Limited Liability Companies. Course #5135G/QAS5135G Course Material

Transcription

1 Limited Liability Companies Course #5135G/QAS5135G Course Material

2 Author s Biography Renee C. Nash, J.D. is an accomplished teacher and author. She spent 14 years as Adjunct Professor of Law, McGeorge School of Law, in Sacramento, California, where her specialties included employment law. She was consistently rated by students as one of the school s top teachers. Her other teaching duties included serving as an instructor for the College of Administrative Law and America s Legal Seminars. She has written a number of training materials for various professionals, including attorneys, accountants and corporate executives. She formerly served as legal counsel to the California Newspaper Publishers Association, corporate counsel to McClatchy Newspapers, Inc. and general counsel to News & Review Publishing, Inc. She has published books and educational materials in the areas of advertising law, employment law, first amendment law and many others. She earned her B.A. from the University of California and her J.D. from McGeorge School of Law, where she graduated With Great Distinction.

3 Limited Liability Companies (Course #5135G/Qas5135G) Table of Contents Page Chapter 1: Introduction and History A. History and Overview of Limited Liability Companies 1-1 B. Comparison with Other Business Forms 1-2 C. Factors Influencing Choice of Entity 1-7 D. Uniform Limited Liability Company Act 1-8 Review Questions & Solutions 1-10 Chapter 2: Establishment of Limited Liability Company A. Formation 2-1 B. Naming a Limited Liability Company 2-5 C. Fees and Reporting Requirements 2-7 Review Questions & Solutions 2-10 Chapter 3: Members Rights and Duties A. Number of Members 3-1 B. Types of Members 3-1 C. Membership Interests 3-1 D. Rights of Members 3-2 E. Duties of Members 3-3 F. LLC Membership as a Security 3-9 G. Transfer, Sale and Assignment of Memberships 3-10 H. Dissociation of Members 3-10 Review Questions & Solutions 3-12 Chapter 4: Management of a Limited Liability Company A. Designating Management of a Limited Liability Company 4-1 B. Managers as Agents of a Limited Liability Company 4-2 Review Questions & Solutions 4-8 Chapter 5: Liability of Members Review Questions & Solutions 5-7 Chapter 6: Professional Limited Liability Companies A. Requirements for Naming and Formation 6-2 B. Limitations on Membership and Practice 6-2 C. Liability of Members of Professional LLC 6-3 D. Foreign Professional LLCs 6-4 E. Note on Professional Corporation 6-4 Review Questions & Solutions 6-6 Table of Contents 1

4 Table of Contents (cont.) Chapter 7: Foreign Limited Liability Companies A. What Constitutes Doing Business? 7-1 B. Laws Governing Foreign Limited Liability Companies 7-2 C. Registration Requirements 7-2 D. Name of Foreign Limited Liability Companies 7-3 E. Revocation of Registration of a Foreign LLC 7-3 F. State Taxation of Foreign Limited Liability Companies 7-3 Review Questions & Solutions 7-4 Page Chapter 8: Financing, Distributions and Withdrawals Part I. Financing a Limited Liability Company: Member Contributions 8-1 A. Type and Amount of Contribution 8-1 B. Liability for Contributions 8-1 C. Additional Contributions 8-2 D. Right to Return of Contribution Upon Withdrawal 8-3 E. Return of Contributions Upon Dissolution 8-4 Part II. Distributions 8-5 A. Pre-Dissolution Distributions 8-5 B. Treatment of Excess Contributions 8-12 C. Post-Dissolution Distributions 8-12 Review Questions & Solutions 8-13 Chapter 9: Merger and Conversion Part I. Merger 9-1 Part II. Conversion 9-3 A. Conversion of Partnership to LLC 9-3 B. Conversion of Corporation to Limited Liability Company 9-4 C. Articles of Conversion 9-5 D. Treatment of Assets of a Converted Entity 9-6 E. Liability of Owners of Converted Entity 9-8 Part III. Conversion of a Limited Liability Company to a New Business Form 9-9 A. Plan of Conversion 9-9 B. Articles of Conversion 9-10 C. Tax Clearance 9-10 Review Questions & Solutions 9-12 Table of Contents 2

