are the shareholders, directors, and officers all at once.
In some cases, manager management is appropriate for conducting the business of the LLC. The following situations may call for manager management:
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 children but does not want them or consider them 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 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 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 of mismanagement, or attempts to assert personal liability. It should be noted that in Germany, where the first LLC format was adopted over one hundred years ago as the GmBH, a failure to prepare annual minutes can lead to piercing of the LLC veil. One can assume that states throughout the United States will adopt such a requirement in the future. (Colorado already has.) The safer practice is to prepare annual minutes for your LLC as you do for your corporation.
Rich Dad Tip
While all fifty states have adopted LLCs, so far only two Canadian provinces—Alberta and Nova Scotia—have provided for them. Investors in Canada frequently use a limited partnership instead of a ULC (Unlimited Liability Company), as LLCs are known in Canada. Canadians also tend to use a U.S. limited partnership when investing in the U.S. as LPs match up better for Canadian taxation.
DISTRIBUTION OF LLC PROFITS AND LOSSES/SPECIAL ALLOCATIONS
One of the remarkable features of an LLC is that partnership rules provide that members may divide the profits and losses in a flexible manner. This is a significant departure from the corporate regime whereby dividends are allocated according to percentage ownership.
For example, an LLC can provide 40 percent of the profits to a member who only contributed 20 percent of the initial capital. This is achieved by making what is called a special allocation.
To be accepted by the IRS, special allocations must have a “substantial economic effect.” In IRS lingo this means that the allocation must be based upon legitimate economic circumstances. An allocation cannot be used to simply reduce one owner’s tax obligations.
By including special language in your LLC’s operating agreement you may be able to create a safe harbor to insure that future special allocations will have a substantial economic effect. (As with ships at sea, a safe harbor for IRS purposes is a place of comfort and certainty.) The required language deals with the following:
1. Capital accounts, which represent the investment of the owner plus accumulated undistributed earnings, less accumulated losses, less any distribution of capital back to the owners. Each member’s capital account must be carried on the books under special rules set forth in the IRS regulations. Consult with your tax advisor on these rules. They are not unusual or out of the ordinary.
2. Liquidation based upon capital accounts. Upon dissolution of the LLC, distributions are to be made according to positive capital account balances.
3. Negative capital account paybacks. Any members with a negative capital account balance must return their account to a zero balance upon the sale or liquidation of the LLC, or when the owner sells his interest.
It should be noted that complying with the special allocation rules and qualifying under the safe harbor provisions is a complicated area of the law. Be sure to consult with an advisor who is qualified to assist you in this arena.
FLOW-THROUGH TAXATION
As has been mentioned throughout, one of the most significant benefits of the LLC, and a key reason for its existence, is the fact that the IRS recognizes it as a pass-through tax entity. All of the profits and losses of the business flow through the LLC without tax. They flow through to the business owner’s tax return and are dealt with at the individual level.
Again, a C corporation does not offer such a feature. In a C corporation, the profits are taxed at the corporate level and then taxed again when a dividend is paid to the shareholder. Thus, the issue of double taxation. Still, with proper planning, the specter of C corporation double taxation can be minimized.
In an S corporation, profits and losses flow through the corporation, thereby avoiding double taxation, but may only be allocated to the shareholders according to their percentage ownership interest. As described above, LLC profits and losses flow through the entity and may be freely allocated without regard to ownership percentages. As such, the LLC offers the combination of two significant financial benefits that other entities do not.
LACK OF PRECEDENT
One of the limits to the LLC is the fact that it is a new entity. As such, there are 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 their operation.
As the years pass this LLC drawback becomes less and less of an issue to many practitioners. But until a cohesive body of LLC law emerges, owners of an LLC must be cognizant that the courts may interpret a feature, a benefit, or even a wrinkle of LLC law in a way that does not suit them. If you are on the fence between selecting a limited partnership, a corporation, or an LLC and do not like the uncertainty associated with a lack of legal precedent, you may want to consider utilizing an entity other than an LLC.
Rich Dad Tips
• California residents must be cautious when considering the use of an LLC. The fees are onerous.
• In addition to the annual LLC franchise fee of $800, the state of California hits LLCs with a fee based on their gross receipts. This fee has nothing to do with whether your company is profitable or not. It is only based on revenue generated, so you can lose money and still owe the fee.
• On gross income of $250,000 to $499,999 the fee is $900. The fee gradually rises to $11,790 on gross income of over $5 million. Be sure to consider this fee when analyzing which entity to use in California.
Limited Partnerships
A limited partnership is similar to a general partnership with the exception that it has two types of partners. The first type is a general partner who is responsible for managing the partnership. As with a general
