MEMORANDUM ON LIMITED LIABILITY COMPANIES IN THE UNITED STATES

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1 MEMORANDUM ON LIMITED LIABILITY COMPANIES IN THE UNITED STATES This memorandum describes certain general characteristics of limited liability companies in the U.S. which we have found to be of interest to those mainly familiar with traditional corporate business organizations of other countries. It does not summarize the law of any particular U.S. jurisdiction in detail, nor does it purport to be complete. Overview The limited liability company ( LLC ) is a hybrid busines entity that combines certain features of partnerships and corporations while eliminating certain disadvantages of these entities. In recent years all 50 states and the District of Columbia have enacted legislation providing for the creation of limited liability companies. Like a corporation, the LLC offers limited liability to its members, and the LLC is similar to a limited partnership in that for tax purposes it is generaly viewed as a pas-through entity: the entity itself does not pay tax on its income, but the income is passed through to its respective members or limited partners who are themselves responsible for filing tax returns and paying tax to the relevant federal, state and local taxing authorities. See Taxes. The LLC has become the preferred form of business organization for new corporate joint ventures, entrepreneurial businesses, family businesses, start-up businesses, high technology and research businesses, oil and gas investments, investments in theatrical productions, real estate investments, venture capital projects, professionals, management leveraged buyouts, structured finance transactions and commodity pools. However, it presents a significant disadvantage to a non-us person that wants to acquire an interest in a U.S. business, as a U.S. limited liability company that does business in the U.S. imposes a U.S. tax filing (and paying) obligation on each of its members, including such a foreign person, and thus may be unsuitable, as well as administratively cumbersome and not tax efficient. Formation In the United States, a limited liability company is created under the laws of one of the fifty states. By complying with formalities dictated by each state the LLC can obtain the right to carry on business in one or more other states as well.

2 Most limited liability companies are formed in either the states of Delaware or New York because these states have a well-developed, flexible body of limited liability company law. However, commercial or operating factors may favor formation in another state. Regardless of the state of formation, limited liability companies generally have the power to engage in a wide range of business activities, whether or not for profit, although certain industries (such as the business of granting policies of insurance, assuming insurance risks, or banking) may be regulated. In the great majority of states, including New York and Delaware, a limited liability company (other than one intended to engage in a specially regulated industry) can be created quickly, simply, and without great cost. The formation procedure consists of the filing with the Secretary of State of the state of formation of an instrument called a certificate of formation in some states, articles of organization or a similar name in other states (the formation document ). This formation document usually sets forth the name of the limited liability company, the address of its office, the designation of the Secretary of State of the state of formation as agent for service of process, the name of the company s registered agent, the duration or date of disolution (if the LLC is to have a specific date of dissolution), a signature of the organizer and certain other information. In most states, the name of the limited liability company must include the word Limited Liability Company, or an abbreviation such as Limited Liability Co. or Ltd Liability Co., or the initials LLC or L.L.C. Although some states do not require an LLC to have an operating agreement (also called the LLC agreement) 1, usually the members choose to adopt a written operating agreement consistent with their intent and the law of the state of the LLC s formation. The operating agreement is similar to corporate by-laws in that it is the primary document that sets forth the rights, powers, duties, liabilities and obligations of members and managers, the allocations, distributions, restrictions on transferability, dissolution, and other provisions. The operating agreement is an internal document of the LLC; it is not filed publicly with the Secretary of State. Some states have additional formation requirements. By way of example, the State of New York requires a notice related to the formation of a limited liability company to be published in two newspapers. The New York publication requirement was amended effective June 1, The most significant provision of the amendment is that if an entity fails to publish the required notice, its authority to carry on, conduct or transact business in New York is suspended, as opposed to the entity ssimply being barred from maintaining an action in New York courts. Under the amended law, within 120 days after formation or filing an application for authority to conduct business in New York, a limited liability company that is formed in New York or qualified to do business in New York on or after June 1, 2006 must publish a copy of its formation documents or a notice containing certain information about itself (for a non-new 1 Note that the State of New York requires an LLC to adopt a written operating agreement. It may be adopted prior to, at the time of, or within 90 days after the filing of the Articles of Organization with the Secretary of State of the State of New York. 2

