WHAT IS LLC (LIMITED LIABILITY COMPANY)?

Tutorials on basics of Limited Liability Company (LLC)

So what does LLC mean?

The first of the limited liability entities to be introduced into the United States, and currently the most prevalent, is the limited liability company. The limited liability company (LLC) is a type of non corporate entity that offers many of the benefits of both partnerships and corporations.

Limited Liability Company Defined

The limited liability company (LLC) is a non-corporate entity that offers limited personal liability to its owners. It is somewhat of a cross between a partnership and a corporation. The LLC is owned by members who either manage the company directly or delegate management responsibility to managers or officers. 

Like a corporation, the owners of a limited liability company are usually not liable for company debts and obligations. Like a partnership, the LLC’s income and losses are allocated to the owners who then pay tax on the limited liability income and profits allocated to them.

Limited Liability Company Characteristics

The limited liability company is an unincorporated entity based on the concept of freedom of contract. It is a legal entity distinct from its owners. The owners of a limited liability company are generally referred to as its members.

The characteristics of any limited liability company will depend on its members’ objectives and the statutes of the state in which it is formed. However, most limited liability companies have common characteristics, including limited liability, flexible management, continuity of life, restricted transferability of interest, unrestricted ownership, certain formalities for formation, and partnership taxation status.

LIMITED LIABILITY 

Like a corporation, the owners of a limited liability company typically have no personal liability for the debts and obligations of the company.

MANAGEMENT 

Management of the limited liability company is very flexible. All members of the limited liability company are granted the right to manage its business unless otherwise provided for in the limited liability company’s articles of organization. 

State statutes typically permit the owners of a limited liability company to allocate management authority among its members in any manner they choose. They may decide to be managed by one individual, by committee, or by the majority of the owners. 

Most limited liability companies appoint a board of managers, similar to a corporation’s board of directors. A written agreement among the members, referred to as an operating agreement, sets forth the details concerning the management of the limited liability company.

Major decisions of a limited liability company are usually made by the members holding a majority of the limited liability company interest, unless otherwise provided for in the operating agreement or by statute.

CONTINUITY OF LIFE 

The statutes of most states provide that a limited liability company may be designed for continuity. Unless the articles of organization provide that the limited liability company will be a term company that will dissolve on a certain future date or event, the limited liability company will be an entity at will, meaning that it exists indefinitely, until the members dissolve it. 

The statutes of some states, however, require that the articles of organization filed with the state must specify a period of duration for the limited liability company.

The death or dissociation of one or more of the members of a limited liability company does not necessarily cause the dissolution of the limited liability company. The statutes of some states provide that the members of a limited liability company must give six months’ notice of their intent to dissociate from the company.

TRANSFERABILITY OF INTEREST 

State statutes place restrictions on the transfer of the ownership interest of the members of limited liability companies. Many of these restrictions may be modified by the company’s operating agreement.

Members of a limited liability company are not considered to be co-owners of the company’s property. That property is owned by the limited liability company itself. A member may usually transfer or assign his or her right to receive distributions to another person. 

This transfer does not necessarily make the new owner of the right to receive distributions a member of the limited liability company. The transferee of a member’s financial rights to a limited liability company does not have the same rights to participate in the management and operation of the limited liability company that members do. 

A person may become a member of a limited liability company only if he or she is substituted, or admitted, to the limited liability company as provided by the company’s articles of organization.

OWNERSHIP 

There are very few restrictions on the number or type of owners who may own limited liability companies. Most state statutes provide that a limited liability company may be formed by one or more persons. That definition of persons usually includes corporations, partnerships, trusts, and other entities.

FORMALITIES OF ORGANIZATION 

The limited liability company is formed in much the same way that the limited partnership or business corporation is formed. Articles of organization are filed with the secretary of state or other appropriate state authority.

In addition, a limited liability company may be subject to annual reporting requirements imposed by the state in which it was organized.

TAXATION 

One of the most important benefits to forming a limited liability company is the partnership taxation status, which is preferable to corporation taxation for most members.

In 1997, the Internal Revenue Service adopted Check the Box regulations,1 which make it simple for a limited liability company to be taxed as a partnership. When the members of a limited liability company file an income tax return for the LLC it is classified, by default, as a partnership. 

