A popular alternative to for-profit corporations is the limited liability company (the LLC). Wyoming was the first state to pass limited liability company legislation, in 1977. Passage by other states was slow because a question existed whether an LLC would be taxed as a corporation or as a partnership. If taxed as a partnership, then tax consequences would flow through to the owners. The IRS clarified this issue to allow pass-through taxation in 1988. Each state now allows some form of LLC. Texas first enacted LLC legislation in 1991.
Structure of an LLC
Like corporations, each LLC must have at least one member. Members ordinarily own the LLC although it is possible for a member not to have a membership interest in an LLC. An LLC may have managers as well. Managers need not be members although often managers are also members. When a Certificate of Formation states that the LLC will have managers, then the managers are the governing authority of the LLC. If the Certificate of Formation states that the LLC will not have any managers, then the members run the LLC. When there are managers, the structure of an LLC closely resembles that of a corporation. When there are no managers, an LLC looks very much like a partnership except that there is no individual liability.
Benefits and Drawbacks of LLCs
LLCs did not take off in popularity until the IRS declared that they were pass-through entities for federal income tax purposes. But the existing corporate law allows a corporation to elect pass-through, or “S” status, which means that the corporation is a pass-through entity, too. Why, then, did the LLC prove so popular? There are two reasons:
1. Taxation Elections. By default, LLCs are pass-through entities, but they can elect to be treated as corporations for tax purposes. Corporations are the opposite: By default, they are not pass-through, but they can elect S status. There is no restriction on the tax pass-through rule for LLCs. However, there are restrictions for corporations that wish to elect S status. According to the United States Code, an S corporation must:
- have no more than 100 shareholders;
- have no shareholders (with certain exceptions) who are not individuals;
- have no shareholders who are nonresident aliens; and
- have no more than one class of stock.
Any one of these factors could rule out S status, leaving the LLC as the only viable alternative.
2. Operational Flexibility. Corporate financial structures are limited by the general corporate law. How a corporation operates also is limited by the general corporate law as modified by corporate by-laws. In contrast, the financial structure of an LLC is not limited. How an LLC operates is controlled by a contract, normally called the company agreement.
These features of an LLC make it attractive to business. They are particularly well-suited for ventures among small groups of sophisticated business persons. But because company structure and operations are subject only to contract among the owners, an investor cannot rely on the ordinary corporate law to protect his or her interests. When disputes arise, they usually are novel issues because no two company agreements are identical.
If you are starting a business in which you expect to have investors, the corporation format probably is better for you. Investors love certainty. There are literally centuries of corporate law to fall back on when trying to resolve a particular issue. Complex LLC company agreements lack the certainty that investors crave. Moreover, lawyers delight in picking apart lengthy, technical documents to find lapses and violations that otherwise might not not occur under a corporate format.
On the other hand, if you do not anticipate investors, or perhaps you have a small circle of family and friends who will invest, the LLC might be for you. The LLC statutes and individual company agreements relieve LLCs of compliance with many legal requirements that corporations must follow.