Limited Liability Company Basics

The limited liability company, or LLC, is a relatively recent addition to the menu of options available when choosing a legal entity. It is a hybrid between a partnership and a corporation, designed to combine the benefits of both. In short, an LLC enjoys the taxation and governance advantages of partnerships while also providing limited liability to the owners similar to a corporation. Below is a description of how an LLC fares in the 4 factors to consider when choosing a business entity.

Limited Liability

One of the biggest advantages of the limited liability company is that, as the name suggests, it provides limited liability protection to its members. As described in an earlier article, limited liability status generally protects the owners of a business in the event that something goes wrong, such as an action that results in injury to a third party. Without limited liability, the owners of the business would be personally liable if the company is sued and the assets of the business are not sufficient to satisfy creditors, such as lenders and plaintiffs in lawsuits. When the owners are personally liable, their personal assets, such as their house or stock assets, can be reached to satisfy the liability. In this regard, the LLC is similar to the corporate form.

Tax Treatment of an LLC

Another great advantage of the LLC is that it is taxed like a partnership by default. This means that it enjoys pass-through taxation. That means that unlike a corporation, which is typically subject to double taxation both at the entity level and at the shareholder level, the LLC is not treated as a tax-paying entity. Instead, all of the profits and losses will pass through to the individual members, who can claim the profits and losses on their personal income.

In certain limited situations, it may make sense for an LLC to be taxed as an S-Corporation, but that decision is fact specific and should be discussed with a tax or legal advisor.

Sources of Funding

An LLC is in between a partnership and a corporation with respect to availability of sources of funding. Like all business forms, an LLC can access debt funding from a financial institution or otherwise. But one of the main drawbacks with the LLC is the difficulty of raising equity financing from professional investors. While an LLC can (and many do) receive professional investment from angels and venture capitalists, it is not the preferred entity type for these funders.

One of the LLC's greatest advantages, the flexibility to structure it in a variety of ways, becomes a disadvantage for enterprises seeking angel and VC funds. This is because professional investors like predictability and familiarity. Just as they want to see a corporation formed in Delaware because they are knowledgable about Delaware's laws and rules regarding corporation, they prefer the corporate form over the LLC because there are many more default rules and requirements with the corporation. Unlike in an LLC, an investor can know with some certainty what her rights (economic, voting, information, etc.) will be as a shareholder.

Formalities

An LLC is easily formed by filing a simple organizing document with the appropriate state official. In California, that would require filing Articles of Organization with the Secretary of State. In Delaware, the equivalent would be filing a Certificate of Formation with the Delaware Division of Corporations.

The other critical document for an LLC is the operating agreement, which spells out a number of things including the rights and duties of the members. For example, the operating agreement lays out whether the organization is managed directly by its members, or through representative managers similar to a corporation's board of directors. In addition, unlike the rigid rules regarding corporations, most states allow members of an LLC great discretion in drafting and tailoring the rights and duties of the members as they see fit. For example, whereas the economic rights (rights to profits) of shareholders in corporations are tied to their percentage ownership of the corporation, members of an LLC can customize those rights to reflect different arrangements.

Governance of an LLC is also more similar to a partnership rather than a corporation. For example, there are no annual or special meetings, notice, or proxy voting requirements.

Final Note: Delaware or California?

We are sometimes asked if an enterprise interested in the LLC entity form should get set up in Delaware or California. Delaware offers the following advantages which may factor into an enterprise's decision on where to form the LLC:

Explicit language in the Delaware LLC statute indicating respect for freedom to contract and enforceability of operating agreements, giving more predictability in drafting an operating agreement. In California, this is only implied, but not explicitly laid out in the statute.
Ability to eliminate liability for breach of contract and of fiduciary duty for members and managers.
Stronger limits on rights of creditors, such as limiting the remedies available to the creditors of members.
A more sophisticated judiciary system that has a track record of protecting businesses, especially against creditors. The sophistication and efficiency of the Delaware Chancery Court also equips it to deal with LLCs since the law regarding limited liability companies is not very developed given that it a relatively new business form. Delaware courts are more likely to develop rules more quickly and more predictably compared to courts in other states.

DISCLAIMER: The information in this article is provided for informational purposes only and should not be construed or relied upon as legal advice. This article may constitute corporate attorney advertising under applicable state laws.