Advantages of Forming an Limited Liability Company

What is an LLC? LLCs are unincorporated legal entities created under state law. Even though LLCs are unincorporated vehicles, the fundamental intent of state statutes is to allow the formation of entities that are legally more similar to corporations than to partnerships. Nevertheless, LLCs usually can be treated as partnerships for federal income tax purposes. The critical point to remember is that, LLCs are not corporations; nor are they partnerships; they are hybrid between the two.

Limited Liability: Ordinarily, only the LLC is responsible for the company's debts, and shields its members from individual liability. However, there are exceptions in which individual members may be held liable, for example, if a member commits a tortuous act: an act that leads to civil actions, other than those involving breaches of contract. Other examples would be professional malpractice or negligent driving that results in injuries and property damage. LLCs generally do not offer liability protection to members and managers beyond what corporations offer shareholders. Members are always exposed to the risk of losing shares of LLC capital as a result of a catastrophic event or judgment against the LLC. There are no restrictions on the owner's involvement in management. In contrast, a limited partner in a limited partnership loses liability protection by undertaking an active role.

Guarantor Liability: When an LLC member has personally guaranteed the obligations of the LLC, he or she is held liable. For example, a prospective landlord will most likely require a personal guarantee from the LLC members before executing an office space lease with an LLC that is relatively new and has no credit history.

Alter Ego Liability: A member may be held liable for the debts of the LLC if the court imposes the "alter ego liability" doctrine. This is a judicial doctrine applied to corporations where a court may hold the individual shareholders liable when the business entity is merely an "Alter Ego" of its shareholders. You might consider a state like Nevada that adds further protection to the "LLC veil."

Although a corporation's failure to hold shareholder or director meetings may subject the corporation to alter ego liability, this is not the case for California LLCs. In California, failure to hold members' or managers' meetings is not usually considered grounds for imposing the alter ego doctrine when the Articles of Organization or Operating Agreement do not expressly require such meetings. However, we believe it is still a good idea to hold your meetings.

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Management and control: Management and control of an LLC is vested with its members unless the Articles of Organization provide otherwise. Typically, an LLC managed by managers provides you with the flexibility to limit management involvement by members.

Voting Interest: Ordinarily, voting interest directly corresponds to interest in profits, unless the Articles of Organization or Operating Agreement provide otherwise.

Transferability: No one can become a member of an LLC - either by transfer of an existing membership or the issuance of a new one - without the consent of members having a majority interest, unless the Articles of Organization provide otherwise. This is key to prevent a creditor from automatically taking over a member's ownership percentage. Typically, a creditor may be awarded a "charging order" against the member's interest, which allows an "economic distribution" at best, and the ability to foreclose on the membership interest in some states, entitling a creditor to profits distributed by the LLC. This scenario only occurs when an LLC is taxed as a limited partnership, and the strategy allows more LLC asset protection than an S- or C-corporation.

Duration: LLCs were traditionally required to specify a date on which their existence would terminate, but many states now allow LLCs to exist perpetually. In most cases, unless otherwise provided in the Articles of Organization or in a written Operating Agreement, an LLC dissolves at the death, withdrawal, resignation, expulsion, or bankruptcy of a member (unless a majority in both the profits and capital interests votes within 90 days to continue the LLC).

Formalities: The existence of an LLC begins when you file the Articles of Organization with the Secretary of State, on the form prescribed by the Secretary of State. The required information on the form includes the latest date the LLC will dissolve, and a statement as to whether the LLC will be managed by one manager, more than one manager, or the members.

To complete a valid formation of an LLC, members must enter into an Operating Agreement. Although the Operating Agreement may be oral or written, we recommend that you have it in writing. If a challenge arises among the members, it may be difficult to prove, or even remember, what you initially agreed upon.

Taxation: S-corporation shareholders obtain basis for loss deductions only to the extent of the basis in stock plus the amount of loans they make to the corporation [IRC §1366]. On the other hand, LLC members (taxed as a partnership) are treated as partners and obtain additional basis in LLC interest for the share of LLC debts [IRC §752]. This is a significant advantage to forming an LLC.

Liability: The big advantage of an LLC over a limited partnership is that the general partner in a limited partnership has unlimited liability which forces you to strongly consider a second entity in an LP to be the general partner.

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