Limited Liability Company vs. Other Entities
Pursuant to your request, this letter is intended to give you some information on the use of an Limited
Liability Company, hereinafter referred to as "LLC") compared to a partnership or a corporation. Please
review the information enclosed and contact me with any questions you may have.
A limited liability company is a relatively new form of business organization that is treated like a partnership for income tax purposes and like a corporation for liability purposes.
Generally, an LLC is a legal entity formed under a statute, other than a partnership or corporation statute, that allows an association of owners (must be Two (2) or more owners in California) to carry on a business with none of the owners having liability for the obligations of the business.
Under the Beverly-Killea Limited Liability Company Act (the Act) (Corp C 17000-17705), an LLC is formed when articles of organization are filed with the California Secretary of State on the Secretary of State's Form LLC-1 and, generally, two or more LLC "members" enter into an operating agreement. California Corporation Code 17050.
The operating agreement may be oral or written and may consist simply of an agreement to form an LLC (California Corporation Code 17001(ab)). The salient nontax characteristics of an LLC are limited liability for its owners (like a corporation) and freedom to structure management rights and financial interests in the entity in virtually any configuration the parties wish (like a partnership).
Most often, an LLC will be treated as a partnership for income tax purposes. The income, gains, losses, deductions, and credits of the LLC generally will flow through to its members for reporting on their personal tax returns.
Until the advent of the LLC, the limited partnership and S Corporation were the primary forms of business entity used to achieve the tax status and limited liability features now offered by the LLC. Each of those forms of business organization, however, has drawbacks. Although a limited partnership allows pass-through tax treatment, flexibility in financial structuring, and limited liability for limited partners, at least one person, i.e., a general partner, must be fully liable for the obligations of the business, and limited partners may not take part in the control of the business without jeopardizing their limited liability.
An S corporation limits the parties' flexibility in structuring their financial arrangements because of the requirements that the corporation have no more than one class of stock (Internal Revenue Code, [hereinafter referred to as "IRC"] 1361(b)(1)(D)) and that items of income, gain, loss, deduction, or credit be taken into account in accordance with the shareholders' pro rata share of the corporation's stock (IRC 1366). Furthermore, only individuals, estates, certain types of trusts, and certain tax-exempt organizations are eligible S corporation shareholders (IRC 1361(b)(1)(B)), and an S corporation will lose its pass-through tax treatment if an ineligible entity becomes a shareholder. Finally, the pass-through income tax treatment offered by an S corporation is not exactly the same as that of a partnership, and this differential treatment can sometimes have adverse tax consequences.
An LLC can provide the advantages of S corporations and limited partnerships without the disadvantages. Unlike a limited partnership, no LLC owner (a "member") need be personally liable for the company's obligations, and each member is permitted to manage the company and to take part in the control of its business without losing the member's limited liability (California Corporation Code 17150, 17101). Unlike an S corporation, any "person" i.e., any individual, partnership, limited partnership, trust, estate, association, corporation, other limited liability company, or other entity, whether domestic or foreign can be a member of an LLC. California Corporation Code 17050(b), 17001(x), 17001(ae).
The owners of an LLC are called members. The Act specifically contemplates management by members (California Corporation Code 17150) and states that a member is not personally liable for any contract, tort, or other obligation of the LLC by virtue of being a member (California Corporation Code 17101). Members of an LLC may waive their limited liability for any or all obligations of the LLC, provided the waiver is set forth in the articles of organization or in a written operating agreement that specifically refers to California Corporation Code 17101(e). An LLC must pay a tax of $800 per year for the privilege of being an LLC regardless of gross receipts or net income. California Revenue & Taxation Code, (hereinafter referred to as R & T C), 17941. This amount is equal to the minimum tax imposed on corporations, including S corporations (Rev & T C 23153(a)), on limited partnerships (Rev & T C 17935(a)), and on limited liability partnerships (Rev & T C 17948(a)).
An LLC pays no net income tax, but unless the LLC has total income of less than $250,000, the LLC must pay an annual fee based on the total income (from all sources reportable to California) for the taxable year. This annual fee is in addition to the $800 tax discussed above. Revenue and Taxation Code 17942(a) sets forth the fee schedule. The fee will range from $500 (for businesses with $250,000 or more but less than $500,000 of total income) to $4,500 (for businesses with $5,000,000 or more of total income).