5 Table of Contents (cont.) Page Chapter 10: Dissolution of a Limited Liability Company Part I. Background 10-1 A. Check the Box Regulations 10-1 Part II. Types of Dissolution 10-3 A. Administrative Dissolution 10-3 B. Judicial Dissolution 10-4 C. Membership Initiated Dissolution 10-7 D. Effect of Operating Agreement on Dissolution Disputes 10-7 Part III. Technicalities of Dissolution 10-8 A. Formalities of Dissolution 10-8 B. Winding Up Business of Dissolved Company 10-9 C. Notice to Creditors D. Merger of Dissolving Entity E. Revocation of Dissolution Review Questions & Solutions Chapter 11: Taxation of LLCs Part I. Historical Treatment 11-1 Part II. Federal Tax Returns 11-3 A. Type of Federal Return LLC May File 11-4 B. Employment and Self-Employment Taxes 11-5 C. Employee Identification Number 11-6 D. Taxation of Distributions 11-9 E. Retained Earnings F. Taxation of a Converted Entity Part III. State Taxes and Fees Review Questions & Solutions Appendices Appendix A Appendix B Appendix C I.R.S. Revenue Ruling: Partnership Classification I.R.S. Regulations Uniform Limited Liability Company Act Glossary Index Table of Contents 3

6 Chapter 1: Introduction and History This material is designed to provide practitioners with an overview of limited liability companies, a relatively new business form in the United States that gives owners the twin benefits of pass-through taxation and limited liability. This chapter will provide a brief history of limited liability companies (LLC) in the United States and then compare them to other types of business forms, including corporations and partnerships. This comparison is not meant to be exhaustive, but should give readers an overview of some of the major characteristics of different business forms and an understanding of what types of businesses would benefit most from each type of entity. A. HISTORY AND OVERVIEW OF LIMITED LIABILITY COMPANIES Limited liability companies have been a popular business form in European and other countries for decades. The first state in the United States to recognize limited liability companies was Wyoming, which allowed them beginning in Florida followed suit in It was not until the IRS agreed in a 1988 Revenue Ruling (Rev. Rul , reprinted in full in Appendix A) to treat LLCs as partnerships for tax purposes that many businesses decided to utilize this new form. This triggered legislative activity throughout the nation and each state sought to give its businesses the opportunity to utilize this new form. By 1996, all 50 states and the District of Columbia had passed laws recognizing limited liability companies and creating statutory frameworks covering their formation, operation and dissolution. Although recognized by the IRS for tax purposes, limited liability companies are purely creatures of state law. A limited liability company is an entity formed by following the procedures required in the state of operation. The owners of an LLC are generally referred to as members. In most states, forming an LLC requires the preparation of only one document, the socalled Articles of Organization, which are filed with the secretary of state or other designated state agency. This document, which is described in detail later in these materials, is usually brief and sets forth general information about the company, including its name, address, agent for service of process, term, and whether it will be run by the members or managers appointed by the members. Every state has detailed rules for what must be contained in this document and generally also offers a fill-in-the blank form that meets its statutory requirements. In California and a few other states, LLCs are also required to file with the state an operating agreement, which, similar to a partnership agreement, provides a blueprint for how the LLC will be run, the financial obligations of the members, and how profits and losses will be divided. As a practical matter, almost every LLC will want to have a welldrafted operating agreement whether or not it is required. To the extent an operating agreement does not exist or is silent on a particular issue, courts will resolve disputes by referring to each state s default statutory provisions governing operation of limited liability companies. Introduction and History 1-1

