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 or her 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 or her 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 for mismanagement or attempts to assert personal liability.
Distribution of LLC Profits and Losses
One of the remarkable features of an LLC is that members may divide the profits and losses in a flexible manner. This is a significant departure from the corporate regime whereby dividends and distributions, respectively, are allocated according to percentage ownership.
As an example, Red, Blue and Tiny each own one third of a business. Red puts in all of the money, Blue does all the work and Tiny doesn’t do much of anything. The business loses $90,000 the first year and makes $120,000 the second year. In an S corporation, the three would each be allocated a loss of $30,000 the first year and a gain of $40,000 in the second year. Red and Blue are understandably not too keen on this distribution scheme. Tiny did nothing.
However, with an LLC, Red could be allocated all of the losses in the first year and Blue could be allocated a large percentage of the gain in the second year. As long as certain special tax split rules are met and each individual pays the taxes on the gains he or she receives, the IRS is amenable to this flexible approach. And in terms of business world reality, where some people put up the money, some do most of the work and a few do absolutely nothing at all, the flexibility of LLC distributions can make all the difference between moving forward and getting bogged down in squabbling over who is doing what.
While you have flexibility you still must have agreement. If two out of three members disagree, absent a well drafted Operating Agreement at the start, a minority member may not achieve the split they want.
Lack of Precedent
One of the initial drawbacks to the LLC was that it was a new entity. There were 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 operation.
Early on, owners of an LLC had to be cognizant that the courts may interpret a feature, a benefit or even a wrinkle of LLC law in a way that did not suit them. And that is still true to a minor extent. If you do not like the uncertainty associated with a lack of legal precedent, you may want to consider utilizing an entity other than an LLC. Still, as the years pass and LLCs are formed in record numbers, this concern has diminished. In fact, in the intervening years between the first and fourth edition of this book, the issue of legal precedent has receded significantly.
The greatest concern I have with the absence of LLC legal precedence deals with how the courts will “pierce the LLC veil” and impose personal liability upon the members. Courts are starting to track the reasons and means for piercing the veil in line with a corporate situation. We shall discuss this issue in greater detail throughout the book.
In a corporate scenario one can easily avoid the imposition of personal liability by simply following certain corporate formalities. These include:
1. Annual meetings of directors and shareholders
2. Timely filings with the state.
3. Preparation of corporate tax returns.
4. Maintaining a separate bank account.
5. Separating personal and business matters.
6. Adequate capitalization of the company.
In the LLC scenario, the last five requirements apply anyway in order to maintain your status. As with a Corporation, you will need to prepare a tax return for each member to reflect the business results of the LLC (unless, as discussed, you are a single-member LLC). In addition, while not all states require annual meetings of the members, as mentioned above, the better practice is to hold such meetings. When some court someday holds that, despite no state requirement to do so, failure to hold member meetings is evidence of a lack of LLC formality you will want to have a minute book chock full of annual meeting minutes to overcome any such challenge.
By adhering to the formalities that a Corporation is required to follow to avoid piercing the corporate veil, it is anticipated that members of an LLC will avoid having their LLC veil pierced in the future.
The chart on the following pages illustrates some of the differences and similarities between the various entities we have discussed.
With our overview and comparison completed, it is now time to consider the various specific issues associated with using and operating Limited Liability Companies and Limited Partnerships. But first, here are some commonly asked questions and their answers regarding LLCs and LPs.
Frequently Asked Questions
When should I use an LLC over an LP and vice-versa?
Since everyone’s situation is different there is no definitive and correct answer to this question. As a general rule, some planners will more frequently use LPs for estate planning and holding purposes and LLCs for operating businesses and real estate investments. However, there can be valid reasons to use LLCs and LPs for the other activities mentioned. If you have a question in your own mind, you and your professional advisor should arrive at the entity best suited for your specific needs.
Is there a difference in liability protection between an LLC and an LP?
The one major difference is that in an LP the general partner is personally liable for the debts and obligations of the Limited Partnership, which may be minimized by using an LLC or Corporation as the general partner. As well, the limited partners, by acting as generals, may become personally liable. In an LLC, managers and members are not personally exposed. Please note that in an LLC, LP or even a Corporation, individuals may be held personally responsible for fraudulent and willful misconduct as well as for the failure to pay payroll taxes to the IRS. Limited liability protection does not extend to intentional bad acts.
Can non-United States citizens be members of an LLC or partners in an LP?
Yes. While non-resident aliens (foreign individuals living outside the United States) may not be shareholders of S Corporations, they may own interests in and be involved in management of an LLC, LP or C corporation.
Can an LLC or LP own stock in a S corporation?
It depends. A single member LLC taxed as a disregarded entity may hold shares in an S corporation. Otherwise, multi-member LLCs, LPs as well as C corporations, irrevocable trusts or non-resident aliens cannot own stock in an S corporation.
If I use a C corporation as the manager of an LLC or the general partner of an LP, should I open a bank account in the name of the C corporation or the LLC/LP?
You may need to open two bank accounts. The business or holding entity will need a
