The pros and cons of LLCs
The use of the limited liability company (LLC) has mushroomed in popularity over the past two decades. IRS statistics show a 66% increase in domestic LLCs between 2005 and 2014, and in 2004 LLCs were already popular entities. The core reasons for their attractiveness for a wide range of business purposes are well–known: chiefly, passthrough tax treatment while offering their owners limited liability similar to that of a corporation. CPAs may be less familiar, however, with some of the other nontax features of LLCs and instances in which forming one may not be advisable. What follows is an overview of some of these features that help explain the ascendancy of LLCs but also their limitations, as well as some innovative uses of the form that are still developing.
LLCs are entities formed under state law that give the owners liability protection while avoiding the double taxation inherent in C corporations and the ownership restrictions of S corporations. Where partnerships have partners and corporations have shareholders, LLCs have members. All states presuppose at least one member, but there is no upper limit on the number of members.
The United States is unusual in that it has no national business entity law. Instead, each state has the power to create whatever types of business entities it wants to. There was a time when only one state, Wyoming, had an LLC statute. How to classify Wyoming LLCs for tax purposes was unclear, since the Internal Revenue Code did not (and still does not) provide any rules for classifying or taxing LLCs. Eventually, the IRS created regulatory default rules (sometimes called the “check–the–box regulations”) under which LLCs with two or more members are normally taxed as partnerships, while LLCs with one member (called a single–member LLC) are disregarded for tax purposes (i.e., taxed as a sole proprietorship, if the sole member is an individual) (Regs. Sec. 301.7701–3(b)). These regulations led to a rapid enactment of LLC statutes, and now all states have LLC legislation. Federal tax classification has no impact on substantive state LLC law and does not, for example, affect the viability of the LLC liability shield.
Because it is possible to elect out of the default rule and have an LLC taxed as a C or S corporation, it is even common for taxpayers to form LLCs when they want corporate tax treatment. Typically, they elect to be taxed as an S corporation, but in light of the 21% corporate rate for tax years after 2017 instituted by P.L. 115–97, known as the Tax Cuts and Jobs Act of 2017, we might see more LLCs elect C corporation tax treatment. The main reason LLCs are preferred to state–law corporations is that they have a more modern statutory architecture, discussed below.
If each state had very different business entity laws, life could quickly get very complicated for interstate business. For that reason, uniform statutes have been developed by the Uniform Law Commission. A substantial majority of states have adopted (typically with some minor adjustments) various uniform acts, such as the Uniform Partnership Act and the Uniform Limited Partnership Act.
The Uniform Law Commission has produced two uniform LLC statutes. The first of these was not widely adopted. As of this writing, the second, often called the Revised Uniform Limited Liability Company Act (RULLCA), has been adopted in 18 states and the District of Columbia and is being considered in another state. While the LLC statutes in the states that have not adopted RULLCA tend to be fairly similar, and RULLCA usually does not represent a radical departure from what is typical, there can be important differences among statutes. However, all LLC statutes have the same liability shield.
Liability shield
LLC members, in their capacity as members, are not liable for the LLC’s obligations. This is effectively the same liability shield that corporate shareholders have. Of course, a member could always agree contractually to be liable for an LLC obligation, and everyone is liable for his or her own torts. Under unusual circumstances, it is possible to “pierce” the LLC’s liability shield and hold one or more members liable for the LLC’s obligations. State law varies in this regard, but, for the most part, some kind of genuine wrongdoing is required.
Series LLCs
A handful of states have adopted “series LLC” legislation. In those states, an LLC may create multiple “series” and, for example, conduct the LLC’s business through various series. Each series has its own independent liability shield, although each series is not treated as a separate entity under state law. Barring piercing, only the assets of a given series are liable for the obligations of that series (see “Series LLCs in Business and Tax Planning,” The Tax Adviser, Jan. 2010).
Series LLCs are not commonly used because it is unclear whether the series liability shield will be respected in a nonseries state. The nonseries state might ignore the series and conclude that the LLC as a whole is liable for all of the LLC obligations, whether incurred by a series or not. It is also doubtful that a series liability shield would be respected in bankruptcy. As a consequence, parties that want multiple liability shields commonly form multiple LLCs. It is quite common in real estate to form a holding company LLC. The underlying owners own this LLC. The parent LLC then forms subsidiary LLCs. Each parcel of real estate (and its associated real estate business) is placed in a separate LLC, with the parent as the sole member.