3 York entity, a copy of its application for authority to conduct business in New York or an appropriate notice) once a week for six weeks in two newspapers (one weekly, one daily) designated by the county clerk of the county in which the entity is located, and file with the New York Department of State proof of publication, consisting of a certificate by the entity and affidavits of publication by the two newspapers. Moreover, some business activities require licenses or permits from state or local governments, or both. In addition, many states require the LLC to file an annual or a biannual report. Membership Interests Ownership interests in an LLC are sometimes called membership interests or units. Most states allow members to contribute almost anything of value in exchange for an interest in an LLC, including cash, property, the right to use property, services performed or an agreement to perform services in the future, a promissory note or other obligation to contribute capital in the future. Except when required by state law (in rare circumstances), there is no minimum amount of capital that must be contributed to an LLC in exchange for an interest in the LLC. Most states do not require disclosure of capital contributions to the public. There is no requirement that membership interests in an LLC be represented by certificates, and it is not common to issue certificates to members, but an operating agreement may provide for certificates to be issued and registered in the name of a member. Similar to a corporation, the LLC may have more than one class of interests. The operating agreement may specify voting and distribution rights of the holders of such units, which may differ from class to class. A membership interest in an LLC is personal property, which may be transferred by a bill of sale, assignment or comparable document. The transfer must first be approved under the LLC s requirements (the requisite member approval requirements are usualy set forth in the operating agreement). In most states, subject to limited exceptions, restrictions on the assignability of LLC interests are permitted and are usually contained in the operating agreement. Typical examples of restrictions on assignability include a right of first refusal, tag-along rights (when a majority member wants to sell its interest, the remaining members have the right to sell their interests in the same transaction) and drag-along rights (a selling member may force the remaining members to sell their interests in the same transaction). It should be noted that an assignee of a membership interest acquires only economic rights in the distributions and does not have other rights of a member until such assignee is admitted as a member into the LLC. New members may be admitted pursuant to the requirements set forth in the operating agreement, and if none are stated, usually upon the vote or consent of a majority in interest, or all, of the members. 3

4 Structure In most states, unless the formation document provides otherwise, the LLC is deemed to be managed by the members. Every state allows single member LLCs. It is also possible to have two members, even though they are related. In a member-managed LLC, each member is subject to the duties and liabilities of a manager. Moreover, each member is considered an agent of the LLC for business purposes, and every act of a member will bind the LLC, unless the member in fact had no authority to act in the particular matter and the person with whom the member dealt was aware of that fact. Members may hold such offices and have such responsibilities as are set forth in the operating agreement. Alternatively, the formation document may vest management responsibilities in the managers. In a manager-managed LLC the managers are similar to directors in a corporation. In the state of New York the law does not require the identity of such managers to be disclosed in the articles of organization. In a manager-managed LLC members owe no duties to the LLC except to the extent that they participate in the management. Members The owners of the LLC are members ratherthan shareholders or partners. A member may be an individual, a corporation, a partnership, another LLC, or any other entity. Like shareholders in a corporation, the members in an LLC are not personally liable for the debts, obligations and liabilities of the LLC. It should be recalled that only those persons who have been admitted to the LLC as members are members in the company. As noted above, transferees of a member s interest are mere assignees that have economic rights to distributions but no other rights, unless such transferees are admitted as members to the LLC. In most states, unless provided otherwise in the operating agreement, members vote in proportion to their interests in the LLC. There is no requirement that every member have voting rights, or have an equal vote on each or any item subject to a vote of the members. The operating agreement usually describes the voting rights for each class of members, the decisions left to the members approval and the vote required to approve these actions (e.g., majority, supermajority or unanimous). In most states, unless otherwise provided in the operating agreement, a majority vote is required for most actions, although certain actions, like approval of the initial operating agreement, require unanimous vote or consent. Members meetings may be held outside the state of formation and outside the United States. Members may attend meetings in person or grant proxies authorizing others to attend and vote on their behalf. In virtually all states, members are permitted to act by unanimous written consent in lieu of a formal meeting. Except as otherwise provided in the operating agreement, a majority in interest of the members entitled to vote constitutes a quorum at the 4

