A limited liability company is a U.S. form of privately owned company that combines the limited liability of a corporation with the simplified taxation of a sole proprietorship or partnership. Owners of a limited liability company, referred to as an “LLC,” report the company’s profits and losses on their personal income tax returns, rather than preparing separate corporate tax returns. This is known as “pass-through taxation.” LLC owners are referred to as “members,” and the company may be owned by a single individual, two or more individuals, or by a corporation or another LLC. To explore this concept, consider the following limited liability company definition.
Definition of Liability
- The state of being legally responsible or legally liable for something.
1790 Middle English
What is a Limited Liability Company
Much like shareholders of a corporation, LLC members are protected from being held personally liable for the debts and claims of the business. In the event the business is unable to pay its debts, such as rent, loan payments, and business supplies, the creditor can only make a claim against the LLC’s assets. This protects the personal assets of the members, who only risk losing the money they have invested in the business, not their home, car, or other personal property.
For example, a sidewalk on the apartment complex property belonging to Happy Housing LLC is broken, causing a tenant to trip and fall. If the tenant wants to file a lawsuit for her injuries, she must file the claim against the LLC, not the owners. If the tenant wins her lawsuit, she can only collect damages against the assets owned by the LLC, not its owners.
Exceptions to Limitation of Liability
LLC members’ protection against liability is not absolute. In the same way corporate shareholders may be held liable for certain acts, so can LLC members. Issues for which an LLC member may be held liable include:
- The member provides a personal guarantee on a business debt or business bank loan
- The member personally and directly injures a person
- The member’s failure to deposit taxes withheld from employees’ wages
- The member deliberately does something illegal, fraudulent, or reckless that harms the company or a person
For example, if James, an employee of Ready-Made Pizza LLC, runs over a man in a crosswalk while delivering a pizza. It turns out James was driving under the influence at the time of the accident. Ready-Made Pizza may be held liable for the negligent acts of its employee while on the job. The man may collect his award of damages from the LLC’s insurance and assets, but not from the owners of the company.
If, however, Todd, Ready-Made’s owner-manager, knew that James had been drinking alcohol but sent him on a delivery anyway, he may be held personally liable for the accident. This is because Todd recklessly sent a drunk driver to make a pizza delivery, which ended in someone being seriously injured.
An LLC’s Liability for Member’s Personal Debts
Assets owned by an LLC generally cannot be directly taken by creditors to satisfy the personal debts of an owner. Other actions that may be taken in such a situation vary by state, but may include:
- Charging Order. A Charging Order is a court order for the LLC to pay a member’s profits from the company directly to the creditor until the debt is satisfied.
- Foreclosure on LLC Interest. A creditor may foreclose on the member’s ownership interest in the company to satisfy his personal debt.
- Order for Dissolution. A creditor may obtain a court order that the LLC be dissolved. In this case, the member’s income from the dissolution and sale of assets of the company paid to the creditor to satisfy the debt.
Single Member LLC Protection
There is some question about whether a single-member LLC enjoys the same protection against debt collection as a multi-member LLC. The purpose of requiring a Charging Order to take an owner’s profits is to protect the other LLC members. In the event the company is owned by a single member, there is no need for such protection. Courts in some states hold that single-member LLCs are not entitled to the protection of a Charging Order, allowing creditors to directly foreclose on the member’s interest in the company to satisfy personal obligations.
Maintaining the LLC as a Separate Business Entity
Another situation that may end in an LLC owner being held liable for the acts and debts of the company is if he treats the LLC as an extension of his personal affairs, rather than as a separate business entity. In this case, a court may find that the owner is actually doing business as an individual, attempting to hide behind the limited liability of the entity, and may order him to be held personally liable for his acts and debts under the business. To help ensure the LLC is perceived as a separate legal entity, the owners should take certain actions:
- Act legally and fairly. Never misrepresent or attempt to hide material facts, or the condition of the owner’s personal, or the business’ finances to creditors, vendors, or others.
- Adequately fund the LLC. Commit enough cash to the business to ensure the company is able to meet predictable operating expenses and financial liabilities.