Business purpose
One important difference between LLC law, on the one hand, and partnership and corporate law on the other, is that in most states an LLC may be formed for any lawful purpose; it need not be a business purpose. State–law partnerships and for–profit corporations, on the other hand, generally must have a business purpose. That means that an LLC could, for example, be formed to hold a family vacation home. The check–the–box regulations apply to business entities, and there are no regulations on how to classify nonbusiness LLCs for tax purposes. The IRS does not seem to be challenging nonbusiness LLCs, but care should be exercised to not create an LLC that could be classified as a tax trust with concomitant adverse tax treatment. This could occur if, for example, parents manage the LLC for the benefit of their children–members.
Operating agreements
Partnerships have partnership agreements, corporations have articles of incorporation and bylaws, and LLCs typically have “articles of organization” and “operating agreements” (though the terminology varies a bit by state). Filing the articles of organization, often a brief document with little substantive information, creates the LLC. The meat of the deal is contained in the parties’ operating agreement, which is not filed and can even give nonmembers important roles. An LLC can own an interest in another LLC, and ultimate economic ownership of an LLC can become quite difficult for an outsider to determine (a common complaint).
Management
Most states permit both member–managed LLCs and manager–managed LLCs, with member–managed as the default rule and an election required to be manager–managed. Generally, in a member–managed LLC, any member may be involved in managing it, though the parties may vary these rights in the operating agreement. As one might suspect, only managers may manage the affairs of a manager–managed LLC, though, again, the operating agreement may vary these rights.
LLCs’ chief (albeit less common) competitor is the limited liability partnership (LLP). An LLP is a general partnership that makes an election to have a liability shield. Usually, the liability shield is the same as for an LLC. If you think it would be crazy not to make the election, you would almost always be right. You might also think that an LLP and an LLC are equivalents. For tax purposes this is true, and for an existing partnership it might make sense to elect LLP status instead of going to the trouble of liquidating and forming an LLC (though some states have conversion statutes that greatly simplify this process).
True partners don’t count as employees for federal employment law purposes, which is why many accounting firms with large numbers of partners often prefer the LLP. An LLP, for example, can have a mandatory retirement age for true partners, but not for employees, because partnerships do not fall within the scope of the Age Discrimination in Employment Act of 1967 (ADEA).
As of this writing, the author is not aware of any cases addressing how LLC members are treated for employment law purposes. Most relevant employment law was developed before LLCs were invented. This lack of clear authority sometimes inclines parties to form LLPs. One could argue, however, that the type of entity one uses should not be dispositive for employment law purposes, although that discussion is beyond the scope of this article.
In most common contexts, the LLC is preferred over a state–law partnership. There are perhaps four main reasons why this is so (besides habit):
Protection from creditors
Creditors of a member have little ability to get at the LLC’s business. Typically, a creditor of a member only has the right to a “charging order.” Under a charging order, the LLC can be required to pay to the creditor any distributions otherwise payable to the member. But the creditor normally has no power to force the LLC to make distributions. Creditors of partners commonly also have this remedy, but in some states a partner’s creditors are not limited to the charging order remedy, while LLC members’ creditors typically are. Increasingly, though, the charging order rules for partnerships and LLCs are the same. A few cases have allowed “reverse pierces,” where creditors of a member are allowed to get at the LLC’s assets. Typically, the member owns all or almost all of the interests in the LLC and has engaged in dubious conduct (see, e.g., Curci Investments LLC v. Baldwin, 221 Cal. Rptr. 3d 847 (Cal. Ct. App. 2017)).
Limited transfer rights
Normally, as is the case with partners — but not corporate shareholders — a member may transfer only economic rights to third parties and not other rights, such as the right to participate in management of the LLC’s business. The operating agreement may expand or (far more likely) restrict these limited rights.
Up to this point, LLCs and state–law partnerships are mostly tied in advantages. LLCs pull ahead with the final two factors.
Fiduciary duties
Some background: If A has a fiduciary duty to B, it means that A has to act in B’s best interest. A could not, as would be the case if A entered into a contract with B, put his interests first. Trustees, for example, have fiduciary duties toward the beneficiaries of a trust. Directors and officers, in the case of corporations, and general partners, in the case of partnerships, have a fiduciary duty of loyalty to, respectively, the shareholders and other partners. Someone with a duty of loyalty cannot compete and must offer any relevant opportunity that comes his or her way to the corporation or partnership first. Only if the corporation or partnership decides not to take advantage of the opportunity may the person owing the duty take advantage of it.
