Limited Liability Companies (LLCs): The Basics

For a general overview of the different types of business entities, see my other article “Choosing the Correct Business Entity: The Basics.” For a quick reference, see also the chart in our article “Comparison of C Corp, S Corp and LLC Entity Types.”

Characteristics

The limited liability company (LLC) is a form of business organization that offers its owners (referred to as “members”) the pass-through federal tax treatment of a partnership, while also protecting members from personal liability for the obligations of the business. The members of the LLC have no personal liability for the obligations of the LLC (but, as is also true for corporate directors and officers, will still have personal liability for their individual acts and omissions in connection with the LLC’s business).

LLC vs. Partnership vs. S-Corp

For all practical purposes, an LLC operates like a limited partnership without the legal requirement of having a general partner who bears ultimate liability for the obligations of the partnership. An S Corporation also has both the limited liability and most of the federal tax pass-through features found in the LLC, but ownership is limited to 100 stockholders, all of whom must be individuals, certain tax-exempt organizations, or qualifying trusts or estates, and none of whom may be nonresident aliens. They also can have only one class of stock. An LLC has none of these restrictions. However, unlike a corporation, in several states, an LLC must have at least two members.

Formation and key documents

An LLC has two principal governing documents. The first is a short (one to two pages) document filed with the Secretary of State, which sets forth the name of the LLC, its address, its agent for service of process, term and whether it will be governed by the members or by managers appointed by the members. This document is generally called the Certificate of Formation (Delaware) or Articles of Organization (California).

The second governing document for an LLC is its operating agreement, which is analogous to (and closely resembles) a partnership agreement used by a limited partnership or a combined Certificate of Incorporation and bylaws used by a corporation. The operating agreement specifies how the LLC will be governed, the financial obligations of the members (for example, additional capital calls could be forbidden, voluntary or mandatory), and how profits, losses and distributions are shared. As with a partnership agreement, the operating agreement for an LLC will be tailored to suit the needs of each individual LLC, with the attendant expense of a specialized legal agreement. Again, boilerplate documents should be avoided.

When you might not want to use an LLC

In addition, the LLC might not be the best form if any of the following are true:

1. Venture capital funding is imminent. The LLC is not suitable for businesses financed by venture capitalfunds because of tax restrictions on the funds’ tax-exempt partners.
2. You plan to issue options to early employees and advisors. While this is doable in an LLC, many employees (especially in tech) are more familiar with the types of equity granted by corporations.
3. You want to start the holding period for QSBS
4. You prefer to use form documents and avoid bespoke legal agreements. LLCs provide a lot of flexibility, but that can result in higher administrative costs (legal and accounting).

When you might want to use an LLC

An LLC can generally be very attractive for businesses financed by corporate investors and, to a lesser extent (because of the passive-loss limitations), wealthy individuals. The LLC is the entity of choice for the startup entity seeking to flow through losses to its investors because:

1. It offers all its members the same liability protection a corporation offers its shareholders.
2. It can have corporations and partnerships as members (unlike an S Corporation) and is not subject to any of the other limitations that apply to S Corporations.
3. Losses can be specially allocated entirely to the cash investors. (In the S Corporation, losses are allocated to all the owners based on share ownership.)

In addition, the LLC can be converted to a corporation tax-free at any time. For example, after the initial startup losses have been allocated to the early-round investors, the LLC could be incorporated to accommodate investment from a venture capital fund in a conventional preferred stock financing. This type of conversion may also enable members to qualify for greater qualified small business stock (QSBS) benefits. Alternatively, incorporation could be deferred until a public offering.