If the members prefer, they can simply check the box on an election form and elect to be taxed as a corporation. Single-member limited liability companies are disregarded as entities separate from their owners for federal income taxation purposes unless the sole member elects to be taxed as a corporation.

Most states follow the federal scheme for limited liability company income taxation. However, some states, especially those that do not have a personal state income tax, may either treat limited liability companies as corporations for income taxation purposes, or they may assess special taxes on limited liability companies.

OTHER FORMS OF BUSINESS

In addition to the proprietorship, partnership, and corporate forms of business, an enterprise may be conducted using other forms of business, such as the master limited partnership, the professional corporation, the limited liability company, and the joint venture.

A master limited partnership is a partnership with limited partner ownership interests that are traded on an organized exchange. For example, more than two dozen master limited partnerships are listed on the New York Stock Exchange, including the Boston Celtics, Cedar Fair,  and Red Lion Inns partnerships. 

Ownership interests, which represent a specified ownership percentage, are traded in much the same way as the shares of stock of a corporation. One difference, however, is that a corporation can raise new capital by issuing new ownership interests, whereas a master limited partnership cannot. It is not possible to sell more than a 100% interest in the partnership, yet it is possible to sell additional shares of stock in a corporation. Another difference is that the income of a master limited partnership is taxed only once, as partners’ individual income.

Another variant of the corporate form of business is the professional corporation. A professional corporation is an organization that is formed under state law and treated as a corporation for federal tax law purposes, yet that has unlimited liability for its owners—the owners are personally liable for the debts of the corporation. Businesses that are likely to form such corporations are those that provide services and require state licensing, such as physicians’, architects’, and attorneys’ practices, since it is generally felt that it is in the public interest to hold such professionals responsible for the liabilities of the business.

More recently, companies are using a hybrid form of business, the limited liability company (LLC), which combines the best features of a partnership and a corporation. In 1988 the Internal revenue Service ruled that the LLC be treated as a partnership for tax purposes, while its owners are not liable for its debts. Since this ruling, every state has passed legislation permitting limited liability companies.

Though state laws vary slightly, in general, the owners of the LLC have limited liability. The IRS considers the LLC to be taxed as a partnership if the company has no more than two of the following characteristics: (1) limited liability, (2) centralized management, (3) free transferability of ownership interests, and (4) continuity of life. If the company has more than two of these, it will be treated as a corporation for tax purposes, subjecting the income to taxation at both the company level and the owners’.

A joint venture, which may be structured as either a partnership or as a corporation, is a business undertaken by a group of persons or entities (such as a partnership or corporation) for a specific business activity and, therefore, does not constitute a continuing relationship among the parties.

For tax and other legal purposes, a joint venture partnership is treated as a partnership and a joint venture corporation is treated as a corporation.

U.S. corporations have entered into joint ventures with foreign corporations, enhancing participation and competition in the global marketplace.

For example, the Coca-Cola Company entered a joint venture with FEMSA, Mexico’s largest beverage company, in 1993, expanding its opportunities within Mexico. Joint ventures are an easy way of entering a foreign market and of gaining an advantage in a domestic market. For example, Burger King, the second largest fast food chain in America, entered the Japanese market through a joint venture with Japan Tobacco Inc., which is two-thirds owned by Japan’s Ministry of Finance, to form Burger King Japan. This joint venture gives Burger King (owned by the British firm, Grand Metropolitan PLC) a fighting chance in competing against McDonald’s almost 2,000 outlets in Japan.

Joint ventures are becoming increasingly popular as a way of doing business. Participants—whether individuals, partnerships, or corporations—get together to exploit a specific business opportunity. Afterward, the venture can be dissolved. Recent alliances among communication and entertainment firms have sparked thought about what the future form of doing business will be. Some believe that what lies ahead is a virtual enterprise—a temporary alliance without all the bureaucracy of the typical corporation—that can move quickly and decisively to take advantage of profitable business opportunities.

Prevalence

The advantages and disadvantages of the three major forms of business from the point of view of financial decision-making are summarized in Exhibit 1.1. Firms tend to evolve from proprietorship to partnership to corporation as they grow and as their needs for financing increase. Sole proprietorship is the choice for starting a business, whereas the corporation is the choice to accommodate growth. The great majority of business firms in the United States are sole proprietorships, but most business income is generated by corporations.

