Limited Liability Companies
Best Practice Summary

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A limited liability company ("LLC") combines certain major advantages of corporations and partnerships.

Quick Reference:

LeapLaw's 50 State pages providea quick reference to laws, as well as LLC name requirements, formation forms summaries of LLC formation requirements in each state.

Advantages and Disadvantages

Advantages
The advantages of organizing a business as an LLC are:

  • An LLC's legal existence, unlike that of a partnership or sole proprietorship, may continue beyond the life of its managers and members and may be perpetual if desired.

  • The owners of the LLC (called members) enjoy limited liability protection similar to the protection offered to stockholders of a corporation. A member's liability for the obligations of the LLC is limited to the amount of her investment. Please note however that in some states, the member of a single-member LLC does not receive the liability shield.

  • An LLC has the option to be taxed as a partnership and thus its owners can avoid "double taxation" of profits.

  • The law governing the economic and control provisions of an LLC are extremely flexible and accordingly, the LLC's operating agreement can be tailored to accommodate a wide variety of business arrangements.

  • LLC members have discretion in allocating profits, losses, income and deductions, which provides great flexibility in crafting the owners’ economic arrangement.

  • Entity-level tax on S corporations may be applied in some states, while generally no such tax applies to LLCs.

  • LLC members can generally move appreciated property into and out of an existing LLC without triggering tax. An LLC is easily converted into a corporation without tax, while converting a corporation into an LLC may result in a large tax bill.

  • The sale of an LLC interest at a premium permits the tax basis of the LLC’s assets to be stepped up to reflect the purchase price premium paid, permitting future tax deductions by the buyer.

  • LLC employee equity, called “profits interests,” can generate capital gains in an exit event, while employee stock options result in compensation income when they are cashed out in an acquisition. LLCs, however, cannot issue tax-favorable incentive stock options.

    Disadvantages
    The major disadvantages of the LLC are:

  • Particularly with a large number of equity owners, it is much more complex to administer than a corporation. An LLC will generally need a detailed operating agreement agreed to specifically by the members, because the governing law does not provide a large number of "default provisions" as it does with a corporation.

  • Entity profits paid to S corporation owners are generally not subject to the self-employment tax, while generally all LLC profits are subject to the tax. Congress is currently discussing applying tax equally.

  • Since some venture capital companies are prohibited from investing in LLCs due to tax rules that apply to their tax-exempt investors, it can be more difficult for an operating LLC to raise outside capital than for a corporation. However, those restrictions often can be structured around.

For more information regarding the selection of the most appropriate business entity, see LeapLaw's Business Structure Comparison Chart.



Formation Process

Statutes
Consult LeapLaw's LLC Connection for incorporation statutes of the 50 states.

Name Reservation
The name of the LLC must be available in the state of formation and should not be deceptively similar to any other business name in the same geographical area or market. State laws generally require that an LLC name contain the words "limited liability company" or one of the abbreviations "LLC"," L.L.C.", LC or "L.C." Please see LeapLaw's Selecting a Business Name Best Practice Summary for procedures to be followed and additional issues to be addressed when selecting a business name.

It is strongly recommended to check name availability of a desired business name as soon as possible in all of the states where the company plans to be incorporated and qualified. Name availability may be determined by calling the secretary of state directly, checking online using LeapLaw's LLC Connection or via Virtual Paralegal Services. When the name will be registered in several jurisdictions, using a service company is likely the most time-efficient solution.

If the name is available, reserving it may be wise if the filing will be made at some later date. It is also important to note that the reservation process in some states can take longer than the time it may take to file the formation or registration documents.

Note: A secretary of state's acceptance of a business name does not mean the name is an available trademark or service mark. Other searches may be required if the company plans to determine any potential trademark or service mark issues. It is good practice to verify with the responsible attorney if the company will require a trademark search and/or domain name registration prior to reserving the name in any states.

A secretary of state may deem the proposed name to be unavailable due to a name conflict with a currently registered business name. Depending upon the state, certain steps may be taken to cure the name conflict. For more information regarding name conflicts, see LeapLaw's Name Reservation Best Practice Summary.

Preliminary Trademark Searches
Trademark searches may be performed to assure that a proposed corporate name is not deceptively similar to an existing mark. Preliminary searches for registered trademarks may be performed for free on the LeapLaw's Intellectual Property Connection.

Note: A trademark or service mark does not have to be registered to be protected. Simply using the mark in commerce gives rise to a claim.

The popular "full" trademark search provides a comprehensive search of a proposed trademark against current federal, state and common law trademarks and domain names. Full searches may be ordered from a trademark search company. The report provides extensive information regarding trademark availability. For more information on trademarks and service marks, see LeapLaw's Trademark Best Practice Summary.

Domain Names
Domain names are registered web site addresses or "URLs". When registering domain names it is best practice to reserve all possible applicable name indicators if the name will serve as the main business name. Domain names may be checked for availability and obtained at Network Solutions. Network Solutions WhoIs can assist in determining current owners of a domain name. Checking the availability of the domain name simultaneous with checking the corporate name availability and trade name status is good practice if the company name is to be a trade name for the business.