An LLC allows as much, and in some cases more, flexibility in structuring management and control than any other form of business organization under California law. An LLC can be managed either by all the members (a "member-managed LLC") or by one or more managers (a "manager-managed LLC"). The managers in a manager-managed LLC may be either members or nonmembers.
The default rule is that an LLC is member-managed (California Corporation Code 17150), but the default rule is effectively superseded by the articles of organization because Item 6 of Secretary of State Form LLC-1 (Articles of Organization) requires a statement indicating whether the LLC is member-managed or manager-managed, and the articles prevail over any conflicting provision in the operating agreement (California Corporation Code 17005(f)). With the adoption of the "check-the-box" regulations (Reg 301.7701-1 301.7701-3), an LLC's status as member-managed or manager-managed is no longer important for the classification of the entity as a partnership or corporation for federal income tax purposes.
In a member-managed LLC, each member is an agent of the LLC, and any act of a member for the apparent purpose of carrying on in the usual way the affairs of the member-managed LLC binds the LLC. California Corporation Code 17157(a). Although the members may agree that a member has no authority to act, either generally or with respect to a particular matter, third parties are not bound by that agreement absent their actual knowledge that the member lacks authority to act. California Corporation Code 17157(a).
The rules in this regard are similar to the rules that apply to general partnerships. In a manager-managed LLC, no member is an agent of the LLC by virtue of being a member. California Corporation Code 17157(b)(1). Instead, every manager is an agent of the LLC, and any act of a manager for the apparent purpose of carrying on in the usual way the affairs of the LLC binds the LLC. California Corporation Code 17157(b)(2). A manager's lack of authority to act is not binding on third parties without actual knowledge of the lack of authority. California Corporation Code 17157(b)(2). The rules in this regard are similar to the rules that apply to limited partnerships (a manager corresponds to a general partner, and a member corresponds to a limited partner) except that the active participation by a member in the management and control of an LLC will not create liability for the member. Whether the LLC is member-managed or manager-managed, the LLC may have officers, including a president, chief financial officer, and secretary. California Corporation Code 17154. Officers, like managers, may, but need not, be members. California Corporation Code 17151(a), 17154(a). Each member of a member-managed LLC has the fiduciary duties of a manager. California Corporation Code 17150. The fiduciary duties that a manager owes to the LLC and its members are the same as those of a partner to a partnership and its partners. California Corporation Code 17153. The fiduciary duties that a manager owes to the LLC and its members may be modified only in a written operating agreement "with the informed consent of the members." California Corporation Code 17005(d). No person who is a manager or an officer of an LLC has any personal liability for any contract, tort, or other obligation of the LLC by virtue of being a manager or officer. California Corporation Code 17158. LLC members have voting rights as specified in the articles of organization or operating agreement. The right to vote may be based on number, capital interest, share of profits, or any other basis. The right to vote may be by class or group of members, and some members may have voting rights to the exclusion of other members. California Corporation Code 17103(a). If the articles of organization and operating agreement are silent with respect to voting rights, the default rules are as follows:
The articles of organization or operating agreement can change the above default rules.
The requirement that the articles of organization may be amended only by a vote of at least a majority in interest of the members as provided in California Corporation Code 17103(b) may not be modified by the articles of organization or operating agreement (California Corporation Code 17005(b)(3)). California Corporations Code 17104 contains an extensive set of default rules for holding meetings, including rules on giving notice, determining quorums, proxies, and action by written consent in lieu of a meeting.
The rights of a member in an LLC are collectively referred to as the member's membership interest. A membership interest includes not only a member's economic interest in the LLC but also all other rights of a member, such as the rights to manage, vote, and receive specified information. California Corporation Code 17001(z). An economic interest in an LLC is a person's right to share in profits and losses of the LLC and the right to receive distributions from the LLC, but an economic interest does not include any other rights of a member, such as the right to manage or to vote, or, except as specified in the Act, the right to information. Corp C 17001(n). Both a membership interest and an economic interest are personal property. California Corporation Code 17300.
The distinction between a membership interest and an economic interest is most important when dealing with the transfer of an interest in the LLC. The default rule is that the transfer of a membership interest requires the consent of a majority in interest of the members not transferring their interests, but the transfer of an economic interest requires no consent. California Corporation Code 17301(a)(1).
