A business owner can choose among a variety of structures for operating the business. These structures range from the simplest simple, such as a sole proprietorship —to the more complex, such as a C corporation. One type of entity that is extremely popular is the limited liability company (LLC). The LLC is unique in that it is a hybrid. It combines the flexibility of a partnership with the asset protection of a corporation.
This article explores some of the benefits that an LLC can offer to its owners.
Separate legal identity
A limited liability company (LLC) is an entity that is separate and apart from its owners, with its own rights, responsibilities and liabilities. This means that an LLC can file a lawsuit (or be sued) in its own name. The company can also buy, own, and use its own real or personal property, make its own contracts and guarantees, lend money and invest funds. Those who do business with a limited liability company must look to the company to satisfy any obligations owed to them, and not to the LLC’s members or managers.
Because an LLC is a separate entity, the owners of the company have limited liability. This is one of the most important benefits to operating as a limited liability company. Limited liability means that the individual assets of LLC members cannot be used to satisfy the LLC’s debts and obligations. A member’s risk of loss is limited to the amount that the member invested in the business.
CT Tip: Limited liability is not absolute. If a member guarantees the obligations of the business or co-signs a loan, then the member’s assets are at risk. Also, it’s possible for a court to disregard the LLC’s existence (“pierce the veil”) and reach the member’s assets. This can occur if the member completely dominated the company and did not treat it as a separate entity; used the LLC form to perpetrate wrong or injustice; or where it otherwise would be considered unfair to treat the member and company separately. Some state laws specifically state that the LLC’s separate existence can be disregarded to the same extent a corporation’s identity can be disregarded. But, even in states that do not have this statutory provision, courts have still acted to disregard the entity based on the member’s actions.
Unless the articles of organization specify differently, a limited liability company has perpetual existence. This means that the owners can change without triggering the dissolution of the company. A member’s death, retirement, or withdrawal from the company for any other reason does not mean that the company must cease to operate.
Most state laws governing LLCs provide that the company is only dissolved when
- an event specified in the operating agreement occurs
- the members consent to the dissolution
- a judicial or administrative action dissolves the company
In some states, the LLC Act provides that the death or withdrawal of the last remaining member causes dissolution. But even in these states, the LLC can provide that a new member will be appointed to continue the LLC.
Flexible management structure
Separate existence, limited liability and perpetual existence are benefits from operating as either a corporation or a limited liability company. However, one benefit that is specific to the LLC is its flexibility. The LLC’s members have many options for the management structure. By state law, the control over the LLC’s business rests with its members. However, the LLC—through its operating agreement and/or its articles of organization — can provide that it will instead be controlled by managers. Managers can be members or non-members, based on what is provided in the operating agreements. This flexibility means that the LLC is suitable for a few owners who wish to run the business together, as well as for a business venture with many owners, spread across the country.
Free transferability of financial interests
An LLC member is an owner of the LLC and the member's ownership interest is referred to as a membership interest. A membership interest has two parts: financial rights and management rights.
The members’ financial rights include the right to share in the profits and losses and receive distributions from the LLC. These rights are the personal property of the member and the default statutory rule is that they may be transferred without restriction. (The operating agreement can provide differently.)
However, most state statutes provide that there are restrictions on the transfer of the remaining interests—including the right to participate in the management of the LLC. This means that a member cannot sell or transfer his or her entire interest, including management rights, without the consent of all of the remaining members. Of course, the LLC’s operating agreement can alter the default rules. For instance, it can provide for less than unanimous consent.
LLCs also offer what is called “charging order” protection. This protects the LLC (and the other members) if a member’s personal creditors seek to seize the member’s LLC interest. While the creditors can reach the financial rights, they generally cannot step into the shoes of the member with regard to managing the LLC.
A limited liability company is a “pass-through” tax entity. Put simply, this means that the LLC’s gains, losses, income, deductions, credits, and other tax items flow-through to the member or members. The members report their share of these tax items on their personal income tax returns and pay taxes at the individual tax rates. An LLC is not subject to entity-level taxation unless it elects to be taxed as a C corporation.
CT Tip: This is an area where the flexibility of an LLC can prove extremely valuable. The share of the tax items can be established via the operating agreement and does not need to match the ownership interests. Moreover, profits, losses and other tax items do not have to be allocated in the same proportions.