And so we come to the end, or the beginning? When we started with Partnerships, we discussed the age-old fiduciary duty doctrines and the, often archaic, structures that general partnerships provide. We then moved on to the wonderful legal technology of “limited liability” that Corporations offer. We finished by noting all of the red tape and administrative functions that one has to facilitate in order to maintain the limited liability gloss.
Thankfully, ‘merica eventually caught on and established a brand new business entity technology that has the “pass through tax” and flexibility available to Partnerships PLUS the all-important limited liability of a Corporation. So let’s dive in.
A common problem with Corporations is called “double taxation.” Basically, under the traditional Corporate structure, any profits that the corporation makes are taxed against the corporation itself, and then taxed again when the shareholders receive a portion of the profits (through a shareholder distribution).
LLCs, on the other hand, do not have this problem. The LLC itself is not taxed on LLC profits, only the members of the LLC themselves. This subtle but effective difference can save LLC companies enormous amounts of money. (see the math).
Just like Corporations, LLCs have “limited liability.” This means that the amount that a member of the LLC would have to pay (your liability) in a lawsuit is limited to the amount that the person invested into the LLC itself. So for example, let’s say that my 4 friends and I are members of an LLC and we each invest $10,000 into the LLC to get it started. Our LLC is a golf resort and during our 3rd year of business, one of our patrons, Bob Cratchety, falls down the stairs at the entrance and breaks his leg. He sues the company for damages and wins a reward of $50,000.
Due to our “limited liability” status, none of the LLC members would have to pay any of Bob’s damages. Even if he won an award of $500,000, we would still only have to pay him money from the LLC itself. If the LLC only had, say $100,000 in its bank account, and it could only get $50,000 from liquidating its assets (selling the golf course), then Bob would only be able to get that $150,000; he would not be allowed to sue us individually for our houses, our cars, or our children’s education fund. Our liability is limited to our investment.
With Corporate law, and the origins of the limited liability system, however, courts would sometimes “pierce the corporate veil,” and allow a suing party to go after a shareholder’s personal assets if the court found that the corporation was a sort of “fraud” or “corporate shell” that was created to shield an owner from liability for releasing a product into the market that was known to be incredibly dangerous. They also pierce the veil if the owners fail to comply with all the rules for maintaining a corporation (more on this below).
While they’re supposed to be treated differently, courts have had a tendency to treat LLCs exactly like they do Corporations. If an LLC owner fails to comply with all the LLC red tape and provisions in his Operating Agreement, the courts are more likely to pierce the veil and allow people to go after people’s own personal assets.
In order to maintain your limited liability status under a corporate form, you have to jump through an enormous amount of administrative hoops to keep a court from “piercing the corporate veil,” as mentioned above, and allowing people who want to sue you to go after your personal assets.
The list of administrative pains in the neck include maintaining corporate minutes, having regular shareholder meetings, sending official notice to the various corporate officers about the regular shareholder meetings and why or why not you will be attending, documenting each major decision brought before the board of directors and why each decision as made and whether it constitutes a major decision that, as written in the bylaws, should include a supermajority vote of the shareholders, shareholder voting trusts and the limits on each voting trust agreement, and on and on and on ad infinitum.
Fortunately, with an LLC, you just make business decisions. Really. That’s it. You can assign officers and have certain voting requirements for major decisions (like whether to sell the business or merge with another business) but for the most part, your job as an LLC member is simply to run your business. You don’t need a law degree (or to pay an in-house corporate counselor) to understand everything you have to do to maintain your limited liability. The mere fact that you have an LLC, basically, gives you limited liability.
LLCs are based in state law, so each state will have a slightly different piece of legislation that allows the formation of LLCs. Thankfully, the vast majority of LLC legislation, across the states, are nearly identical, and most LLC business papers can be setup in such a way as to avoid any issues with whatever state you’re registering your business in.
Registering your LLC with your secretary of state is a snap. You’ll have to write up your Management Agreement (called an “Operating Agreement” for LLCs) and file it with the Secretary of State so that it’s on record. You’ll also need to include the acronym “ LLC” after every single printing of your business name. This is to give the public warning that, if they do dealings with you, you have limited liability and they won’t be able to go after your personal choice alienware shwag.
Another thing you should know is that in the absence of a filed Operating Agreement for an LLC, the courts usually default to provisions in your state’s LLC legislation. Essentially, if you don’t have an official operating agreement, the courts will sort of fill in the blanks for you and make you comply with their version of your company’s operating agreement.
This gap filling may be helpful, but it also may do harm, as they create business requirements that are stock and not necessarily ones that you’d want in your business. They’re also more likely to pierce the veil in the absence of your own operating agreement because it looks more like a shell company that doesn’t “deserve limited liability.” For those reasons, creating and registering with the state your own Operating Agreement does wonders to protect your Limited Liability status as an LLC, and it allows you to customize your company’s management agreements.
As you can see, LLC agreements, as new a technology as it is in the legal world, are almost all upside when it comes to creating business entities. They are far preferable to partnerships and corporations as they have the benefits of both without all the downside and chaff.
Are there any blog topics you’d like to see? Any legal questions you’d like answered? Please feel free to leave them in the comments section or shoot me an email. I’d be happy to help out.
– Jonathan Sparks, Esq.