A limited liability company (LLC) is a business entity that combines flexibility in ownership and liability protection. Used correctly, an LLC can limit the ability of creditors to reach beyond the assets held by the LLC and insulate owners–and their assets–from liability. Forming an LLC is a relatively straightforward process; however, owners should recognize that there are ongoing filing requirements and formalities that must be maintained to maintain the entity and, by extension, the liability protection an LLC is intended to offer.
How Do I Form an LLC?
To form an LLC, the owner must first submit a relatively simple document, typically called “Articles of Organization,” with the appropriate state authority. In Maryland, owners must submit Articles of Organization to the Maryland State Department of Assessments and Taxation. In the District of Columbia, owners must submit Articles of Organization to the Department of Licensing and Consumer Protection. In Virginia, Articles of Organization must be submitted to the Virginia State Corporation Commission.
The information required in the Articles of Organization differs slightly from state to state, but most jurisdictions require:
- A unique name for your LLC that has not been registered before by any other business owner in that jurisdiction;
- Information concerning the principal place of business of the LLC;
- Contact information (name and address) for a “resident agent” for the LLC who is the LLC’s point of contact within the state and is authorized to receive legal documents on behalf of the LLC;
- A brief statement of the purpose for which the LLC is being formed.
In addition, some jurisdictions (including the District of Columbia) require names and contact information for owners of the LLC, which will become part of the public records.
Almost every jurisdiction in the United States now contemplates electronic filing of Articles of Organization via the applicable state agency’s website and expedited processing, meaning that an LLC can be formed and registered with the state agency in a matter of days or even same-day.
What Is the Benefit of an LLC From a Liability Perspective?
Properly structured and maintained, individual members of an LLC will not be personally liable for the debts and obligations of the LLC. This means that a member-owner can protect their other assets, directly owned by the member, from any debts or obligations of the LLC.
However, owners should be aware that they will generally always be responsible for personal torts and their personal negligence. If an owner driving an LLC vehicle strikes another person, the owner may still face personal liability as the driver of the vehicle. On the other hand, if a non-owner employee is driving an LLC-owned vehicle and strikes a third party, owner-members would generally be insulated from liability through a properly maintained LLC structure.
However, it is critical that the members of an LLC actually treat the LLC like a different entity–or, in lawyer-speak, follow “corporate formalities.” The LLC should maintain a bank account in its name (not an individual member’s) for depositing and withdrawing funds. Member withdrawal (or “distributions”) from LLC bank accounts should ideally follow a formal schedule similar to an employer pay period, and members should not consistently liquidate and then re-capitalize LLC accounts from personal funds. Any contracts entered into in connection with the LLC’s operations, such as lease agreements, supplier agreements, purchase orders, utility bills, etc., should name the LLC itself, and not any member, as the applicable party. Assets used in the LLC’s business operations (e.g., vehicles, equipment, computers) should be titled in the name of the business.
When a member of an LLC does not maintain these corporate formalities, creditors of the LLC may be able to “pierce the corporate veil” in a lawsuit such that the LLC structure will be disregarded and the member will be personally liable as if he or she were conducting business in such member’s own name.
How Is an LLC Taxed?
By default, an LLC is a “pass-through entity”. This means the LLC itself is typically not responsible for paying federal or state income tax; that liability is instead passed through to the members in proportion to their interests or other agreed-upon allocation. A significant difference between corporations and LLCs is that, unlike an LLC, corporate earnings are taxed both at the entity level and again when such earnings are distributed to shareholders as dividends (co-called “double taxation”).
It is important to note, however, that the LLC may nonetheless be primarily responsible for collecting, remitting, and reporting other (non-income) taxes, such as payroll taxes, sales and use taxes, and gross receipts taxes. If the LLC fails to properly collect and remit these taxes, the member(s) responsible for managing the LLC may nonetheless be held personally liable for such failure.
While beyond the scope of a summary article, we would note that LLC members may nonetheless make elections to be subject to corporate, small business (or “S”) corporation, or other various alternative tax regimes, which should be done only following careful consideration of the resulting tax effects.
What Other Reporting and Filing Requirements Might an LLC Need to Consider?
Forming an LLC by filing Articles of Organization is often only the first step in appropriately registering the LLC to conduct business.
Some jurisdictions require the LLC to obtain one or more business licenses depending on the nature of the LLC’s operations. In addition, most jurisdictions require periodic reports to be filed and a corresponding administrative fee to be paid to keep the LLC in “good standing” and in existence.
Failure to comply with the various filing requirements can subject the LLC to penalties, fines, and – in extreme cases – loss of limited liability protection entirely. It is therefore critical that owners understand the various filing obligations to which the LLC may be subject at the time of formation, and to periodically review any filing requirements that may arise from changes in the LLC’s operations.
What is an Operating Agreement, and Does an LLC Need One?
Let me start this section with an analogy. My daughter is now at the age where she can ride her bike around our neighborhood. Almost always, she’ll ask me, “Do I need to wear my helmet?” And exactly always, I say yes. Not because of the 99% of the time she would otherwise be fine, but because of the 1% risk that something unexpected happens.
With that in mind, generally speaking, owners are not required to enter into a formal agreement concerning the rights of each member or how the LLC will be managed (such agreement is typically referred to as an “Operating Agreement”). The limited liability company laws in each jurisdiction will provide certain default rules for the various rights of members, duties of managers, and procedures for how the LLC may be managed.
However, owners should be aware that in the absence of an agreement to the contrary, these default rules will be binding upon them and any successors to their interests. For example, the laws of each jurisdiction differ as to the ability of a member to transfer such member’s interest in the LLC to an unrelated third party. An owner may learn, after the fact, that his or her business partner has sold such partner’s membership interest in the LLC to a completely unrelated third party. Likewise, a deceased member’s interest may transfer by operation of law to a surviving spouse or other heir, who may then have gained effective control of the LLC’s operations without any other member’s consent. In the absence of an Operating Agreement prohibiting such transfers, state law may provide no recourse whatsoever to the non-transferring members who will now be stuck with business partners they didn’t sign up for.
An Operating Agreement is like my daughter’s bike helmet. You may not need it 99% of the time, but you definitely want to have it for when the unexpected arises. We encourage all owners to collaborate and discuss how the LLC should be managed and what their respective rights and obligations should be before forming the LLC and commencing operations, and to memorialize those discussions into a formal, written Operating Agreement.
Even for a single-member LLC, a basic operating agreement will evidence the member’s ability to consummate certain transactions on behalf of the LLC (e.g., enter into banking or loan agreements), which third parties may require prior to entering into any relationship with the LLC. It will also help demonstrate that corporate formalities are being maintained, provided a member/manager’s actions are consistent with the requirements outlined in the Operating Agreement.
If the relationship of the members, the number or identity of the members, or the nature of the Company’s operations changes in the future, an operating agreement can be amended to reflect those changes in circumstances.
If you are thinking about forming an LLC, trying to determine whether an LLC is an appropriate structure for an entity, or if you already formed an LLC and would like to discuss strategy, growth, or ongoing compliance issues, contact Tim Canney, chair of the business and tax practice at Bulman Dunie, at (301) 656-1177 x331 or tcanney@bulmandunie.com.