7 An LLC may be classified for Federal income tax purposes as either a partnership or a corporation. A domestic LLC with at least two members is automatically classified as a partnership for Federal income tax purposes unless it elects to be treated as a corporation. This is done by filing IRS Form Unlike a partnership, none of the members of an LLC are personally liable for its debts. Practically, an LLC operates like a limited partnership without the requirement for a general partner. Unlike an S corporation, an LLC has no limits on the number of shareholders, classes of stock, or type of shareholders. Because in most cases losses pass through to the members of an LLC, an LLC can be attractive to corporate investors and wealthy individuals. However, note that not all limited liability companies will be entitled to pass-through taxation. This determination is made by applying the rules set forth in Section 7701 of the Internal Revenue Code and the so-called Kintner regulations (Treas. Reg. Sec ), which identify six characteristics indicative of corporate status: 1) the presence of associates, 2) an objective to carry on business and divide the gains, 3) continuity of life, 4) free transferability of interests, 5) centralization of management, and 6) limited liability. Simply put, if the limited liability company is more like a corporation than not, it will be taxed as one. This and other tax issues will be discussed in more detail later in these materials. Even if an LLC does not qualify for tax treatment as a partnership, there are other advantages to choosing this business form, including: Limited liability for all owners Flexibility in selecting a management structure Limited formalities, such as meetings and record-keeping B. COMPARISON WITH OTHER BUSINESS FORMS The most common forms of business are the sole proprietorship, partnership, including limited partnerships, corporations, and S corporations. This section will provide an overview of the major aspects of these different business forms and compare them to limited liability companies. 1. Sole Proprietorships A sole proprietorship is an unincorporated business that is owned by one individual. It is the simplest form of business organization to start and maintain. The business has no legal existence separate and apart from the individual owner. Its liabilities are the owner s personal liabilities and the owner undertakes the risks of the business for all assets owned, whether used in the business or not. The owner includes the income and expenses of the business on his or her own tax return. Introduction and History 1-2

8 There are no special forms to file with state agencies to create a sole proprietorship. Depending on the location and type of business, however, a sole proprietor may be required to obtain a business license or file a fictitious business name statement. A sole proprietor can sell all or part of his or her business at any time without gaining the consent of others. As the business grows, a sole proprietor can also decide to change the structure of the business, either by incorporation, filing to become a limited liability company or perhaps even by adding a partner. A sole proprietor, as the sole owner, has total flexibility in changing the nature of his business at any time so long as it conforms to the legal requirements of the new type of business entity. 2. Partnerships A partnership is a business that is generally operated by two or more persons. A partnership can be a legally distinct entity from its partners or a mere aggregate of its partners depending upon its type. Other business entities, such as a corporation or limited liability company, can also enter into partnerships for the purpose of engaging in a new or related business. For purposes of this discussion, however, we will assume that a partner is a natural person. There are two main types of partnerships: general partnerships and limited partnerships. a. General Partnerships In a general partnership, all partners are "general partners", meaning each has unlimited liability for the partnership's debts and can incur obligations on the partnership's behalf within the scope of the business. Each partner acts as an agent for the other partners and the partnership, and therefore, has authority to bind the partnership through his or her actions, including the execution of contracts. Partnerships have few legal formalities. A general partnership does not require a written agreement; one can be formed with nothing more than a general understanding or handshake between the partners. Each partner must merely intend to establish a business relationship with the other(s) for the partnership to be born.. A general partnership does not require a written agreement; one can be formed with nothing more than a general understanding or handshake between the partners. As with an LLC, without a written agreement, state partnership laws will govern a partnership. Each state (with the exception of Louisiana) has its own laws governing partnerships, usually referred to as "The Uniform Partnership Act" or "The Revised Uniform Partnership Act." These statutes set forth the basic legal rules that apply to partnerships and will control many aspects of a partnership to the extent alternative provisions are not provided in a written partnership agreement. Introduction and History 1-3

9 A partnership is not a taxable entity. Each partner includes his or her share of the partnership's income or loss on his or her tax return. A partnership can allocate profit and losses flexibly, not just on stock ownership as in an S corporation. This allocation can also change over time. A partnership can generally accept and distribute property without being subject to tax. Internal Revenue Code Section 351 allows a partnership to convert into a corporation without taxation if the incorporation is done properly. Unlike a corporation, a partnership generally dissolves upon the death or withdrawal of a partner. A partnership agreement can, however, provide for alternatives to liquidation after dissolution, such as the buyout of a deceased or withdrawn partner, election of a new general partner, and continuation of the business by the remaining partners. Partnerships, like other types of business entities, can be converted into a limited liability company. The conversion of a partnership into an LLC classified as a partnership for federal tax purposes does not terminate the partnership. The conversion is not a sale, exchange, or liquidation of any partnership interest, the partnership's tax year does not close, and the LLC can continue to use the partnership's taxpayer identification number. Conversions and mergers involving LLCs will be discussed in more detail later in these materials. One of the main disadvantages of a partnership over a limited liability company is that all of the partners are liable for all of the debts and obligations of the partnership. This is not true with limited partnerships, as Table 1.1, below, shows. Table 1.1 Comparison of Liability of Owners Between LLC with Partnership LLC General Partnership Limited Partnership Members not liable All partners liable All general partners liable; limited partners not liable so long as they are not involved in management b. Limited Partnerships A limited liability partnership (LLP) has one or more general partners with the same liability and power as in a general partnership, and one or more "limited partners". A limited partner's liability is no more than the amount of the capital he or she invests in the company. Generally, limited partners cannot participate in running the partnership, or they become subject to a general partner's liability. This is one aspect of an LLP that may make an LLC a more attractive option; all owners can participate in management and maintain limited liability. Note, however, in many states, a limited liability partnership offers only very limited protection, insulating only against the liability arising from malpractice committed by another partner in the firm, and does not confer general protection against trade creditors or against other liabilities of the limited liability partnership, as a rule. Introduction and History 1-4