The Objective of Financial Management

So far we have seen that financial managers are primarily concerned with investment decisions and financing decisions within business organizations. The great majority of these decisions are made within the corporatebusiness structure, which better accommodates growth and is responsible for 89% of U.S. business income. Hence, most of our discussion in the remainder of this book focuses on financial decision-making in corporations, but many of the issues apply generally to all forms of business.

EXHIBIT 1.1 Characteristics of the Three Basic Forms of Business

FORMS OF BUSINESS ENTERPRISE

Financial management is not restricted to large corporations: It is necessary in all forms and sizes of businesses. The three major forms of business organization are the sole proprietorship, the partnership, and the corporation. 

These three forms differ in a number of factors, of which those most important to financial decision-making are:

■ The way the firm is taxed.

■ The degree of control owners may exert on decisions.

■ The liability of the owners.

■ The ease of transferring ownership interests.

■ The ability to raise additional funds.

■ The longevity of the business.

Sole Proprietorships

The simplest and most common form of business enterprise is the sole proprietorship, a business owned and controlled by one person—the proprietor. Because there are very few legal requirements to establish and run a sole proprietorship, this form of business is chosen by many individuals who are starting up a particular business enterprise. The sole proprietor carries on a business for his or her own benefit, without participation of other persons except employees. The proprietor receives all income from the business and alone decides whether to reinvest the profits in the business or use them for personal expenses.

A proprietor is liable for all the debts of the business; in fact, it is the proprietor who incurs the debts of the business. If there are insufficient business assets to pay a business debt, the proprietor must pay thedebt out of his or her personal assets. If more funds are needed to operate or expand the business than are generated by business operations, the owner either contributes his or her personal assets to the business or borrows. 

For most sole proprietorships, banks are the primary source of borrowed funds. However, there are limits to how much banks will lend a sole proprietorship, most of which are relatively small.

For tax purposes, the sole proprietor reports income from the business on his or her personal income tax return. Business income is treated as the proprietor’s personal income.

The assets of a sole proprietorship may also be sold to some other firm, at which time the sole proprietorship ceases to exist. Or the life of a sole proprietorship ends with the life of the proprietor, although the assets of the business may pass to the proprietor’s heirs.

Partnerships

A partnership is an agreement between two or more persons to operate a business. A partnership is similar to a sole proprietorship except instead of one proprietor, there is more than one. The fact that there is more than one proprietor introduces some issues: Who has a say in the day-to-day operations of the business? Who is liable (that is, financially responsible) for the debts of the business? How is the income distributed among the owners?

How is the income taxed? Some of these issues are resolved with the partnership agreement; others are resolved by laws. The partnership agreement describes how profits and losses are to be shared among the partners, and it details their responsibilities in the management of the business.

Most partnerships are general partnerships, consisting only of general partners who participate fully in the management of the business, share in its profits and losses, and are responsible for its liabilities. Each general partner is personally and individually liable for the debts of the business, even if those debts were contracted by other partners.

A limited partnership consists of at least one general partner and one limited partner. Limited partners invest in the business but do not participate in its management. A limited partner’s share in the profits and losses of the business is limited by the partnership agreement. In addition, a limited partner is not liable for the debts incurred by thebusiness beyond his or her initial investment.

A partnership is not taxed as a separate entity. Instead, each partner reports his or her share of the business profit or loss on his or her personal income tax return. Each partner’s share is taxed as if it were from a sole proprietorship.

The life of a partnership may be limited by the partnership agreement.

For example, the partners may agree that the partnership is to exist only for a specified number of years or only for the duration of a specific business transaction. The partnership must be terminated when any oneof the partners dies, no matter what is specified in the partnership agreement.

Partnership interests cannot be passed to heirs; at the death of any partner, the partnership is dissolved and perhaps renegotiated.

One of the drawbacks of partnerships is that a partner’s interest in the business cannot be sold without the consent of the other partners.

So a partner who needs to sell his or her interest because of, say, personal financial needs may not be able to do so. Another drawback is the partnership’s limited access to new funds.