Certificate of Formation

An LLC does not exist until a Certificate of Formation or Organization is filed with the secretary of state of the state in which the LLC is to be organized. The information which must be provided on the certificate varies from state to state. Most states will require the designation of a resident agent.

Forms
Pre-printed forms can be found at LeapLaw's Corporate Connection or contact Virtual Paralegal Services. If the state does not have pre-printed forms, the charter may be drafted using state statutes.

Amendments
Following the filing of the formation certificate, information may be amended pursuant to the operating agreement and the state laws.

Operating Agreement

The operating agreement defines the structure of an LLC and is drafted around the laws of the state of organization. The flexibility permitted in drafting the operating agreement is a major benefit of the LLC structure. An LLC may use a simple format providing for control by a single managing member with a partnership tax structure; or it may have a more complex corporate-like structure with classes and series of members, a board of managers with classes and committees, complicated tax advantages and other provisions that result in a lengthy document.

Note: The provisions of the agreement governing members' contributions, allocation of gains and losses and distribution of assets must comply with applicable tax laws and regulations for the LLC to maintain "flow-through" tax treatment.

Management
An LLC operating agreement provides for the management structure of the LLC. It may provide that the company be managed by:

  • A single manager or managing member who is responsible for all of the day-to-day activities of the LLC, much like the managing partner of a partnership or the sole general partner of a limited partnership.

  • A board of managers or managing members, much like a board of directors of a corporation, where action is taken by majority or super-majority vote.

  • A slate of officers appointed by the managers or members.

  • Any combination of the above desired by the members.

The exact powers, duties and responsibilities of each position will be defined in the operating agreement. If the LLC structure is similar to a corporation, the role of managers will be similar to the role of directors of a corporation (although, unlike a corporation, an LLC may grant different numbers of votes to different individuals). If the LLC structure is similar to a limited partnership, the role of the manager may be similar to that of a general partner. The operating agreement should provide details regarding the votes needed for each type of action to be approved.


Initial Consent

The managing members, manager or board of managers will take an initial vote upon formation in order to authorize basic business necessities such as ratifying the actions of the authorized person, opening of a bank account and foreign qualifications. The initial manager vote may also fill the offices provided for in the operating agreement, if any.

Sample Initial Consent of Managers

Members; Membership Interests

The equity owners of an LLC are called members. The equity securities of LLCs are known as membership interests. Members can be individuals or business entities. Massachusetts law provides for single member LLCs.

Membership interests are generally expressed either in "units" or as "percentage interests" in the LLC. Please note that a percentage interest may represent an equity percentage, a voting percentage, or both, depending how it is defined in the operating agreement. Unlike shares of stock, the characteristics of membership interests are completely flexible and the membership interests of different members may combine economic ownership and voting power in different combinations as agreed to by the members.

A member of an LLC may purchase a membership interest in exchange for cash, property or services rendered. The interest comes with certain rights and restrictions as provided in the operating agreement (although certain applicable state laws may apply as a "default" if there is no operating agreement). Membership interests may or may not be evidenced by a certificate. Interest issuances and transfers may be tracked on a ledger similar to a stock ledger, or simply set forth in the operating agreement and subsequent amendments.

Special Member. An LLC may appoint one or more special members whose sole purpose is to prevent the termination of the Company for failure to have a Member.



Federal Identification Number

The Internal Revenue Service issues federal identification numbers (FIN) also known as an Employer Identification Number (EIN) to new businesses. To apply for an FIN, an IRS Form SS-4 (pdf) must be filed with the IRS. As of January 2, 2002, Form 2848, Power of Attorney is no longer necessary for third-party designees. Completing the the new "Third Party Designee" section on the Form SS-4 will suffice.

Tax identification numbers may be provided:

  • Online in just a few minutes


  • Via telephone by calling (866) 816-2065 Monday through Friday, 7:30 a.m. to 5:30 p.m. Tax identification numbers will not be provided to a third party designee over the phone at the time of the initial phone call. After information is provided to the tele-TIN representative, the Form SS-4 must be faxed and the Third Party Designee section is reviewed. The third party designee may receive the number over the phone once the application has been reviewed and the third party information is submitted into the database. This may take 2 hours to 2 days depending upon the number of current requests.
  • LeapLaw's Federal Identification Number Checklist provides a list of information for completing the Form SS-4.

    Practice Tip: Got a Double EIN? When requesting an EIN for an LLC, you may have 2 numbers assigned. This happens when a single member LLC has employees. Since the LLC isn't responsible for withholding taxes, the IRS does not cross-reference the member's social security number. Instead, they issue an additional EIN which the IRS refers to as the "sole proprietor number" for withholding purposes.

Entity Classification
For federal tax purposes, an LLC may be classified as a sole proprietorship (referred to as an entity to be disregarded as separate from its owner), partnership or a corporation. If the LLC has only one member, it will automatically be considered to be a sole proprietorship (referred to as an entity to be disregarded as separate from its member), unless an election is made to be treated otherwise.

If the LLC has two or more members, it will automatically be considered to be a partnership unless an election is made to be treated as a corporation. If an election to classify is not made, a default classification of partnership (multi-member LLC) or sole proprietorship (single member LLC) will apply.