10 While each state has a general and limited partnership act, partners may generally establish their own arrangements in the partnership agreements. Such agreements override most of a state's default partnership provisions. In the absence of any provision to the contrary, profits and losses are divided evenly among the partners. Death or withdrawal of a limited partner does not generally result in the liquidation of a limited partnership. The deceased partner's limited partnership interest can be passed on to heirs or successors. Unlike a general partnership, partners in a limited partnership must file a certificate and a written partnership agreement with the secretary of state. 3. Corporation A corporation is a legally distinct entity owned by its shareholders. Shareholders elect a corporation's board of directors, but otherwise do not actively manage the corporation. The board of directors usually makes the major corporate decisions; the corporation's officers, who are appointed by the board of directors, conduct the corporation's day-today management. A single person can be a corporation's owner and sole director, and may serve as any officer required by law. A corporation survives the death of a shareholder or other changes in ownership. This is a key difference with other types of business entities, whose longevity is limited (See Table 1.2 below). Table 1.2 Comparison of Longevity of Different Business Forms ENTITY Sole Proprietorship Partnership C Corporation S Corporation LLC LONGEVITY Generally dies with the proprietor, no legal existence beyond owner Spelled out in partnership agreement or by operation of law if no agreement Can be formed in perpetuity Cannot be formed in perpetuity and maintain pass-through tax status Governed by operating agreement or state law In forming a corporation, prospective shareholders transfer money, property, or both, for the corporation's capital stock. A corporation generally takes the same deductions as a sole proprietorship to compute its taxable income. A corporation can also take special deductions. The profit of a corporation is taxed to both the corporation and to the shareholders if and when the profit is distributed as dividends. However, shareholders cannot deduct any loss of the corporation. Most large businesses operate as corporations, the most familiar entity and that most closely regulated by law. A corporation's principal appeal is the limited liability provided to its shareholders. A corporation's creditors can collect only from the corporation's Introduction and History 1-5

11 assets, and cannot collect directly from the shareholders even if corporate assets are insufficient to pay all debts and liabilities. A corporation is taxed as a separate legal entity unless it is an S corporation, discussed below. Under current federal income tax law, a corporation is taxed on its net income, defined as gross income less allowable deductions. Corporate tax rates range from 15% to 35%. Non-cash property will be taxed as part of the corporation unless the person or group of people contributing the property owns at least 80% of the corporation. If the corporation distributes money or other property, such as dividends, to its shareholders, the shareholders will be taxed on the distributions. In brief, some of the major benefits of corporate status include: Unlimited life span Free transferability of ownership Limited liability of all owners Ownership interests may be easily given to employees Various classes of stock may be issued 4. S Corporation An eligible domestic corporation can avoid double taxation (once to the shareholders and again to the corporation) by electing to be treated as an S corporation. An S corporation generally is exempt from federal income tax. Its shareholders include on their tax returns their share of the corporation's separately stated items of income, deduction, loss, and credit, and their share of non separately stated income or loss. Shareholders generally choose to form an S corporation when the corporation is profitable and distributes nearly all of its profits to the shareholders, or when the corporation incurs substantial losses that shareholders wish to deduct from their personal income tax returns. Profits and losses must be allocated based on share ownership for tax purposes. Shareholders of an S corporation must include on their individual tax returns the profits of the S corporation even if no money was distributed to them. To qualify for S corporation status, a corporation must meet the following criteria: It may have no more than 100 shareholders who are individuals, certain taxexempt organizations, certain trusts or estates, and none of whom are nonresident aliens. It may issue only one class of stock. The corporation generally cannot own 80% or more of any other corporation. Introduction and History 1-6