The transfer of an economic interest simply entitles the transferee to receive from the LLC any allocations of income and loss and any distributions that the transferor had the right to receive; the transfer of an economic interest does not dissolve the LLC or entitle the transferee to vote, participate in management, or exercise any other rights of a member. California Corporation Code 17301(a)(2)-(3). There may be good reasons under the tax and securities laws, however, to restrict the transfer of an economic interest in the LLC even though the transferee has no voting, management, or other rights. The default rule is that the transferee of an economic interest may be admitted to the LLC as a member, in substitution for the transferor, only on a vote in favor of such admission by a majority in interest of the other members (California Corporation Code 17303(a)), but whether or not such substitution occurs, the transferring member remains liable to contribute capital as agreed and to return any distributions made in violation of law or the operating agreement (California Corporation Code 17301(b), 17303(c)).
A requirement that a majority of the nontransferring members of an LLC consent to the transfer of a membership interest will cause the LLC to lack the corporate characteristic of "free transferability." The restriction on transferability of a membership interest is important for controlling the membership in the LLC. However, with the adoption of the "check-the-box" regulations (Reg 301.7701-1 301.7701-3), it is no longer important for the classification of the entity for federal income tax purposes.
The operating agreement may provide for the termination of a member's membership or economic interest. On termination of a member's economic interest, the member is entitled to return of the member's capital contribution. Any provision of the operating agreement concerning the termination of membership and the return of a member's contribution will be enforceable unless the member establishes that the provision was unreasonable under the circumstances at the time the agreement was made. California Corporation Code 17100(c). The right of a member to assert that such a provision is unreasonable may not be eliminated by the articles of organization or the operating agreement. California Corporation Code 17005(b)(2).
The favored tax treatment of the LLC, its limited liability features, and its flexibility for structuring financial and managerial operations make the LLC a form of business organization to be considered for a new business having two or more owners. Choice-of-entity analysis should now include this new form of business organization. An LLC can be particularly advantageous in the following situations.
Existing unincorporated businesses. Any existing business that is a partnership and any sole proprietor bringing in a partner should consider converting to LLC form. Generally, the conversion can be done without triggering income tax. Venture capital investors. Because of the organizational and structural flexibility of LLC's, the ability to engage in management without fear of liability, and the ability to make special allocations and deduct losses, an LLC may be attractive to venture capital investors. An LLC may not be able to attract venture capital, however, if it restricts the right of investors to sell their ownership interests or if the venture capital investor is a partnership that has tax-exempt or foreign partners.
Although the LLC form of organization has many desirable features, it is not suitable for every business. An LLC may not be appropriate in the following situations. Existing incorporated businesses. Converting a corporation into an LLC will generally result in a taxable liquidation of the corporation, even if the corporation has elected to be an S corporation. A statutory merger of a corporation into an LLC, for example, will ordinarily be treated as a liquidation of the corporation and a contribution of the distributed assets by the shareholders to the LLC. The tax cost of liquidating the corporation should be calculated and considered before deciding to convert the form of business organization from corporation to LLC.
Businesses planning to go public. With some exceptions, a partnership whose ownership interests are publicly traded is taxed as a corporation. An LLC that becomes publicly traded would therefore lose one of the primary benefits of being an LLC, i.e., partnership tax treatment, and, compounding that loss, the capital markets might discount the value of an ownership interest because of unfamiliarity with LLC interests as compared to stock. An LLC could incorporate before going public and avoid this result, and for certain businesses, an initial period of operation as an LLC may be suitable. Until it incorporates, however, an LLC could not offer tax-favored incentive stock options and employee stock purchase plans, which are common ways of compensating and motivating employees working for a business intending to go public, and, as mentioned above, an LLC might not attract certain investors. Businesses doing business nationwide. LLC's that intend to do business nationwide will be concerned about doing business in the few remaining states that have not adopted LLC statutes. The courts of those states may respect the limited liability provisions of the state of organization, but if the courts instead treat the LLC as a general partnership, each member could be fully liable for the obligations of the LLC in that state. Accordingly, LLC's may wish to avoid doing business in any such state or to form a corporate subsidiary to do business there.
I hope that the information stated above is not too detailed for you and that it gives you some of the ideas and information needed to decide on which is the form of entity that suits your needs. Should you have any questions, or wish to discuss this matter further, please feel free to contact me.
Very truly yours,