How to Use Limited Liability Companies & Limited Partnerships. Garrett Sutton

not answer to anyone (except, of course, possibly your spouse and the IRS). And, because the IRS views a single-member LLC as a “disregarded entity” for tax purposes, you may not even need to file an LLC tax return. Instead, the LLC’s profits and losses can flow directly onto your personal tax return, be it Schedule C, E, or F (depending on the type of trade or business carried on by your single-member LLC). And, a single-member can also include a husband and wife as joint tenants, or a living trust. Better yet, while the IRS views a single-member LLC as a disregarded entity (thus obviating the need for an LLC tax return), the law still views a single-member LLC as being entitled to limited liability protection. Single member LLC’s are so popular that in Chile they have created the EIRL (Empresario Individual Responsabilidad Limitada), a nationally chartered single member limited liability entity.

      But for every benefit comes a drawback. Several U.S. states now deny asset protection to single member LLCs. (We shall explore the reasons for this in Chapter Eight.) In varying degrees, California, Colorado, Florida, Kansas and Montana, among other states, do not support single member LLCs. Additional states may follow suit. (Know that Nevada and Wyoming do protect the single member LLC.) But again, when weighing the advantage of no LLC tax return, you’ve got to weigh it against a possible loss of entity protection. Many people may choose to have a two or more member LLC just to be safe, and to file an LLC tax return as necessary.

      Another flexibility benefit has to do with ownership. One of the reasons that people have a problem utilizing the Sub S corporation is the limit on owners. When LLCs were created, a Sub S corporation could only have 35 or fewer shareholders. The IRS has since raised that number to 100. Certain foreign citizens and domestic entities are still prohibited from becoming shareholders of a Sub S corporation.

      The LLC offers the flexibility of allowing from one member to an unlimited number of members, each of whom may be a foreign citizen, trust or a corporate entity. And unlike an S corporation, you won’t have to worry about losing your flow-through taxation in the event one shareholder sells his or her shares to a prohibited shareholder.

      Flexible Management

      LLCs offer two very flexible and workable means of management. First, they can be managed by all of their members, which is known as member-managed. Or they can be managed by just one or some of the members or by an outside nonmember, which is called manager-managed.

      It is very easy to designate whether the LLC is to be member- or manager-managed. In some states, the Articles of Organization filed with the state must set out how the LLC is to be managed. In other jurisdictions, management is detailed in the Operating Agreement. If the members of an LLC want to change from manager-managed to member-managed, or vice versa, such a change can be accomplished by a vote of the members.

      In most cases, the LLC will be managed by the members. In a small, growing company, each owner will want to have an active say in how the business is operated. Member management is a direct and simple way to accomplish this.

      It should be noted that in a Corporation there are several layers of management supervision. The officers – president, secretary, treasurer and vice presidents – handle the day-to-day affairs. They are appointed by the board of directors, which oversees the larger, strategic issues of the Corporation. The directors are elected by the shareholders. By contrast, in a member-managed LLC the members are the shareholders, directors and officers all at once.

      In some cases, such as the following, manager management is appropriate for conducting the business of the LLC:

       1. One or several LLC members are only interested in investing in the business and want no part of management decision-making.

       2. A family member has gifted membership interests to his or her children but does not want them (perhaps because they are not ready) to take part in management decisions.

       3. A nonmember has lent money to the LLC and wants a say in how the funds are spent. The solution is to adopt manager management and make him or her a manager.

       4. A group of members come together and invest in a business. They feel it is prudent to hire a professional outside manager to run the business and give him or her management authority.

      As with a Corporation, it is advisable to keep minutes of the meetings held by those making management decisions. While some states do not require annual or other meetings of an LLC, the better practice is to document such meetings on a consistent basis in order to avoid miscommunication, claims for mismanagement or attempts to assert personal liability.

      Distribution of LLC Profits and Losses

      One of the remarkable features of an LLC is that members may divide the profits and losses in a flexible manner. This is a significant departure from the corporate regime whereby dividends and distributions, respectively, are allocated according to percentage ownership.

      As an example, Red, Blue and Tiny each own one third of a business. Red puts in all of the money, Blue does all the work and Tiny doesn’t do much of anything. The business loses $90,000 the first year and makes $120,000 the second year. In an S corporation, the three would each be allocated a loss of $30,000 the first year and a gain of $40,000 in the second year. Red and Blue are understandably not too keen on this distribution scheme. Tiny did nothing.

      However, with an LLC, Red could be allocated all of the losses in the first year and Blue could be allocated a large percentage of the gain in the second year. As long as certain special tax split rules are met and each individual pays the taxes on the gains he or she receives, the IRS is amenable to this flexible approach. And in terms of business world reality, where some people put up the money, some do most of the work and a few do absolutely nothing at all, the flexibility of LLC distributions can make all the difference between moving forward and getting bogged down in squabbling over who is doing what.

      While you have flexibility you still must have agreement. If two out of three members disagree, absent a well drafted Operating Agreement at the start, a minority member may not achieve the split they want.

      Lack of Precedent

      One of the initial drawbacks to the LLC was that it was a new entity. There were not many court decisions defining the various aspects of its use. With Corporations and partnerships, on the other hand, you have several hundred years of court cases creating a precedent for operation.

      Early on, owners of an LLC had to be cognizant that the courts may interpret a feature, a benefit or even a wrinkle of LLC law in a way that did not suit them. And that is still true to a minor extent. If you do not like the uncertainty associated with a lack of legal precedent, you may want to consider utilizing an entity other than an LLC. Still, as the years pass and LLCs are formed in record numbers, this concern has diminished. In fact, in the intervening years between the first and fourth edition of this book, the issue of legal precedent has receded significantly.

      The greatest concern I have with the absence of LLC legal precedence deals with how the courts will “pierce the LLC veil” and impose personal liability upon the members. Courts are starting to track the reasons and means for piercing the veil in line with a corporate situation. We shall discuss this issue in greater detail throughout the book.

      In a corporate scenario one can easily avoid the imposition of personal liability by simply following certain corporate formalities. These include:

       1. Annual meetings of directors and shareholders

       2. Timely filings with the state.

       3. Preparation of corporate tax returns.

       4. Maintaining a separate bank account.

       5. Separating personal and business matters.

       6. Adequate capitalization of the company.

      In the LLC scenario, the last five requirements apply anyway in order to maintain your status. As with a Corporation, you will need to prepare a tax return for each member to reflect the business results of the LLC (unless, as discussed, you are a single-member LLC). In addition, while not all states require annual meetings of the members, as mentioned above, the better practice is to hold such meetings. When some court someday holds that, despite no state requirement