12 Because all shareholders of an S corporation must be individuals, an S corporation cannot raise funds from venture capital funds, corporations or institutional investors. The one-class-of-stock requirement prevents the business from issuing inexpensive founders' stock for key employees. Most corporations that raise money from outside sources will issue two classes of stock: convertible preferred stock for investors and common stock for the employees. Common stock is often issued at a small fraction of the price of the preferred stock because it lacks the liquidation, dividend, voting and other preferences of preferred stock. Thus, S corporations are most commonly used for family or other closely owned businesses that get their capital from their individual shareholders and/or debt from outside sources. C. FACTORS INFLUENCING CHOICE OF ENTITY Every business venture is unique. Every owner or investor has different goals and concerns. As a result, no single business structure is perfect for any certain type of business. There are, however, a number of factors that most people will want to consider when selecting the appropriate structure for their entity. S corporations, partnerships and LLCs all provide flow-through income for owners, which is desirable, particularly when the owners are not employees and therefore do not draw a salary, and when the owners do not necessarily wish to reinvest significant profits in the company. In a C corporation, monies paid out in the form of a salary either to owners or non-owners become a tax-deductible business expense to the company, and the employee is then taxed on his or her earnings. One of the first issues, therefore, in determining whether an LLC is an appropriate business form is whether the organizers expect the business to initially generate a profit or not. If the business expects to lose money initially, a flow-through entity like a partnership, LLC or S corporation is preferable because it will allow owners to deduct the losses from their taxable income. Another important issue is the level of participation investors want to have in the management of the enterprise. Different forms restrict the level of involvement if owners want to maintain limited liability status. With a limited liability company, members can choose who will manage the entity. Some, all or none of the members may choose to engage in management. Other types of entities impose more restrictions. Another issue in determining a business form is the number of people who will be investing in the business. See Table 1.3 below for a comparison of rules governing different business forms. Introduction and History 1-7

13 Table 1.3 Comparison of Rules Limiting Ownership in Different Business Forms ENTITY LLC General Partnership Limited Partnership OWNERSHIP RESTRICTIONS There is no upper limit on the number of members a limited liability company may have Must have at least 2 general partners Must have at least one general and one limited partner C Corporation Most states allow single-shareholder corporations, some require a minimum of two; there is no maximum S Corporation Same as C Corporation, but subject to a cap of 100 owners By definition, of course, a sole proprietorship is owned by a single individual. Many other factors may come into play in choosing the best entity for each particular business. These include: Termination: How easy will it be to wind up the business and return capital and profits to owners? A sole proprietorship, for example, can simply and quickly be sold and consent from others is not required. Cost: What is the cost in setting up the business? The simpler the structure, the smaller the cost. Ease of Operation: How easy will it be to run the business? Are there many formalities associated with the business structure? Corporations, for example, will require a significant amount of formalities, including meetings, record-keeping and, in some cases, public disclosures. The rest of these materials will focus specifically on limited liability companies and how each of these and other issues apply to this special type of business form. D. UNIFORM LIMITED LIABILITY COMPANY ACT The National Conference of Commissioners on Uniform State Laws is an organization that enacts model legislation to serve as guides for individual states. In 1995, the Conference promulgated the Uniform Limited Liability Company Act ("ULLCA"). Although its provisions are purely recommended, they serve as an important guide in analyzing approaches to dealing with specific legal issues. They can also be very influential in affecting state law. The following states have adopted the provisions of the ULLCA and are referred to as ULLCA jurisdictions: Alabama, Hawaii, Illinois, Montana, South Carolina, South Dakota, U.S. Virgin Islands, Vermont and West Virginia. Because of its influence on state law, provisions of the ULLCA are discussed throughout this course. The entire act is provided in Appendix C. Introduction and History 1-8

