THE LIMITED LIABILITY COMPANY What Is A Limited Liability Company? The limited liability company (also called the LLC) is a form of business entity just now becoming popular in the U.S., although it's been available in Germany, France, and many other countries for decades. Until its recent acceptance by a number of U.S. states, the business executive had three common choices when forming a business: the sole proprietorship, the corporation, or the partnership. The LLC is a hybrid between the partnership and the corporation. It has all the flexibility of a partnership to define its own management structure, rules of procedure, voting rights, distribution of profits and a myriad of other details. The structure is created by a contract among all the parties. At the same time, if structured properly all the members and the management will enjoy limited liability typical of a corporation. It is generally assumed that the combination of these two elements will be the reason most LLCs are formed, although there is a great deal of latitude with regard to the structure. It offers many advantages over the Subchapter S corporation, which has been the traditional method of combining corporate liability protection with partnership-type taxation. History Of The LLC The origin of the modern LLC laws allowing limited liability companies is in the German law of 1892 which created the GmbH (Gesellschaft mit beschranker Haftung). In the 60 years which followed, almost 20 countries adopted similar laws. In France, for example, the same type of company is known as the SARL (Societes de Responsabilite Limitee). In Central and South America it is known as the limitada. In the U.S., the first state to adopt a modern limited liability company statute was Wyoming, on March 4, 1977. Florida followed in 1982 by enacting a similar statute. Now, a number of states have either enacted similar laws or have legislation pending. It has become the most talked about and most imitated new business law in America. However, the IRS gave no assurance that such an entity could qualify to be treated as a partnership until September 2, 1988, when Revenue Ruling 88-76 was issued. It was the first Revenue Ruling from the IRS regarding LLCs. In February, 1993, the IRS issued four Revenue Rulings which describe the classification standards the IRS will apply to LLCs who desire partnership tax treatment. Now that the issue of pass through tax treatment has been settled, it is time for the business owner to seriously consider this form of entity when forming new ventures, and to replace the form he already adopted for existing enterprises. Some lawyers predict that the LLC will steadily gain popularity as people become educated about its benefits until it will largely replace the partnership and the corporation as the preferred entity. Where? LLC laws have been enacted in: Arizona (1992), Colorado (1990), Delaware (1992), Florida (1982), Illinois (1992), Iowa (1992), Kansas (1990), Louisiana (1992), Maryland (1992), Minnesota (1992), Nevada (1991), Oklahoma (1992), Rhode Island (1992), Texas (1991), Utah (1991), Virginia (1991), West Virginia (1992), Wyoming (1977). Most of the other states either have laws pending, or a legislative committee is studying the matter, so you should check on recent developments in your state. For investment and holding companies not doing an active business in a particular state, then you could use another state to form the LLC. Delaware? The Delaware LLC law was passed on October 1, 1992. Delaware has a long history as the home of the best corporate law in the U.S. The law is considered to be pro-management and has a tradition of respecting good faith management decisions. There exists a strong partnership in Delaware between the corporate bar, the legislature and the judiciary, which helps to maintain a legal atmosphere second to none. This tradition of excellence in corporate law is likely to attract those who want to form LLCs in the U.S. The Delaware LLC statute is clearly the most flexible. It follows a tradition that Delaware lawyers call the "Freedom of Contract" which allows broad flexibility among members of an LLC to create the details of the structure of the company in the way that best suits their needs. More than any other state LLC statute, the Delaware law allows the parties to draft the LLC company agreement as they may require and "opt in" the elements they desire, without a lot of regulations or restrictions. The Delaware law presumes that the entity will be treated as a partnership, unless otherwise classified. It allows extensive protection to members and managers. It does not require that the duration be stated in the Certificate of Formation, and it limits the liability of the members to their investment in the company. The Delaware law also allows for a structure in which the death of a member will not cause an automatic dissolution. All these elements together are not included in the Wyoming statute, or in any of the others. The drafters of the Delaware LLC law sought deliberately to create it in such a way as to give maximum flexibility, so that it would allow creativity among the drafters of the company agreements. Delaware LLCs pay an annual state fee of $100, the same as limited partnerships. Legislation was passed in July, 1993, that now provides for Delaware corporations to convert their status to LLC by merging the old corporation into a new LLC. The LLC may take the same name as the corporation, with proper filing details. Delaware has again distinguished itself, and it promises to be one of the leaders in the formation and maintenance of LLCs. Comparison With Subchapter S Corporation An LLC provides its members with liability protection and tax treatment similar to that enjoyed by stockholders of an S corporation. However, an S corporation also is subject to the following statutory restrictions: 1) It is limited to one class of ownership interests (i.e., one class of stock). 