Limited Liability Company FAQs

By | November 20, 2007
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Table of Contents

What is a limited liability company?

A limited liability company is a hybrid legal entity, with elements of the structure of both corporations and of partnerships. Its organization is similar to a corporation, but it enjoys many of the operational and tax benefits of partnerships.

While the limited liability company is a relatively new type of legal entity (first recognized in the U.S. in 1977), all 50 states and the District of Columbia have now passed legislation authorizing the creation of LLC’s.

How is a limited liability company structured?

Limited liability companies are, in some ways, organized in a manner similar to corporations. The shareholders of a corporation have their counterpart in limited liability companies as its members. These members are the owners of the company, in much the same way that shareholders are the actual owners of a corporation. The company is managed by managers, who may or may not be members of the company as well.

What are the tax benefits of organizing a business as a limited liability company?

If a limited liability company is organized properly, it will be taxed as a partnership. In some cases, it may even be taxed as a sole proprietorship. This means that there will only be one level of taxation. The profits and losses of the company are passed through to the individual owners, in the same manner as in the taxation of partnerships. Corporations, on the other hand, are subject to a double taxation–first at the corporate level and then an additional tax at the individual level, after corporate profits in the form of dividends are passed on to shareholders.

When is a limited liability company taxed as a partnership, and when is it taxed as a sole proprietorship?

If the limited liability company has only one member, it will be treated as a sole proprietorship for federal tax purposes, unless the member-owner elects otherwise.

If the limited liability company has two or more members, it will be taxed as a partnership under IRS rules, unless it elects to be taxed otherwise. In order for a limited liability company to be taxed as a partnership, however, there are a few restrictions upon the distributions such companies can make to their members. First, the distribution allocations must have some “substantial economic” relation to the actual economic risks or rewards of the members, and second, the members may be subject to income tax on their contribution of future services to the company.

A multiple-member limited liability company may also elect to be taxed as a corporation instead of being taxed as a partnership.

What are the advantages of organizing a business as a limited liability company?

There are several advantages inherent to the limited liability company structure. The primary advantage is the combination of tax and liability treatment enjoyed by these companies. Limited liability companies are taxed like partnerships, meaning that income is only taxed once. But the limited liability company members are shielded from company liability in much the same way that corporate directors and shareholders are shielded. Thus, the company enjoys one of the most important benefits of corporate structure without one its most significant liabilities. Note, however, that like corporations, members and officers are not shielded from personal liability for their own negligence, recklessness or criminal activity, of course for people charged with criminal activity or a felony, the help of a criminal lawyer could really help your defense for these cases.

Another advantage of the limited liability company structure is that the company can distribute its profits to its members in any manner it wishes, without strict correspondence to the percentage of the company owned by each member.

Does a limited liability company have to be run by its members?

One of the management capabilities of a limited liability company is that the members may choose to manage the company themselves or they may select managers to manage the company. Most states have a default rule that the members are the managers of the company. This is unlike corporations, in which the shareholders elect the directors, who in turn, select the officers of the corporation, who then manage the company. In limited liability companies, the members may either remain as the managers or they may select managers to run the company. If management is desired by managers, these managers may either be members of the limited liability company or they may be non-members.

Do the members of a limited liability company need to be natural persons, or can they be artificial legal entities?

Most states do not require the members of a limited liability company to be a natural person. Corporations, partnerships, or other artificial legal entities can be members of a limited liability company in these states.

For specific rules on member eligibility in your state, please see the State Law Digest included with the purchase of an LLC form from www.findlegalforms.com.

Are members of a limited liability company required to pay self-employment taxes?

Members may be required to pay self-employment taxes on their share of the company profits. However, if the member works 500 hours or fewer for the company in a given year, they may avoid having to pay this tax. If one or more members of your limited liability company fall into this situation, you should consult a competent tax professional.

What are the advantages of members managing the limited liability company themselves?

In limited liability companies that are managed entirely by members and all members participate, the ownership interests in the limited liability companies are generally not considered to be securities under state and federal law. This eliminates an enormous amount of paperwork and regulation from the operation of the member-managed limited liability company. In most situations, this will be the management style with the most flexibility.

Where some members of the company act as managers but others do not, it is important to note that even non-voting/non-managing members will be considered to have earned the profits of the company and thus, they will be required to pay personal income tax on any limited liability company income that passes to them.

