Limited Liability Companies: What Are They and Should I Form One?
March 4, 2022
This month, we examine the limited liability company (LLC), one of the most popular filed business structures. The LLC boasts flexibility, liability protection, and generally favorable tax status possibilities. These qualities make the LLC a superb choice for many businesses despite some limitations.
Management Terms Explained
In discussing and regulating the LLC, Texas LLC law uses language not commonly used by laypersons. Prospective LLC owners should ideally familiarize themselves with this language to understand the law, their business attorney, and the company’s governance documents. Texas LLC law calls LLC owners “members.” An owner’s ownership interest in the company is called a “membership interest.” For the avoidance of doubt, LLC members do not include company employees, officers, directors, or managers, unless the employee or manager is also an owner of the company. To habituate readers to proper terminology, the remainder of this discussion will use the proper terms used by Texas law.
Management Flexibility
The LLC benefits from flexibility of management and operations. In the same way that a partnership may set forth its own management structure in its partnership agreement, an LLC may establish its own management structures, duties, and other valuable operational matters in its operating agreement or company agreement. For example, the LLC may establish terms for monetary distributions to its members. Because this matter often leads to disputes, breaches of contract, breaches of fiduciary duties, and litigation, LLC members should consider discussing monetary distribution policies before forming the company and should ideally set forth these policies in the operating agreement or company agreement. The LLC may also elect whether its members or non-member managers will manage the company. The LLC’s operating agreement or company agreement may set forth rules for myriad other matters, such as voting rights, operational duties, and more.
The law requires fewer formalities and recordkeeping matters of the LLC than of other structures. This frees small businesses to make efficient use of oftentimes-limited manpower. In an important distinction from other structures, such as corporations, at the time of this discussion, LLC members need not contribute capital to receive ownership interests in the company. Especially where a member does not contribute capital, however, the company and its members should carefully record issuance of membership interests in a written or electronic ledger. The LLC may also consider issuing certificates or other written record to each member in a manner similar to corporations’ issuance of share certificates, though this is not required.
Liability Protection
The LLC offers robust liability protections. Provided the LLC and its members properly separate and manage assets, LLC members are liable only to the extent of their investment in the company, and the LLC will protect its members’ personal assets. Moreover, the LLC protects its members from joint and several liability. This means that LLC members are not liable for one another’s errors and omissions, as general partners of a partnership may be. Although no business structure can guarantee freedom from liability, LLC’s liability protections are among the most robust of Texas entity types.
Tax Treatment
The LLC enjoys a uniquely flexible tax status. Although the LLC is a well established business entity under business law, the LLC does not have its own federal income tax regime. By default, a single-member LLC, an LLC with a single owner, is a disregarded entity under tax law. In other words, a single-member LLC does not file a federal income tax return and does not pay taxes at the entity level; instead, the LLC member will report the LLC’s income and expenses directly on the member’s own income tax return. By default, a multi-member LLC, an LLC with multiple owners, is treated for tax purposes as a partnership. This means the multi-member LLC will not pay taxes at the entity level, and the company’s profits and losses pass through to the LLC members, each of whom in turn includes the respective shares of the profits and losses in the member’s income tax return. By default, both the single-member LLC and the multi-member LLC enjoy pass-through tax status. This default arrangement may suffice for a small business with a single owner and with little or no intention to grow.
Although some businesses may find no need to engineer their default tax statuses under tax law, the LLC may elect to be taxed as another entity type. For example, an LLC may elect to be taxed as an S-corporation. Taxation as an S-corporation also confers pass-through taxation such that the LLC will not pay taxes at the entity level and affords other tax advantages, especially for businesses aiming to grow. Although election for S-corporation status appeals to many aspiring businesses, tax law and business law strictly limit the types and numbers of owners and businesses that may elect S-corporation status. The law also imposes a strict time limitation for electing S-corporation status. Failure to meet these limitations may cause other tax burdens upon the business, and these burdens may be significant depending on the type of business. We will explore S-corporation elections in more detail in a separate discussion.
Limitations
Despite the many attractive characteristics lending the LLC its popularity, the structure does entail some limitations. Although the LLC may grow substantially and soundly and although it is possible for LLC to be publicly traded, LLCs are not typically publicly traded. An LLC targeting public trading will often convert into a corporation before an initial public offering, and, in most cases, the LLC cannot maintain its advantageous S-corporation status if it becomes publicly traded due to some of the limitations of S-corporation status elections discussed above. Moreover, statutes and case law surrounding the LLC structure is less developed than those of corporations and partnerships. Although the LLC structure lends its members protection, this uncertainty causes some uncertainty regarding the fiduciary duties of LLC members and managers as well as other facets of the structure.
Despite these disadvantages, the LLC is among the most popular business entities, especially among businesses with no intention to become publicly traded. Its flexibility of structure and management keeps small businesses lean, and its tax status grants the business freedom of choice. These qualities make the LLC a strong choice for many businesses.