2) It must be a domestic corporation. 3) It may not have more than 35 stockholders 4) Stockholders may not include other corporations, nonresident aliens, partnerships, certain trusts, pension funds, or charitable organizations 5) It cannot have subsidiaries. None of these restrictions applies to the LLC. This flexibility creates considerable freedom in planning distributions and special allocations of income and loss. Comparison With The Limited Partnership An LLC is taxed in substantially the same manner as a limited partnership, without the following disadvantages that limited partnerships have with regard to liability: 1) A limited partnership must have at least one general partner who is liable for debts of the partnership, while all of the members of an LLC may be protected from such liability; and 2) The participation of limited partners in the management of a limited partnership can result in a loss of limited liability protection, while such participation by members of an LLC will not have such effect, provided such management does not violate the applicable LLC statute. Accordingly, a member of an LLC treated as a limited partnership would be able to "materially participate: for purposes of Section 469 of the Internal Revenue Code -- which limits the utilization of passive activity losses and credits -- while maintaining limited liability protection. For Which Purposes Are LLCs Being Currently Formed? * Venture capital, real estate, and other investment firms: Control, division of profits and losses and many other aspects may be specified in the agreement, plus pass through tax treatment when properly structured. * Family business enterprises: Control can be spelled out and estate planning considerations can be customized as an integral part of the agreement. Pass through tax treatment when properly structured. * Entrepreneurial start-ups: Pass through tax treatment like Subchapter S, but without the restrictions on ownership if properly structured. No limit on the number of investors. * Professional corporations: Accountants, attorneys, doctors, psychologists, financial planners and all professionals now working through partnerships can free themselves of the liability for their partner's actions, while retaining the same control structure as their partnership. The Formation Process Each party to an LLC must agree to a contract with all the other members that will become the "constitution" of the company. This document may be called the "Company Agreement," "The Articles of Organization," "The Minutes of the First Meeting of Members", or any other name, unless the particular state has a required name. This agreement should set forth the company's policy and procedure regarding important matters such as voting rights and restrictions, differences among members, or classes of members, investment into the company by each member, restrictions on access to information among members, rights of management, restrictions on transfer of ownership interests, distribution of profits, required meetings (if any), notices of meetings, quorum rules, inclusion of new members, continuation options upon the death of a member and all other provisions the company wants to include. Most states allow the inclusion of provisions and elements almost without restriction. This gives the drafters of the agreement the opportunity to be creative. Since this form of entity is relatively new all the available inclusions will not be commonly known immediately. This represents a danger to the LLC, which can only change it's agreement by the unanimous agreement of the members. In drafting the agreement, careful consideration must be given to the IRS position regarding tax classification of the entity. Although the law allows tremendous flexibility, the IRS is very specific about the test it will apply when determining whether to tax the entity as a partnership or as a corporation. Since pass through tax treatment is expected to be a prime consideration of most organizers, the drafters must create an agreement which provides for the IRS Rules. (If your lawyer or accountant is not familiar with these rules, they are contained at 28 CFR 301.7701-2, 3 and 4). Although do-it-yourself incorporation is generally not a problem, because the limited liability company agreement is as complex as a partnership, and calls for originality and creativity, it is probably best to use a lawyer experienced in such matters. (He does not necessarily have to be a lawyer in the state where it is formed -- you may find better experience elsewhere, and that experience will usually translate to the state that has just enacted a statute more readily than a local lawyer will absorb the nuances of a strange entity.) The differences and possibilities are too vast for a simple do-it-yourself procedure to be wise at this time. Who Should NOT Form an LLC? * Companies planning to operate their business in a state that does not currently recognize LLCs should seriously consider the consequences of losing their limitation on liability in that state, before forming an LLC. * Entrepreneurs who do not want to bear the responsibility, cost and possible future constraints of a customized company structure should consider sticking to the time-tested more rigid structure that a general stock corporation offers. * Sole owner companies cannot be LLCs. An LLC must have two members, by definition, or it automatically dissolves. (Of course, the second owner could be a children's trust or a family limited partnership holding 1%.) For help with forming a simple Delaware LLC, write to Incorporation Information Package, 818 Washington Street, Wilmington DE 19801 and specify that you want LLC information. If you need help with a more complex LLC structure, you should contact Asset Protection Corporation, Suite 201A, 14418 Old Mill Road, Upper Marlboro MD 20772.