Explanation of an LLC

by Jeff Franco J.D./M.A./M.B.A.

A limited liability company is a specific type of legal business entity such as a corporation or partnership. LLC’s are authorized under each state government’s rules and regulations. Although some variations exist, the relevant regulations of each jurisdiction have many similarities. The flexibility an LLC provides its member may be beneficial for certain types of businesses.

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Members

The owners of the LLC are considered members of the organization. Members do not have a specific interest in identifiable assets of the LLC; rather, they have an interest in the LLC as a whole. This interest entitles you to periodic distributions from the LLC based on its profit and loss as the operating agreement stipulates. Each member has the right to manage the affairs of the firm, vote on business matters and obtain information such as the LLC’s books and records. However, unlike a shareholder’s shares in a corporation, your interest in the LLC is not freely transferable unless the operating agreement allows you to do so. You can assign your financial interest in the LLC to another individual; however, that individual only obtains a right to distributions and does not become an active member.

Liability

Many business owners choose the LLC structure for the limitation on personal liability it provides members. Any debt or obligation the LLC incurs through the normal course of business does not affect individual member’s liability. Creditors of the business do not have a claim against any member in the event the LLC defaults on a debt or contract obligation. However, a lender has a rightful claim on all business assets that members fund through contributions.

Operating Agreement

While operating agreements are not required in most states, it is advisable for an LLC to draft one. An operating agreement defines the scope of rights and duties that each member has with other members and with the LLC. This agreement may provide the rights and duties of a member who acts as a manager, the types of activities in which the LLC may engage and the requirements members must meet before a valid amendment to the agreement becomes effective. Each member must act in a manner that is not disloyal to the business. The operating agreement can provide examples of specific types of member activities that warrant sanctions. Commonly, the agreement precludes a member who acts on behalf of the business from usurping LLC business opportunities for personal gain. Without an operating agreement, the "default rules" of the state control the LLC.

Elective Tax Treatment

The IRS offers the members of an LLC discretion in choosing the tax rules to apply. Although the IRS automatically designates single-member LLCs as a sole proprietorship, and all others as partnerships, you may elect to treat the LLC as a corporation for tax purposes. You can make the election immediately upon formation by filing IRS Form 8832. This form also allows you to change a prior corporate election back to its original designation. However, the form of taxation you choose is binding for at least 60 months. This flexibility is not available to other businesses that legally incorporate as corporations.