By: Daniel P. Simpson
The purpose of this article is to explain what a limited liability company (“LLC”) is, the special words which comprise the lexicon of LLCs and why LLCs are the entity of choice for most new businesses. The LLC is a creature of statute from state to state just like a corporation. In New Jersey, it is created by filing a document with the New Jersey Department of Treasury called a Certificate of Formation. The Certificate of Formation need not be complex, although it can be. It must state the name of the LLC, the name and address of the registered agent for service of process and the duration which may be perpetual or some shorter period.
Once the Certificate of Formation has been filed, then the LLC can transact business. The LLC is a separate legal entity that can hold title to property, hire employees and enter contracts. The principal advantage of an LLC is that, like a corporation, the owners are not liable to third-party creditors of the LLC (unless they are liable for a reason other than being an owner, such as commission of a tort personally). However, unlike a corporation, the LLC may be taxed as a partnership. Consequently, if the LLC files a partnership income tax return but pays no taxes. Instead, it “passes through” all items of income and loss to the individual members.
The owners of the LLC are not called stockholders but members. What members own in the LLC is not stock but their membership interests. There is no fixed management structure for an LLC. This is both an advantage and a disadvantage. The advantage is that the management structure of each LLC can be tailored precisely to suit the members. The disadvantage is that unless a fairly comprehensive document called an Operating Agreement is prepared, there will be no management structure. This flexibility is in contrast to the rigid, well-understood structure of corporations, where the stockholders elect the directors, who, acting as a board, elect the officers, who run the corporation. That is not necessarily so with an LLC. The election of managers can be provided for, or they can be designated by name in the Certificate of Formation of Operating Agreement along with provisions for succession. Similarly, the authority of the managers may be limited or unlimited, as provided in the Operating Agreement. If a more formal management structure including officers such as president, vice president, and secretary is desired, the Operating Agreement can so provide.
The capital structure of an LLC can be anything that is desired. There can be different classes of interest with different returns on investment and different voting rights or no voting rights at all. All of these requirements must be spelled out in the Operating Agreement. In market contrast, in the world of S corporations, there can only be one class of stock other than the occasional separate class which is identical financially but has different or no voting rights.
Like a well drafted stockholders agreement or partnership agreement, an Operating Agreement will, in addition to setting forth management structure, capital structure and profit and loss sharing will also have provisions generally restricting the transferability of interests and providing for the purchase of interests in the event of death, bankruptcy or disability, and the potential funding of the same through insurance.
Unlike an S corporation, any person or entity may be a member in an LLC. For example, an LLC is often the preferred entity of choice for ownership of real estate by two or more corporations, other LLCs or other business entities or individuals.
While there are many advantages to the LLC, please do not believe that corporations are dead. They are not. However, an LLC should be considered as an alternative every time a person or persons form a new business entity.
This publication is intended for general information purposes only and does not constitute legal advice. The reader should consult legal counsel to determine how the law may apply to specific situations.