Short of selling part of their own ownership interest, the partners can raise money only by borrowing from banks—and here too there is a limit to what a bank will lend a (usually small) partnership.

In certain businesses—including accounting, law, architecture, and physician’s services—firms are commonly organized as partnerships.

The use of this business form may be attributed primarily to state laws, regulations of the industry, and certifying organizations meant to keep practitioners in those fields from limiting their liability.

Corporations

A corporation is a legal entity created under state laws through the process of incorporation. The corporation is an organization capable of entering into contracts and carrying out business under its own name, separate from it owners. To become a corporation, state laws generally require that a firm must do the following: (1) file articles of incorporation, (2) adopt a set of bylaws, and (3) form a board of directors.

The articles of incorporation specify the legal name of the corporation, its place of business, and the nature of its business. This certificate gives “life” to a corporation in the sense that it represents a contract between the corporation and its owners. This contract authorizes the corporation to issue units of ownership, called shares, and specifies the rights of the owners, the shareholders.

The bylaws are the rules of governance for the corporation. The bylaws define the rights and obligations of officers, members of the board of directors, and shareholders. In most large corporations, it is not possible for each owner to participate in monitoring the management of the business. For example, at the end of 2001, Emerson Electric Co. had approximately 33,700 shareholders. It would not be practical for each of these owners to watch over Emerson’s management directly. Therefore, the owners of a corporation elect a board of directors to represent them in the major business decisions and to monitor the activities of the corporation’s management. The board of directors, in turn, appoints and oversees the officers of the corporation. Directors who are also employees of the corporation are called insider directors; those who have no other position within the corporation are outside directors or independent directors. In the case of Emerson Electric Co., for example, there were 18 directors in 2002, six inside directors and 13 outside directors. Generally it is believed that the greater the proportion of outside directors, the greater the board’s independence from the management of the company. The proportion of outside directors on corporate boards varies significantly. For example, in 2002 only 44% of Kraft Foods’ board are outsiders, whereas 89% of Texas Instrument’s board is comprised of outside directors.

The state recognizes the existence of the corporation in the corporate charter. Corporate laws in many states follow a uniform set of laws referred to as the Model Business Corporations Act.3 Once created, the corporation can enter into contracts, adopt a legal name, sue or be sued, and continue in existence forever. Though owners may die, the corporation continues to live. The liability of owners is limited to the amounts they have invested in the corporation through the shares of ownership they purchased.

Unlike the sole proprietorship and partnership, the corporation is a taxable entity. It files its own income tax return and pays taxes on its income. That income is determined according to special provisions of the federal and state tax codes and is subject to corporate tax rates different from personal income tax rates.

If the board of directors decides to distribute cash to the owners, that money is paid out of income left over after the corporate income tax has been paid. The amount of that cash payment, or dividend, must also be included in the taxable income of the owners (the shareholders).

Therefore, a portion of the corporation’s income (the portion paid out to owners) is subject to double taxation: once as corporate income and once as the individual owner’s income.

The dividend declared by the directors of a corporation is distributed to owners in proportion to the numbers of shares of ownership they hold. If Owner A has twice as many shares as Owner B, he or she will receive twice as much money.

The ownership of a corporation, also referred to as stock or equity, is represented as shares of stock. A corporation that has just a few owners who exert complete control over the decisions of the corporation is referred to as a close corporation or a closely-held corporation. A corporation whose ownership shares are sold outside of a closed group of owners is referred to as a public corporation or a publicly-held corporation.

Mars Inc., producer of M&M candies and other confectionery products, is a closely-held corporation; Hershey Foods, also a producer of candy products among other things, is a publicly-held corporation.

The shares of public corporations are freely traded in securities markets, such as the New York Stock Exchange. Hence, the ownership of a publicly-held corporation is more easily transferred than the ownership of a proprietorship, a partnership, or a closely-held corporation.

Companies whose stock is traded in public markets are required to file an initial registration statement with the Securities and Exchange Commission (SEC), a federal agency created to oversee the enforcement of U. S. securities laws. The statement provides financial statements, articles of incorporation, and descriptive information regarding the nature of the business, the debt and stock of the corporation, the officers and directors, any individuals who own more than 10% of the stock,     among other items.