LIMITED LIABILITY COMPANIES
IN THE STATE OF CALIFORNIA
by
Jennifer J. Hagan, Esq.
A Limited liability company or "LLC"
offers the simplicity and flexibility of a sole proprietorship, while at the
same time, affording to company members the limited liability enjoyed by
corporate shareholders and the pass through tax advantages of a partnership
without the restrictions imposed upon limited partnerships and Subchapter S
corporations. Limited liability companies may engage in any lawful business
activity except banking, insurance, trust company business, or certain service
professions which require a license and which are governed by the Business
& Professions Code or the Chiropractic Act. Certain professionals such as
lawyers, accountants, doctors and registered nurses are precluded from
conducting business in the LLC form.
The LLC is not a partnership or a
corporation, but a hybrid of the advantages offered by both, and offering the
business person a new alternative. Because it is a separate legal and distinct
business entity, it is capable of suing and being sued, and having rights, obligations,
powers and privileges accorded to it by state statute. A LLC must be organized
through the filing of a document called "Articles of Organization"
with the Office of the Secretary of State. Filing fees must be paid and
thereafter, the LLC must pay a minimum yearly franchise tax fee of $800.00.
However, taxes due each year are based on the LLC income (defined as “worldwide
gross income plus cost of goods sold”), and a fee scale has been created by the
Franchise Tax Board which may increase the overall taxes owed to not less than
$800 and not more than $11,790 per year. (see FTB publication 3556 for more
details).
The laws concerning the organization, operation and
management of a Limited Liability Company are codified in the California
Corporations Code Section 17000 et seq.
A LLC will often be a desirable form of business
entity for business ventures that are closely held or which involve a
relatively small number of participants. Some suggested businesses include:
Restaurants
Consultants
Venture Capital Transactions
Real Estate Finance, Investment, or Projects not
requiring (a broker’s license)
Outbound Investments from the United States
Joint Ventures
It is important to note that currently, the law as
stated in Cal Corp Code Section 17375 does not allow a LLC to render
professional services as that terms is defined by the Corporation Code Section
13401(a). Certain businesses not allowed to operate as a LLC include those
personal service businesses which can only be lawfully rendered pursuant to a
license, certification or authorization as set forth in the Business and
Professions Code or Chiropractic Act. Therefore, persons performing personal
professional services such as architects, accountants, lawyers, doctors, dentists,
real estate brokers or agents, and chiropractors may not provide said services
in the form of an LLC.
1. Pass-Through Taxation - If the LLC is set up to
be taxed as a partnership rather than a C corporation, earnings of an LLC are
taxed only once, and otherwise treated like the earnings of partnerships, sole
proprietorships and most Subchapter S corporations.
2. Limited Liability - A member's interest is
generally limited to only the amount of money which the member has invested in
the LLC. The member is entitled to have his/her/its other personal assets
shielded from the creditors of the LLC.
3. Flexible Management Structure - LLCs are free to
establish any management structure agreed upon by its members and as set forth
in the Operating Agreement. LLCs are not required to hold meetings on any kind
of annual basis, not required to file yearly forms to maintain status, and may
separate profit interests from voting interests.
4. Estate Planning - A single-member LLC may be used
to hold property located in another state to avoid an ancillary probate
proceeding in a foreign jurisdiction.
Organization - LLCs are required to be organized
pursuant to state statute, thus requiring some paperwork, as opposed to a
partnership or sole proprietorship.
Improperly Organized - If the LLC is not properly
organized, the members could lose the right to passive taxation of profits.
Conversion to a Corporation - If the members of the
LLC wish to later conduct business in the form of a corporation, the conversion
may be viewed as a sale of assets and subject to state sales tax.
Fees in Addition to Minimum Tax – In addition to
minimum taxes, LLCs are required to pay a fee on total income which ranges from
$900 to $11,790. The LLC annual fee is based on a total income reportable to
California. Under Revenue and Taxation Code 24271, that term is defined to mean
all worldwide gross income plus costs of goods sold. Therefore, if you are a
business with a high income but low net profit, you could conceivably pay much
more in taxes and fees in the LLC form rather than the corporate form.
In order to form a LLC, there must be at least
one (1) member to hold membership interest in the LLC. (See California
Corporations Code Section 17050(b) which was amended effective January 1, 2000
to allow for single member LLCs). There may be more than one (1) member if
appropriate. The membership interests are not required to be held on a pro rata basis, but may be held in
any percentage not to fall below a 99-1 threshold. Married persons qualify as
two separate persons and may participate as members in the LLC on an individual
basis, and corporations may hold membership interests as well. The name given
to an LLC must include either the phrase "Limited Liability Company,"
or the letters, LLC or LLC.
A LLC is owned by its members. They are analogous to
partners in a partnership or shareholders in a corporation. Members may
participate in the day-to-day operations of the business or designate managers
to operate the business. The members receive share certificates which represent
their respective "ownership" or "membership interest" in
the LLC.
In order to properly organize, a document named the
"Articles of Organization" must be filed with the Office of the
Secretary of State together with a filing fee of $70.00. Unless the Articles
are filed over the counter, it will usually require approximately four to six
weeks for the Articles to be processed. Effective the date of organization, the
business entity is free to conduct business and make contracts. Within four
months after the beginning of its initial tax year, the LLC must pay a minimum
franchise tax fee to the Franchise Tax Board of $800.00.