14 The ULLCA, according to its drafters, is flexible in the sense that the vast majority of its provisions may be modified by the owners in a private agreement. The majority of the Act sets forth default rules designed to operate a limited liability company without sophisticated agreements and to recognize that members may also modify the default rules by oral agreements defined in part by their own conduct. The Act combines two simple default structures which depend upon the presence of designations in the articles of organization. All default rules under the Act flow from these two designations. First, unless the articles reflect that a limited liability company is a term company and the duration of that term, the company will be an at-will company. Generally, an at-will company dissolves more easily than a term company and its owners may demand a payment of the fair value of their interests at any time. Owners of a term company must generally wait until the expiration of the term to obtain the value of their interests. Secondly, unless the articles reflect that a company will be managed by managers, the company will be managed by its members. This designation controls whether the members or managers have apparent agency authority, management authority, the nature of fiduciary duties in the company, and important dissolution characteristics. Introduction and History 1-9

15 CHAPTER 1 REVIEW QUESTIONS The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. 1. Limited liability companies were first established as a business form in the United States. a) true b) false 2. What is required to create a limited liability company in most states: a) filing an operating agreement and articles of organization with the secretary of state or other appropriate state agency b) filing articles of organization with the secretary of state or other appropriate state agency c) filing an operating agreement and articles of organization plus public notice advertising d) everything set forth in (c) in addition to judicial approval and a strict background check of members 3. How may an LLC be classified for federal income tax purposes: a) only as a sole proprietorship b) only as a corporation c) only as a partnership d) as either a partnership or a corporation 4. An advantage of choosing the LLC business form is the flexibility in selecting a management structure. a) true b) false 5. A general partnership requires a written agreement. a) true b) false Introduction and History 1-10

16 6. Partnerships can be converted into a limited liability company. a) true b) false 7. A limited liability partnership must have: a) more than one general partner b) more than one limited partner c) at least one general partner d) limited partners that participate in the running of the partnership 8. An eligible domestic corporation can avoid double taxation by electing to be treated as an S corporation: a) true b) false 9. How many members may a limited liability company have: a) no more than 10 b) no more than 100 c) there is no limit so long as all the members are natural persons d) there is no limit Introduction and History 1-11

17 CHAPTER 1 SOLUTIONS AND SUGGESTED RESPONSES 1. A: True is incorrect. Limited liability companies have been a popular business form in European and other countries for decades. B: False is correct. LLCs were popular in European and other countries prior to being permitted in the United States. The first state in the United States to recognize limited liability companies was Wyoming, which allowed them beginning in By 1996, all 50 states and the District of Columbia had passed laws recognizing limited liability companies. (See page 1-1 of the course material.) 2. A: Incorrect. Some, but certainly not most states, require the filing of an operating agreement in addition to the articles of organization. B: Correct. In most states, members need file only Articles of Organization to initiate a limited liability company. C: Incorrect. Only a few states require public notice advertising. D: Incorrect. There are no such requirements for judicial approval or background checks in any state. (See page 1-1 of the course material.) 3. A: Incorrect. A single member LLC can elect this treatment, but it is not mandated for all companies. B: Incorrect. This is one option, but it is certainly not the only one. C: Incorrect. This is only one option. D: Correct. It is this flexibility in selecting a tax treatment that makes LLCs so popular. A domestic LLC with at least two members is automatically classified as a partnership unless it elects to be treated as a corporation. (See page 1-2 of the course material.) 4. A: True is correct. Even if an LLC does not qualify for tax treatment as a partnership, there are other advantages to choosing this form of business entity, including the flexibility in selecting a management structure. B: False is incorrect. Other advantages include limited liability for all owners and limited formalities, such as meetings and recordkeeping. (See page 1-2 of the course material.) Introduction and History 1-12

18 5. A: True is incorrect. Partnerships have only a few legal formalities. A general partnership does not require a written agreement. One can be formed with nothing more than a general understanding or handshake between the partners. B: False is correct. In a partnership, each partner must merely intend to establish a business relationship with the other(s) for the partnership to be born. A written agreement is not required (See page 1-3 of the course material.) 6. A: True is correct. Like other types of business entities, partnerships can be converted. The conversion does not terminate the partnership. B: False is incorrect. The conversion is not a sale, exchange, or liquidation of any partnership interest, the partnership s tax year does not close, and the LLC can continue to use the partnership s taxpayer identification number. (See page 1-4 of the course material.) 7. A: Incorrect. Only one general partner is required. B: Incorrect. Only one limited partner is required. C: Correct. At least one general partner and one limited partner are required. D: Incorrect. Generally, limited partners cannot participate in the running of the partnership, or they become subject to a general partner s liability. (See page 1-4 of the course material.) 8. A: True is correct. An S corporation is generally exempt from federal income tax. Its shareholders include on their tax returns their share of the corporation s separately stated items of income, deduction, loss, and credit, and their share of non separately stated income or loss. B: False is incorrect. Shareholders generally choose to form an S corporation when the corporation is profitable and distributes nearly all of its profits to the shareholders, or when the corporation incurs substantial losses that shareholders wish to deduct from their personal tax returns. (See page 1-6 of the course material.) Introduction and History 1-13

