How Does an LLC Protect Me?

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

Jurisdictions throughout the country allow entrepreneurs to create limited liability companies and benefit from the array of protections the structure offers its owners. However, to take advantage of these benefits, you must adhere to all formation requirements in the jurisdiction where you create the LLC. Additionally, you must not co-mingle your personal assets with those of the business.

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Business Obligations

The most frequent reason that investors choose the LLC structure is for the limitation on personal liability inherent in the entity. All debts and obligations of the business are the sole responsibility of the LLC. Although individual members may bind the LLC to debts and other contracts, provided they act within the scope of their authority in the normal course of business, other parties are precluded from enforcing these obligations against individual members. The limitation on personal liability allows owners to mitigate their risk to the property and cash they contribute to the business.

Tax Liability

The federal tax law automatically designates an LLC with multiple members as a partnership solely for tax purposes, and single-member LLCs as sole proprietorships. Partnership taxation imposes the obligation to pay income tax on the member rather than the entity itself. However, the LLC must report all earnings and deductions on an informational partnership tax return each year. The LLC then allocates those earnings to each member based on her respective ownership interests on Schedule K-1. The member must report her K-1 allocations on a personal income tax return. Members are only responsible for their respective share of earnings. In the event a member fails to comply, the IRS has no recourse against other members.

Fiduciary Duties

Every jurisdiction imposes fiduciary duties on LLC members that require a minimum standard of conduct. The fiduciary duty of loyalty protects the interests of other members and the LLC by imposing personal liability on a breaching member. For example, the duty of loyalty requires that a member always put the interests of the LLC and the other owners before the member’s personal interests. In the event a member directly competes with the LLC or directs business away from it, the other members can seek judicial intervention to impose personal liability on the member for lost business profits.

Membership Rights

All jurisdictions provide the owner of an LLC the right to participate in managing the business. Your ability to manage the business and vote on issues affecting the LLC offers some protection to your investment in the LLC insofar as you can hinder another member’s ability to make executive business decisions. These voting rights also allow you to oversee the day-to-day operations of employees and inspect the books and records of the company. Although the operating agreement may restrict the level of management activity you may engage in, if you obtain the membership interest prior to the adoption of the agreement, your vote can hinder other members’ ability to adopt and enforce an agreement provision.