An election is made by using Form 8832, Entity Classification Election. If the company desires to be treated as an S Corporation, it must file a Form 8832 together with a Form 2553, Election By a Small Business Corporation. These filings should be sent via certified mail to the IRS Address in Philadelphia, PA.

>Got a Double EIN? When requesting an EIN for an LLC, you may have 2 numbers assigned. This happens when a single member LLC has employees. Since the LLC isn't responsible for withholding taxes, the IRS does not cross-reference the member's social security number. Instead, they issue an additional EIN which the IRS refers to as the "sole proprietor number" for withholding purposes.

Foreign Registrations

Foreign registrations must be filed in states in which the LLC will be doing business other than the state of organization, and are governed by the laws of such states. Failure to register as a foreign LLC in a state while doing business in that state will subject the LLC to possible penalties and fines. See LeapLaw's Foreign Qualification Best Practice Summary for more information on foreign qualification requirements and procedures.


Record Keeping

State laws require that limited liability company records be maintained at the principal address of the business. The company records book should contain original copies of:

  • Certificate of formation or organization of the LLC and any amendments thereto
  • Operating agreement and any amendments or restatements
  • Actions by members or managing member in chronological order
  • Actions by manager or board of managers in chronological order
  • Copies of any foreign qualification certificates
  • Annual reports
  • Form SS-4 together with Form 8832 (if any)
  • Names and addresses of each member and manager
  • Information regarding capital contributions and dates when such contributions were made
  • Any information regarding dissolution of the LLC
  • Certificate of formation or organization of the LLC and any amendments thereto
  • Operating agreement and any amendments or restatements
  • Actions by members or managing member in chronological order
  • Actions by manager or board of managers in chronological order
  • Copies of any foreign qualification certificates
  • Annual reports
  • Form SS-4 together with Form 8832 (if any)
  • Names and addresses of each member and manager
  • Information regarding capital contributions and dates when such contributions were made
  • Any information regarding dissolution of the LLC

Sample Company Records Index

Additional information on creating and maintaining a company records book may be found at LeapLaw's Minute Book Best Practice Summary.


Annual Reports; Franchise Tax

Applicable state law should be checked to determine whether annual reports or franchise tax filings are required. 50 State Periodic Reports Chart provides a quick reference to LLC annual report requirements.


Cessation of Business

Conversions and Mergers
Generally it is impractical for an LLC to offer membership interests in a public offering. In addition, certain tax rules and rules governing the investment of pension funds may make it difficult or impossible for an operating LLC to attract venture capital financing. Accordingly, it is common for an LLC to give up its tax advantages when it is ready to raise significant capital.

LLCs may be merged into other types of organizations. Delaware also allows for the conversion of an LLC into a corporation. If a Delaware LLC converts into a Delaware corporation, the business will keep its original date of formation and federal identification number. It may be necessary to file a Form 8832 to change the LLC's tax treatment from that of a partnership to that of a corporation.

Delaware provides for conversion of an LLC into any other Delaware business entity and accordingly, a Delaware LLC may convert into a corporation for the purpose of selling securities to the public. However, in order to convert a non-Delaware LLC into a Delaware corporation, the LLC would have to first merge into a newly-formed Delaware LLC, immediately followed by conversion of the LLC into a Delaware corporation.

For additional information regarding mergers, see LeapLaw's Mergers Best Practice Summary.

Dissolution
The legal existence of an LLC ceases upon its dissolution or cancellation. Dissolution is governed by state law, but usually occurs:

  • on a pre-determined date or the occurrence of a specific event set forth in the operating agreement

  • by a vote of sufficient members as set forth in the applicable state law

  • Upon the resignation or termination of all members, unless there is a continuance clause in the operating agreement

Upon dissolution:

  • property and assets of the LLC are distributed among the members according to the liquidation provisions of the operating agreement;

  • a certificate of cancellation is filed with the secretary of state, canceling the certificate of formation;

  • certificates of withdrawal are filed in other states in which the LLC is qualified to do business; and

  • licenses and permits held in the LLC's name may be terminated or sold.

Company Records Books

State laws require that limited liability company records be maintained at the principal address of the business. The company records book should contain original copies of:

  • Certificate of formation or organization of the LLC and any amendments thereto
  • Operating agreement and any amendments or restatements
  • Actions by members or managing member in chronological order
  • Actions by manager or board of managers in chronological order
  • Copies of any foreign qualification certificates
  • Annual reports
  • Form SS-4 together with Form 8832 (if any)
  • Names and addresses of each member and manager
  • Information regarding capital contributions and dates when such contributions were made
  • Any information regarding dissolution of the LLC

Additional information on creating and maintaining a company records book may be found at LeapLaw's Minute Book Best Practice Summary.

LeapLaw's
Related Best Practice Summaries

Federal Identification Number
Filing Mechanics
Forming a Delaware LLC
Forming a Massachusetts LLC
Minute Book
Name Reservation
Qualification
Service Companies/Registered Agents
Trademarks and Service Marks

 
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