As soon as possible after organization, it is
advisable to obtain a federal tax identification number, open a new bank
account in the name of the business, and hold an organizational meeting for the
purpose of adopting a membership agreement and appointing officers. If employees
are to be paid, then the LLC must apply with the EDD for a state payroll
number.
A LLC may be managed by its members (owners) or by
selected managers. If the LLC will be managed by its members, each member will
have an equal vote in the decision making process of the company. If the
members choose, they may elect a manager or managers to act in a capacity
similar to a corporation's board of directors. The elected manager(s) will be
in charge of the daily affairs and operations of the business.
It is advisable for the LLC to operate under the
terms of an "Operation Agreement." This agreement allows for maximum
flexibility in the formation and management of the LLC. Members and their
respective interest(s) are identified, provisions made be made for the sharing
and distribution of profits and losses, and allocations made for capital investment
and expenses. Further, the operating agreement constitutes the complete
understanding between the members on how the members will be treated in certain
events.
Members always have a fiduciary duty to each other
distinct from the issues of standard of conduct for managers or members who act
as managers. The Operating Agreement may provide for express fiduciary duties
in addition to those provided by statute and those duties which are inherent
given the nature of the legal relationship between and among the members and
the LLC.
In the absence of an Operating Agreement, the
statute controlling Limited Liability Companies provides for management of the
company and the treatment of members. Limited Liability Companies are governed
by California Corporations Code Section 17000 et seq., to the extent that an
Operating Agreement does not control the field.
1. Advantages Over Other Forms of Business
Entities
A. Corporations
1. LLCs are
not subject to the same formalities as corporations, such as the requirements
for calling and conducting meetings, and annually electing directors and
officers.
2. The rights,
duties, privileges and preferences of the members may be defined in the
operating agreement, which is a private document not required to be filed with
the state. In contrast, the rights, privileges and preferences of shareholders
may be provided by the Articles of Incorporation, which are filed with the
Secretary of State, and/or Bylaws.
4. There is no
cumulative voting for the election of managers.
5. Managers of
the LLC may be removed in accordance with the terms of the Operating Agreement.
It is more difficult to remove the directors of a corporation.
6. There are
not as many restrictions concerning a distribution to LLC members as there are
to stockholders of a corporation.
B. General Partnerships
1. Partners
are personally liable for the debts of the partnership. Members are not
personally liable for the debts of the LLC.
2. A partner
always has the authority to bind the partnership. A non-managing member has no
authority to bind the LLC to contracts or obligations.
3. A partner
may independently cause the dissolution of the partnership. A member does not
have the statutory right to dissolve the LLC, however, such right may be
provided for in the Operating Agreement.
Disadvantages Over Other Forms of Business Entities
A. In certain
transactions, the business community at large is much more familiar with the
structure of a corporation and may be uncertain about a LLC, and the authority
of its officers.
B. LLCs are
relatively new, having been authorized by the State of California in 1994,
therefore, there is very little state case law concerning transactions with
LLCs.
An advantage of the LLC is its tax flexibility. The
members of the LLC are allowed to select how the entity will be taxed. The IRS
will presume that an LLC will be taxed as a partnership unless the LLC seeks
corporation taxation status. Partnership taxation allows for passive, flow
through taxation to the individual members. Thus, there is no separate entity
level tax.
The LLC has the option to elect to be taxed as a C
corporation. To preserve this election, the LLC is required to file a Form 8832
with the IRS. If this election is made, the LLC will be required to file its
own separate tax return and pay an independent entity level tax. The only
financial reason to elect C corporate taxation status is to retain profits in
the LLC to have them taxed at the corporate rather than the personal rate.
In order to be taxed as a partnership, the LLC must
lack two out of the four corporate characteristics:
1. Continuity of Life
2. Free Transferability of Interest
3 .Centralized Management
4. Limited Liability
The variations must be set forth in the Operating
Agreement. If the LLC does not have an Operating Agreement, the Limited
Liability Company default statute classifies all California LLCs as a
partnership. If the LLC is classified as a partnership for federal income tax
purposes, it may specially allocate income and loss to its members in
accordance with IRC Section 704(b). Unlike Subchapter S corporations, LLCs are
not restricted on the number and type of members that it may have. LLCs may
have any number or variety of classes or series of membership interests.
The sale of a membership interest in an LLC is a
sale of a “Security”, and therefore regulated by state and federal laws
concerning the sale of securities. This memorandum is not intended to review
the laws with respect to the sale of securities which would be a very long
discussion. However, it should be noted that before the sale of any membership
interest in an LLC, the founders should obtain from the investor a subscription
and investment representation letter/agreement which sets forth that that
investor recognizes that there are restrictions on the sale of the membership
interest and which also reduces the exposure to the LLC. The Company is also
required to make certain written disclosures to potential investors which allow
the investor to appreciated and understand the risks of making and/or losing
his/her investment.
END OF MEMORANDUM
The
information provided herein is not intended as legal advice and should not be
acted upon. If you have questions about this subject matter or would like to
consult with an attorney about business entity questions or other start-up
matters, please call Jennifer J. Hagan or James Hagan at The Hagan Law Firm
(650) 322-8498. www.Haganlaw.com.