What are the advantages of having non-members manage the limited liability company?

Generally, this form of management style is chosen when the company’s members have little or no expertise in the particular business and desire a skilled manager or management team to handle all the affairs of the business.

In such companies, the ownership and transfer of membership interests may possibly subject the company to regulation under state and federal securities laws. If you choose this type of management structure, a competent tax professional should be consulted.

Can the limited liability company be managed by a mix of managers and non-managers?

It is possible to run a limited liability company by a combination of members and non-members. This choice may be appropriate for limited liability companies that desire to have an outsider (non-member) with particular expertise participate in the management decisions. For any number of reasons, the non-member manager may be desired: so that all profits are passed only to members, so that all losses are only sustained by members, or any other reasons specific to your particular business situation. Again, there is a special tax situation that may arise regarding those members who do not participate in the management of the company. They may avoid paying self-employment taxes on their share of the company profits if they work for 500 hours or less at the company’s business. If one or more of your members fall into this category, a competent tax professional should be consulted. Finally, the ownership and transfer of membership interests in a limited liability company that is managed, even in part, by managers may possibly subject the limited liability company to regulation under state and federal securities laws. If you choose this type of management structure, a competent tax professional should be consulted.

What documents outline the structure of a limited liability company?

A limited liability company’s primary organizational document is its Articles of Organization. This document serves a purpose similar to a corporation’s Articles of Incorporation. It provides the state with information regarding the framework of the limited liability company business. A few states refer to this central organizing document by another name— for instance, Washington state calls it a Certificate of Formation.

The second important document for a limited liability company is its Operating Agreement. This document is the limited liability company equivalent of a set of corporate bylaws. Within this document, the basic rights and responsibilities of the members or managers are defined. If matters relating to these areas are not covered by an adequate Operating Agreement, the state’s default rules will, generally, take effect.

What specific information must be included in the Articles of Organization?

Each state has its own requirements regarding the information that must be stated in the Articles.
This information usually includes some combination of the following:

  • Name of the company
  • Duration of the company, if less than perpetual
  • Purpose of the company
  • Registered agent’s name and address
  • Initial member’s name and addresses
  • Any reservation of the right to admit new members
  • The right of the company to continue business following an act of dissolution
  • Whether the company will be managed by members or managers
  • Manager’s names and addresses, if managed by managers
  • Contributions of members to the company
  • Future contributions required of members to the company

Most states require that the information included in the Articles be updated regularly, generally on an annual or biennial basis. For more information about specific requirements in your state, please see our State Law Digest for Limited Liability Companies.

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Are there fees associated with setting up a limited liability company?

Each state has a filing fee associated with the filing of a limited liability company’s Articles of Organization. This fee may range from $40 to upwards of $500. In addition, some states base this fee on the capitalization of the company, generally charging more for companies with capitalization of over $50,000. There may also be an additional fee charged for an annual or biennial report for the company. For details of the fee requirements in your state, check the State Law Digest.

Are there ongoing filing obligations involved with running a limited liability company?

Most states require limited liability companies to file regular reports updating the company’s information. These reports are generally required on either annual or biennial basis. For specific report filing requirements for each state, please see State Law Digest.

At what point in the life of the limited liability company are the organizers no longer personally liable for the company’s debts and obligations?

States have several different general times when the limited liability company is officially formed for the purposes of determining liability. In general, a limited liability company is formed when either:

  • Its Articles of Organization are filed with the state
  • Its Articles of Organization have been approved by the state
  • The Articles of Organization have been approved by the state, but may be made
    retroactive to the date of original submission
  • The company has chosen to delay the date of effectiveness to a later date than the filing or approval of the company’s submission of the Articles of Organization

If your company will be involved in an enterprise that will have potential liability immediately upon formation, it will be wise to understand the particulars of your state’s rules in this area. Please check the State Law Digest for information on your state

How are profits and losses apportioned to the limited liability company’s members?

As noted earlier, one of the principal flexibilities of the limited liability company is the ability to structure the division of profits and losses to members in any reasonable manner. Members may be provided their distribution of profits and losses in direct proportion to their contributions of money, services, or property to the company. This, in fact, is most often the clearest method by which to structure distribution. However, this form of business entity allows endless possibilities to tailor such distributions to the circumstances of your business. If a member is contributing a particular expertise, they may be compensated by a greater percentage of share in the profits of the business. If a member chooses not to participate in the management of the company, those members who do manage may earn a greater percentage share in the profits and losses. Look closely at your particular business organization and contributions to decide the fairest manner in which to distribute the proceeds or losses of the limited liability company.

