Functions of a Limited Liability Company

The Internal Revenue Code (IRC) does not recognize limited liability companies as their own business structure. The three business structures that the IRC recognizes are sole proprietorships, partnerships, and corporations. The IRC sees multiple-member LLCs as a subcategory of either a partnership (two or more people who have joined together to own and operate a business for profit and share profits earned, losses taken, and costs paid to vendors) or a corporation. By default, an LLC is taxed the same way as a sole proprietorship or partnership, depending on whether it has a single member or multiple members. An LLC can elect to be taxed in the same way as a corporation, with the profit being held in the company.

LLCs are flow-through organizations, sometimes called pass-through organizations. In a flow-through company, the company's income, expenses, and deductions are passed through to the individual members in accordance with the company's ownership agreement.

Suppose last year the company AllHealth LLC had revenue of $100,000 and total expenses of $75,000, for a total profit of $25,000. Its operating agreement allows it to distribute only 15 percent of its revenue as profit, so it donates $10,000 to charity. This leaves $15,000 to be distributed among the members. The operating agreement dictates that each member gets an equal share. There are four members, so each member receives $3,750. This amount passes through the company without being taxed. Even if the money is reinvested and a member does not receive the money, it will be taxed on the member's individual tax return.

Each member will be responsible for their own tax liability based on the allocated profit or loss of the company. For example, suppose Dr. Mary, as an individual, records the profit she receives as individual income and is taxed at the individual rate for her tax bracket. FirstFloor Doctors LLC will book this amount as income for the business and, in turn, will distribute its income, expenses, and deductions to its members in accordance with its operating agreement. A single-member LLC is the same as a sole proprietorship by default in that all of the income and expense of the LLC are considered to be those of the single owner. Likewise, only the single owner controls the organization.

Members of an LLC are not employees of that LLC. If the LLC hires a manager, whether or not the manager is also a member, the manager may be an employee. The manager would earn a taxable salary, but that salary is independent of membership. Members are seen as self-employed and, as such, are responsible for their own taxes and self-employment tax.

One of the benefits of a limited liability company is implied in the name. The amount that can be recovered from an individual member in the event of a lawsuit is limited.

A liability is a legal or financial debt or obligation. When Dr. Mary enters into a contract as an individual, she is personally responsible for meeting the terms of that contract. If she defaults, a court may order that her personal assets be seized to remedy the default. However, if she signs a contract as a managing member of the LLC, a judgment for default could only go against the LLC and not Dr. Mary's personal assets.

As a member of AllHealth LLC, Dr. Mary has a fiduciary duty to the company. This fiduciary duty means that she has a requirement or responsibility to work in the best interest of a person or organization—in this case AllHealth LLC. If she does not act in the company's best interest, this may be considered self-dealing, a situation in which a fiduciary makes a decision on behalf of the corporation that benefits either that fiduciary or a person with whom they have a relationship. If this happens, the limitation in liability would not extend to her, and she could be liable for the agreements she made or wrongs she committed as part of the company. Likewise, since she breached her fiduciary responsibilities, the company could file a lawsuit against her. A court may find that the members of an LLC are running the company in such a way as to benefit themselves but not build the business. The court may then choose to ignore a limited liability structure and declare that company members are personally liable for the business's debts or liabilities, which is called piercing the corporate veil.

For example, AllHealth gives money to a charity. The charity is composed of the same members as the LLC, and the money from the charity is used to pay the members of the LLC and help them avoid taxation. A court could declare that the members created the LLC as a corporate veil to help them avoid paying taxes. In this case, the courts could pierce the veil and hold each LLC member personally liable for the activity. Likewise, if two of the members were doing this without the knowledge of the other two, the two that were self-dealing would lose liability protection, while the other two may not.

To maintain liability protection, the members of an LLC have certain rights. As in a partnership, the members first and foremost have the right to information. Though a manager may have the ability to make company decisions and bind the company, the members have a right to be informed of all those activities. Members also have a right to the distribution of profits and losses, as laid out in the operating agreement and any individual member agreements. In addition, the members have a right to withdraw from the LLC at any time. If a member exercises this right, then the LLC may choose to dissolve, or close down, or it may dissolve by operation of law, depending on the state law governing it.

Generally, members have the right of first refusal. This means that sales of membership shares must be offered to the existing members before they are sold to an outside entity, assuming that the operating agreement allows membership shares to be sold at all.

Once potential LLC members understand the rights and responsibilities of this form of organization, they can decide whether to form an LLC (or whether to join an existing LLC). As potential members consider their options, it makes sense for them to think about whether this business would someday need investors and, if so, whether the LLC structure would be attractive to those investors.

Limited liability companies are often compared to corporations because both offer limited liability to owners, which is not the case with most business structures. Beyond this similarity, however, there are significant differences between the two business structures.

One of the biggest differences is in the formation of the company. Both business structures require the registration of the company name, but the paperwork involved for an LLC is much simpler than that required for a corporation. Corporations require articles of incorporation, which describes all the organizational components of the business. This includes the vision statement, shareholders' requirements, and the directorship of the corporation. Because LLC registration does not require any of this, in some states filing for an LLC is considerably easier.

Corporations are owned by individuals that own shares in the form of stock. LLCs, on the other hand, are owned directly by members. A corporation can issue stock, but an LLC cannot. Both LLCs and corporations can issue bonds, however. Bonds are created from company debt, so they do not confer ownership.

In most cases, courts consider a corporation to be its own entity. Because of this, the corporation holds profits and losses. There is no requirement for a corporation to distribute profits to its shareholders. Instead, the corporation can keep the profit as retained earnings and use those earnings to grow the business.

In contrast, LLCs need to attribute income, expenses, and deductions to their members. If an LLC sees a loss, then the individual members will pay for that loss, or the company may go out of business. In a corporation, the company simply books the loss and tries to recoup it in the next period, if possible. If not possible, it may raise capital from shareholders or through a loan.

The pass-through of profit has tax implications. Corporate shareholders are taxed on the dividends (money paid regularly to shareholders out of profits) they receive and not on the net profit of the corporation. The corporation is taxed at its own rate as a separate entity, and then the shareholder is taxed on the dividends paid. The LLC member, in contrast, is taxed based on the distributive share that the member is allocated. The member may not actually receive the money, but the tax liability is still theirs.

The Internal Revenue Code (IRC) allows for the formation of an LLC and for the election to tax the LLC as a corporation. This situation is not common, however, and it requires specialized knowledge to put into place. When this election is taken, the IRS treats LLC income as it would a corporation's income and treats the distribution as it would treat a corporation's dividends.

The law considers each corporation to be an entity unto itself, so the death of an individual shareholder does not affect the life of the company. A corporation continues in perpetuity (in other words, forever), until it is voluntarily dissolved or forced to dissolve because of insolvency or when appropriate filings are missed without remediation. On the other hand, LLCs are affected by the life and solvency of the individual members.