19 9. A: Incorrect. There is no hard number cap on the number of members an LLC can have. The only type of entity with such a restriction is an S corporation. B: Incorrect. No states have an upper limit on the number of members an LLC is allowed. C: Incorrect. There is no such limitation on who can be a member. D: Correct. No state has a limit on who can be a member (other than for professional LLCs). (See page 1-8 of the course material.) Introduction and History 1-14

20 Chapter 2: Establishment of a Limited Liability Company A. FORMATION The limited liability company, while recognized by the Internal Revenue Service for tax purposes, is still a product of state laws. Thus, in determining the mechanism required to form a limited liability company, organizers must examine the law of the state in which they wish to operate. All 50 states and the District of Columbia recognize limited liability companies and have statutory schemes governing their creation and operation. By way of illustration, we will examine the formation requirements in California and compare and contrast its requirements to other states where appropriate. The first step in California and all other states is the filing of the Articles of Organization with the Secretary of State. This is similar to the requirements for the formation of a corporation, which begin with the filing of Articles of Incorporation, also with the Secretary of State. Persons organizing the limited liability company may be, but are not required to be members of the entity. This is generally true of all states. In addition to Articles of Organization, California expressly requires limited liability companies to execute an Operating Agreement. Although most states do not have such a requirement, as a practical matter, almost all entities will need such a document to govern their affairs. The Operating Agreement and its importance will be discussed in connection with other topics. While an LLC can be formed in many states solely through the filing of Articles of Organization, a few states, including Arizona, New York, and Pennsylvania, require the extra step of public notice advertising. The purpose of public notice advertising is to alert members of the public who might engage in business with the entity that it will be operating as a limited liability company. In New York, for example, the advertisement must be published in two different newspapers in which the business will operate weekly for six successive weeks. Public notice advertisements must be published in a newspaper of general circulation in the county in which the business will be operated. A newspaper of general circulation is one which has been adjudicated as such by the local courts. Since not all newspapers meet this requirement, organizers need to be careful that the newspaper they choose meets the legal requirements. As always, look to the statute of each state to determine what, if any, public notice advertisement is required. Each state, including California, has specific requirements for the type of information that must be included in the Articles of Organization. Most, if not all, states make the process simple by providing fill-in-the blank sample forms. The following example is for companies organized in Texas, provided by the Texas Secretary of State. Establishment of a Limited Liability Company 2-1

21 Establishment of a Limited Liability Company 2-2

22 Establishment of a Limited Liability Company 2-3

23 Each state also spells out in statute the specific information that must be included in the Articles of Organization, as well as the information it has the option to include. Pursuant to Code of Corporations Section 17051, California requires articles to include all of the following: The name of the limited liability company. This following statement: The purpose of the limited liability company is to engage in any lawful act or activity for which a limited liability company may be organized under the Beverly-Killea Limited Liability Company Act. The name and address of the initial agent for service of process on the limited liability company who meets certain statutory qualifications or, in the alternative, a designated corporate agent. Establishment of a Limited Liability Company 2-4