5 members m eting. Most states do not require the LLC to have annual or regular meetings of members. 2 In most states, a member may withdraw from the LLC only at the time of an event specified in the operating agreement and in accordance with the operating agreement. The operating agreement may impose any restrictions on the transferability of member interests (including prohibition on assignment prior to dissolution of the LLC). See Membership Interests. In states like New York and Delaware, unless otherwise stated in the operating agreement, a member may not withdraw from an LLC prior to dissolution and winding up of the LLC. Managers As set forth above, the members of the LLC may designate one or more managers to manage the affairs of an LLC. In a manager-managed LLC the managers are generally appointed and removed by the members. The managers may also be members of the LLC. In most states any person or entity could be a manager of the LLC. 3 In most states, in a manager-managed LLC the managers have agency authority to bind the LLC and the members do not have such authority. Except for certain actions reserved for members under state law, the members may generally transfer to managers unlimited authority to manage the affairs of the LLC. Officers In most states an LLC is not required to have officers. However, members may designate officers in the operating agreement. If an LLC is managed by one manager, the manager may hold a title of chief executive officer, president or a similar recognizable title. If the LLC is managed by members, each member has actual or implied agency authority to represent and contract on behalf of the LLC. In a managed-managed or member-managed LLC, the members usually designate one or more members or managers, as the case may be, to hold the office of secretary and treasurer, for practical purposes. If an LLC designates one or more officers, the scope of authority of these officers is usually set forth in the operating agreement. Taxes The Internal Revenue Service treats the LLC as a partnership for federal income tax purposes. However, the LLC may elect to be taxed as a corporation. Federal tax regulations allow the LLC to elect its tax status and, for income tax purposes, state law follows federal law. State and city taxation should also be considered. By way of example, the state of New York imposes a tax based on the number of members in the LLC; New York City imposes special taxes and fees; and the states of Florida and Texas impose income or franchise taxes. 2 However, the LLC law of the State of New York requires that, unless otherwise stated in the operating agreement, an LLC shall hold meetings of members annually. 3 It should be noted that the state of Colorado requires a manager that is a natural person to be at least 18 years of age, and the state of Minnesota requires at least the chief manager to be a natural person. 5

6 Also, depending on the nature of its business, the LLC may have to pay or collect sales taxes, withholding taxes and other taxes. The LLC needs to obtain a taxpayer identification number from the Internal Revenue Service. If the LLC is taxed as a partnership, gains, loses, income deductions and credits pas through the LLC to the members. (That is, the entity itself does not pay tax on its income, but the income is passed through to its members who are themselves responsible for filing tax returns and paying tax to the relevant federal, state and local taxing authorities, whether or not the LLC has distributed funds to members to permit them to pay their taxes). Moreover, if the LLC is taxed as a partnership, it may designate special alocations among the members. If the LLC elects to be taxed as a corporation, the income of the entity is taxed at the corporate rate and only any distributions to the members are taxed as part of the members income. Dissolution and Winding Up The LLC is usually dissolved upon the first of the following to occur: the date for dissolution, if any, set forth in the formation document or in the operating agreement; the occurrence of events specified in the operating agreement; the vote or written consent of the members who own (a) more than two-thirds in some states or (b) the majority in interest in other states (or such other percentage designated in the operating agreement) of the LLC; at any time that there are no members, provided that the LLC may be continue if certain requirements are met; or the entry of a decree of judicial dissolution. Unless otherwise provided in the operating agreement, the death, retirement, resignation, expulsion, bankruptcy or dissolution of any member or the occurrence of any other event that terminates the continued membership of any member does not cause the dissolution of the LLC. Upon the dissolution of the LLC (other than pursuant to a judicial dissolution), unless otherwise provided in the operating agreement, its affairs are wound up and the assets of the LLC are distributed in the following manner: first, to creditors, including members who are creditors, then, unless otherwise provided in the operating agreement, to members, first in satisfaction of their liabilities for distributions, second, for the return of their contributions, and the balance, in proportion to their membership interests. 6

7 When the LLC is dissolved and the winding up of its assets is complete (or within a certain time period after the commencement of winding up), a filing with the Secretary of State of the state of formation is usually required to complete the process. In most states the LLC may be converted into a corporation and a corporation may be converted into the LLC upon the filing of required documents and payment of the fees dictated by each state. For additional information, contact: David C. Camerini, Esq. Fox Horan & Camerini LLP 825 Third Avenue New York, New York Main Tel: Direct Tel: Facsimile: dccamerini@foxlex.com Fox Horan & Camerini LLP August 2006 The contents of this publication are for general information purposes only and should not be regarded as legal advice. The distribution of this publication to any person does not constitute the establishment of an attorneyclient relationship. This material may be considered Attorney Advertising in some jurisdictions. IRS CIRCULAR 230 DISCLOSURE: ANY STATEMENTS REGARDING FEDERAL TAX LAW CONTAINED HEREIN ARE NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, FOR THE PURPOSES OF AVOIDING PENALTIES THAT MAY BE IMPOSED UNDER FEDERAL TAX LAW OR TO PROMOTE, MARKET OR RECOMMEND TO ANOTHER PARTY ANY TRANSACTION OR MATTER ADDRESSED HEREIN. 7