A limited liability company is a hybrid entity that has the qualities of both a partnership and corporation. Depending on the number of owners, an LLC can be taxed as a partnership, corporation or sole proprietorship. A dual class LLC is a special type of LLC that minimizes self-employment tax and is analogous to a limited partnership.
Structure of a Dual Class LLC
The owners of an LLC are known as "members." A dual class LLC is structured to admit different types of members. It has general members who are active and manage the LLC, contributing time or expertise. It also has limited members who are passive and contribute only capital to the LLC, similar to limited partners in a limited partnership.
Members of a dual class LLC are treated differently than members of a traditional LLC for federal tax purposes. A traditional LLC can be taxed like a corporation or partnership, where all members may be subject to self-employment taxes. With a dual class LLC, only general members must pay self-employment taxes. For example, consider a dual class LLC with three members: Jane, John and Sarah. Jane and John are limited members who invest $25,000 each in the dual class LLC. Sarah is a general member who puts in work and services, which are valued at $25,000. Sarah is subject to self-employment taxes, but Jane and John are not. Ultimately, the decision of which members must pay self-employment taxes is made by the IRS.
Creating a Dual Class LLC
To create a dual class LLC, certain state forms must be filed, many of which are typically available through Secretary of State websites and online legal document providers. State law varies on the paperwork and filing process. For example, in Texas, this involves creating articles of organization, an operating agreement, company minutes, membership certificates, ledger and corporate seal, and payment of fees. Because the requirements vary from state to state, anyone considering creating a dual class LLC should consult an attorney.
An operating agreement outlines the rights and responsibilities of all LLC members and provides for checks and balances. Some states require one and others do not. A dual class LLC operating agreement addresses such issues as voting rights, responsibilities of members, financial issues, methods for amending the agreement, information on how a member can withdraw, and information on how the company can be dissolved or sold. Even if an operating agreement is not required by state law, it is a good idea to have one because it helps protect members against liability in case of a lawsuit.