Do members vote equally regarding the actions and affairs of the company?

The default rules that are in effect in most states provide that a member’s right to vote is allocated in proportion to the member’s contributions to the limited liability company. A few states provide that member’s voting rights are per capita, in other words, each member gets one vote only. In some states, managers are also given one vote in the affairs of the company. State default rules also typically provide that limited liability company matters be decided by either a majority or unanimous vote of the members. In all states, the Operating Agreement of the company may override most of these provisions and provide for voting divisions in any proportions desired, including denying voting rights to certain members. However, in many states, the default rules may not be overridden with regard to decisions on major company matters, such as the sale of all company assets, the dissolution of the company, or amendments to the Operating Agreement or Articles of Organization. Also note that in order to place any such restrictions in the Operating Agreement or Articles of Organization, it will be necessary to abide by the state default rules in order to adopt the original version of each document. Please consult the State Law Digest for the situation in your particular state.

Are members required to hold regular meetings?

Most states do not require regular membership or management meetings. However, it is often prudent for the members and/or managers to hold at least annual meetings to review the conduct of the company and plan for the future. In addition, meetings may be necessary more often in order to handle major affairs of the business that are beyond the scope of the managers alone, such as dissolving the company.

Are non-member managers shielded from liability in the same way that members are?

While every state offers liability protection to members of limited liability companies, some states also extend such protection to employees, non-member managers, and agents of the company. However, please note that anyone who is shielded from personal liability for the normal debts and obligations of a company are not shielded from personal liability for their own negligence, recklessness, or criminal activity. Please check your state’s limited liability company statute (citation available in our State Law Digest) for information on the rules regarding the limits of the liability shield.

Does the limited liability company continue its existence if a member withdraws from the company?

Limited liability companies can determine for themselves whether the company will continue after a member withdraws. This determination is spelled out in the company’s Articles of Organization. If no rule is set forth in the company’s Articles, then the default rules of the state of organization will govern.

To find out what the default rules are in your state, see our State Law Digest, which includes a citation to each state’s limited liability company statute.

Can a member transfer his interest in the limited liability company to a third party?

Limited liability companies can determine for themselves whether a member can transfer ownership interest in the company to a third party. This determination is spelled out in the company’s Articles of Organization. If no rule is set forth in the company’s Articles, then the default rules of the state of organization will govern. The default rule in most states requires either a majority or unanimous vote of the members in order to obtain consent to transfer a limited liability company ownership interest.

To find out what the default rules are in your state, see our State Law Digest, which includes a citation to each state’s limited liability company statute.

How can a limited liability company make operating distributions to its members?

Limited liability companies can determine how operating distributions are made to their members. This determination is spelled out in the company’s Articles of Organization. If no rule is set forth in the company’s Articles, then the default rules of the state of organization will govern. The variations on this rule are distribution on a per-capita basis, distribution on a proportionate basis based on each member’s contribution, or distribution on a per-profit share basis.

To find out what the default rules are in your state, see our State Law Digest, which includes a citation to each state’s limited liability company statute.

The following forms found in our Limited Liability Company Forms section relate to the topic of this article:

Limited Liability Company Forms Combo Package – Limited Liability Company Forms Combo Package for use in all states. Save money with this convenient combo packages containing the most used forms and agreements needed to start and operate an LLC. Avoid headaches and save time by always having the right form at your disposal.

Amendments – Various amendments for limited liability company formation documents for use in all states.

Articles of Organization – Articles of Organization for a Limited Liability Company for use in all states. This document outlines the basic structure of the limited liability company and also provides everything you need to prepare, draft and file your LLC’s Articles of Organization.

Member Meetings – LLC Member Meeting related forms, including kits for the first and annual meetings, for use in all states.

Operating Agreements – Operating Agreements for Limited Liability Companies for use in all states.

Pre-Organization Kits – LLC Pre-Organization Kit to help you set up an LLC in all states.

Termination of Limited Liability Company – Termination of Limited Liability Company Kits, which provide the tools for terminating the existence of a limited liability company.

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