The fiduciary duty of loyalty sometimes creates inappropriate barriers. In Banks v. Bryant, 497 So. 2d 460 (Ala. 1986), a group of individuals formed a corporation to operate a dog–racing track in one part of Alabama. Some of the shareholders, who were officers of the corporation, decided to form another dog–racing track on the other side of the state. After the second track became successful, nonparticipating shareholders from the first corporation successfully sued the shareholders in the second corporation for breach of the fiduciary duty of loyalty. The Supreme Court of Alabama concluded that the opportunity to open the second track should have first been offered to the first corporation because ” ‘[c]orporate personnel may not for personal gain divert unto themselves the opportunities which in equity and fairness belong to their corporation’ ” (quoting Henn, Handbook of the Law of Corporations §237 (2d ed. 1970)).
Many states provide that a partner’s fiduciary duty of loyalty cannot be changed by agreement. There is often a limited ability to modify (but not eliminate) the fiduciary duty of loyalty under partnership law. On the other hand, many LLC statutes, including RULLCA, go further, permitting the fiduciary duty of loyalty to be eliminated “[i]f not manifestly unreasonable” (RULLCA §110(d)). If an LLC in a state that had adopted RULLCA had been used to operate the first dog track in the case discussed above, the members, when forming the LLC, could have agreed that they had no obligation to offer an opportunity to the LLC (perhaps outside a certain radius). It is possible that the parties could also have reached this agreement under many state partnership law rules, but they could not be as confident that the agreement would have held up, as they could be in many LLC states.
This added measure of safety inclines parties to form LLCs rather than LLPs. Even if the parties do not plan on restricting the duty of loyalty currently, they may want to down the road, so, again, they prefer to start with an LLC. That said, the Uniform Law Commission has approved a revised version of the Uniform Partnership Act that would apply to partnerships the same rules as LLCs in this regard. The change has not yet been widely adopted. Further, limited partnership law is yet a different universe, and it is common for limited partnership agreements to have agreements on fiduciary duties.
Agency law
An associated area of law that can be relevant is agency law. Generally, an agent acting with “actual authority” can bind his or her “principal” to a contract. Thus, if the LLC authorizes a member to enter into a contract, and the member does so on the LLC’s behalf, the LLC is bound by the contract. Under these circumstances, the agent acting within the scope of his or her authority has no individual liability or responsibility with regard to the contract. An agent can also bind a principal to a contract even if acting without actual authority, if the agent is acting with what is called “apparent authority.” Of course, acting without actual authority can make the agent liable to the principal. Ordinarily, for apparent authority to exist, the principal must have said or done something to make a third party reasonably believe that the agent has authority, even though the agent might not.
Under the partnership statutes in most states, a general partner has the apparent authority to engage in any act within the ordinary course of business of the partnership (and thus bind the partnership to an agreement), even if actual authority is lacking. In some states, the same rule applies to LLC members (or managers in the case of a manager–managed LLC). This potential ability of a partner or member to bind the entity to an unauthorized agreement can obviously be problematic.
Under RULLCA, however, members do not have statutory apparent authority. While most of RULLCA is fairly mainstream, some would call the agency rule a radical departure from the norm. RULLCA took this step because, without looking at the formation documents, it is difficult to know whether one is dealing with a manager–managed or member–managed LLC, and thus it is difficult to know what kind of authority any given member might have. Thus, under RULLCA, a member can bind the LLC only if he or she has actual authority or is acting with apparent authority created independent of the LLC form, e.g., by some kind of communication by the LLC to the third party. At least in RULLCA states, an LLC offers greater protection from the unauthorized actions of its members than a partnership does.
RULLCA seems to be gaining traction. As more states adopt it, LLC law will become more uniform and LLCs may become even more dominant. Many are already raising questions about the lack of transparency with LLCs, and their voices may get louder (see, e.g., “Anonymous Owner, L.L.C.: Why It Has Become So Easy to Hide in the Housing Market,” The New York Times, April 30, 2018). (And, as noted earlier, some courts are permitting reverse pierces in ways that likely would not have been sanctioned before the LLC revolution.) The increasing dominance of LLCs is likely to generate increasing debate about their proper use and about whether more protection is needed for third parties dealing with LLCs and for creditors of members and the LLC itself.
About the author
Walter D. Schwidetzky, J.D., LL.M., MBA, is a professor of law at the University of Baltimore. He thanks professor Daniel Kleinberger (emeritus, Mitchell Hamline School of Law) for his helpful comments on this article.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.
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