 9, 2019.
  21. ↑ Falby, Bruce E. (August 22, 2013). "Delaware amends its LLC Act: managers and controllers owe fiduciary duties unless LLC agreement provides otherwise". DLA Piper.
  22. ↑ Bainbridge, Stephen (September 27, 2014). "Didn't sign your LLC operating agreement? Think that'll get you off? Think again". ProfessorBainbridge.com.
  23. ↑ "Register Your Business". SBA. U.S. Small Business Administration. Retrieved October 9, 2019.
  24. ↑ "Instruction SS-4 (Rev. January 2011)" (PDF). Retrieved October 9, 2019.
  25. ↑ "LLC Filing as a Corporation or Partnership". IRS. Internal Revenue Service. Retrieved October 9, 2019.
  26. ↑ Everett, John; Henning, Cherie; Raabe, William (August 2010). "Converting a C Corporation into an LLC: Quantifying the Tax Costs and Benefits". Journal of Taxation. 113 (2).
  27. ↑ "IRS Form 8832 (Rev. January 2011)" (PDF). Retrieved October 9, 2019.
  28. ↑ "Tax Advantages of Corporations – Updated for Tax Year 2016". TurboTax. Retrieved October 9, 2019.
  29. ↑ Avi-Yonah, Reuven S. (September 2004). "Corporations, Society, and the State: A Defense of the Corporate Tax". Virginia Law Review. 90 (5): 1193–1255. doi:10.2307/3202379. ISSN   0042-6601. JSTOR   3202379.
  30. ↑ Sim, Michael (2018). "Limited Liability and the Known Unknown". Duke Law Journal. 68: 275–332. doi:10.2139/ssrn.3121519. ISSN   1556-5068. S2CID   44186028.
  31. ↑ Hamill, Susan Pace (November 1996). "The Limited Liability Company: A Catalyst Exposing the Corporate Integration Question". Michigan Law Review. 95 (2): 393–446. doi:10.2307/1290118. ISSN   0026-2234. JSTOR   1290118. S2CID   158517043.
  32. ↑ "26 CFR § 1.704-1". Internal Revenue Service. Legal Information Institute.
  33. ↑ 26 U.S.C.   § 1361
  34. ↑ "26 CFR § 1.1361-1(c)(1)(B)". Internal Revenue Service. Legal Information Institute.
  35. ↑ "26 CFR § 1.1361-1(e)(3)(ii)". Internal Revenue Service. Legal Information Institute.
  36. ↑ "Determining an Individual's Tax Residency Status". Internal Revenue Service. December 10, 2021.
  37. ↑ "U.S. Tax Residency – Green Card Test". Internal Revenue Service. October 22, 2021.
  38. ↑ "Substantial Presence Test". Internal Revenue Service. October 27, 2021.
  39. ↑ "Closer Connection Exception to the Substantial Presence Test". Internal Revenue Service. December 7, 2021.
  40. ↑ "Sturm v. Harb Development, 298 Conn. 124, 2 A.3d 859 (2010)". Google Scholar. Retrieved October 9, 2019.
  41. ↑ Parsons, James (February 1, 2019). "Here Are the Benefits of Multiple LLCs or Corporations for Your Businesses". Entrepreneur.
  42. ↑ Brown, Robert L.; Gutterman, Alan S. (2005). Emerging Companies Guide: A Resource for Professionals and Entrepreneurs. American Bar Association. p. 68. ISBN   1590314662.
  43. ↑ Auerbach, Alan J.; Hines, James R. Jr.; Slemrod, Joel (2007). Taxing Corporate Income in the 21st Century. Cambridge University Press. p. 240. ISBN   978-1139464512.
  44. ↑ For example, HMRC in the United Kingdom, "HMRC Tax Manuals, DT19853A". Gov.UK. Government of the United Kingdom. May 25, 2017.
  45. ↑ Badger, Emily (April 30, 2018). "Anonymous Owner, L.L.C.: Why It Has Become So Easy to Hide in the Housing Market". The New York Times.
  46. 1 2 Watson, Libby (April 6, 2016). "Why are there so many anonymous companies in Delaware?". Sunlight Foundation.
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