- Keep LLC finances separate. Use a federal employer identification number rather than a member’s social security number, maintain a business-only bank account, and never mix personal finances in the company’s accounting ledgers.
- Create an operating agreement. Composing and adhering to a formal limited liability company operating agreement helps establish the existence of a separate business entity.
Disadvantages of a Limited Liability Company
The first disadvantage to an LLC is a lack of flexibility when adding or removing owners of the company. In many states, when a member leaves an LLC, no matter the reason, the business entity must be dissolved, and all of the legal obligations to closing a business fulfilled. The remaining members may then start a new LLC if they desire.
Members of an LLC are considered to be self-employed, and are required to pay self-employment tax contributions toward their social security and Medicare accounts. This tax amount may be based on the LLC’s entire net income.
Forming an LLC
To create a Limited Liability Company, Articles of Organization must be filed with the state’s LLC division, which is generally a division of the Secretary of State’s office. Most states provide a one-page form making the Articles of Organization easy to create, and filing fees vary by state. Information provided on the Articles includes the LLC’s name and address, contact information of the registered agent, and names and addresses of the LLC’s members. An operating agreement should be created, setting out the rights and obligations of each member, as well as their percentage interests in the company, and share of the profits.
Specific steps to forming an LLC include:
- Choose a Business Name. The LLC name must be unique, and must indicate that the company is an LLC. This is done by including the term “LLC” or “Limited Liability Company” in the actual name. The name cannot contain words restricted by the state in which the company is registered, such as “bank,” “trust,” “insurance,” “college,” or “university.”
- File Articles of Organization. Completed Articles of Organization must be filed with the entity responsible for business organizations in the state. This is usually the office of the Secretary of State, but may be the state’s corporate commission, Department of Commerce and Consumer Affairs, Department of Consumer and Regulatory Affairs, or Division of Corporations. When the Articles are filed, the LLC’s name is automatically registered, making it unnecessary to go through a separate name filing.
- Create a Limited Liability Company Operating Agreement. While most states do not require LLCs to have an operating agreement, and the agreement is not filed with the state, it is a highly recommended document for every company. The operating agreement gives specific structure to the company’s organization, management, and finances.
- Obtain Required Permits and Licenses. After registering the LLC, licenses and permits required by local, state, and federal agencies must be obtained to operate the business legally.
- Declare the Business. Many states require that the formation of an LLC be published in the local newspaper. Requirements vary by jurisdiction, so it is important to check with the business filing office prior to publication.
Managing an LLC
In most LLCs with two or more owners, the members share equally in the management of the business. This is referred as a “member managed” LLC. An alternative method of managing an LLC is to designate one person, rather a member or outsider, to be responsible for the day-to-day management of the company. This “manager-managed” LLC allows the non-managing company owners to reap the profits without the stress of management, however only the specified manager may act as an agent of the LLC, and make management decisions.
Foreign vs. Domestic Limited Liability Company
A domestic limited liability company or corporation is one doing business in the same state in which it was organized or incorporated. A foreign limited liability company is one doing business in a state other than where it was organized. The documents for the formation of a LLC in most states do not have a specific designation for a domestic limited liability company, but all have a designation for a foreign company.
Limited Liability Company Taxes
The IRS considers an LLC to be a “pass-through entity,” rather than a separate entity, for tax purposes. This basically means that income from the business passes through the business straight to the members, who must then report profits and losses on their individual income tax returns. Each member of an LLC is required to deposit quarterly estimated taxes with the IRS. In this way, the LLC itself does not pay taxes, and does not file a tax return. The members, however, must file IRS form 1065, which provides the IRS with information on each member’s share of the company.
Related Legal Terms and Issues
- Business Entity – An organization established and existing apart from any other interest, business or personal.
- Damages – A monetary award in compensation for a financial loss, loss of or damage to personal or real property, or an injury.
- Recklessly – To act with no concern for the consequences, without caution, or carelessly.
- Registered Agent – A person designated by a business entity to receive legal correspondence and service of process on behalf of the entity. Also known as a “resident agent” or a “statutory agent,” the registered agent may be an officer of the corporation, an owner of the business, or a third party contracted specifically for that purpose.