24 If the limited liability company is to be managed by one or more managers and not by all its members, the articles of organization must contain a statement to that effect. Neither the names nor numbers of the managers need to be included. If the limited liability company is to be managed by only one manager, the articles of organization shall contain a statement to that effect. California, like many other states, does not require the articles to set forth any specific powers of a limited liability company. California also provides that, at their election, organizers may include any other information not specifically prohibited by law, including the following: A provision limiting or restricting the business in which the limited liability company may engage or the powers that the limited liability company may exercise or both. Provisions governing the admission of members to the limited liability company. The time at which the limited liability company is to dissolve. Any events that will cause a dissolution of the limited liability company. A statement of whether there are limitations on the authority of managers or members to bind the limited liability company, and, if so, what the limitations are. The names, numbers and qualification of the managers of the limited liability company. Other information can be included, including provisions governing the admission of members into the limited liability company, at the election of the organizers. Remember that many states have different requirements, including different forms, that must be used for professional limited liability companies. B. NAMING A LIMITED LIABILITY COMPANY There are several different issues associated with the naming of a limited liability company. The first issues are restrictions on the types of names that are allowed and requirements for what must be included in the name. The next main issue is the process for reserving the desired name in the company s state of operation. 1. Name Requirements and Limitations All states require a limited liability company to identify it as such. For example, California Corporation Code Section requires the name of each limited liability company to contain either the words limited liability company or the abbreviation LLC or L.L.C. as the last words in the name of the limited liability company. All states also allow for the abbreviation of certain words in the name of the entity, including the words limited and company may be abbreviated to "Ltd." and "Co.," respectively. Establishment of a Limited Liability Company 2-5

25 Likewise, California and other states prohibit the use of entity names which are too similar to that of an existing business or would otherwise cause confusion among consumers. Other specific requirements under California law include: A limited liability company may adopt a name that is similar to, but not the same as, the name of an existing domestic or foreign (out of state or country) limited liability company if the existing limited liability company consents in writing to the use of the name and the Secretary of State s Office finds that under the circumstances the public is not likely to be misled. The consent letter should be submitted on the letterhead of the consenting limited liability company, signed by an authorized officer of that company. If a proposed name is reserved utilizing consent, a currently dated consent must accompany each renewal request. The limited liability company name may not falsely imply governmental affiliation. All names must use the English alphabet or Arabic numerals (0, 1, 2, 3, 4, 5, 6, 7, 8, 9) or a combination thereof. Roman numerals are treated as letters and not translated into their numeric equivalent. Symbols are not allowed in an entity name; except, an ampersand & may be used in an entity name as a conjunction in place of the word "AND". The name of a limited liability company cannot include the words "bank," "trust," "trustee," "incorporated," "inc.," "corporation," or "corp.". [California Corporations Code Section 17052(d)] The name of a limited liability company cannot include the words "insurer" or "insurance company" or any words suggesting that it is in the business of issuing policies of insurance and assuming insurance risks. [California Corporations Code Section 17052] Many states, including California, expressly allow the name of one or more members to be used in the name of the entity. Additional naming rules apply in some states that allow professional limited liability companies. For example, in Idaho, the name of a professional limited liability company must end with the words Professional Company or the abbreviation PLLC or P.L.L.C. The District of Columbia requires such entities to contain the words professional limited liability company or to cite the abbreviation PLLC or P.L.L.C. As always, organizers need to refer to the statute of each specific state for name restrictions and requirements. 2. Reserving a Company Name Many states allow organizers to reserve the name of a limited liability company prior to the filing of Articles of Organization. A few other states, including Georgia, actually require organizers to select the name prior to the filing of articles. Some states also have special forms or other rules applicable to professional limited liability companies. Establishment of a Limited Liability Company 2-6

26 Remember that reserving the name of a limited liability company with the proper state agency in the case of California and many other states, the Secretary of State is not the same thing as filing a fictitious business name, which may be required depending on the type of business to be conducted and where it is to be conducted. Organizers must contact the city and/or county clerk and/or recorder where the principal place of business is located for information regarding filing or registering fictitious business names. The first step in naming a limited liability company is generally to check the availability of a desired name. Most states, including California, maintain a registry of existing company names that can be referred to by organizers. In California, inquiries can be made by writing to the Secretary of State. Some states have existing names available on-line to help speed up the process. Once you determine that your desired name is not being used or one so similar so as to cause confusion in the market place the next step is to reserve that name. Each state has a specific limit on how long the name can be reserved prior to the filing of articles of organization. In California, for example, a name can be reserved for up to 60 days. Each state, including California, generally charges a fee for the right to reserve a name. C. FEES AND REPORTING REQUIREMENTS All states require organizers to pay a fee for registering as a limited liability company. The fee is generally charged for the filing of the Articles of Organization and varies greatly from state-to-state as set forth in Table 2.1 below. Some states, including Pennsylvania, charge a higher fee for the registration of professional limited liability companies. States also charge a registration fee to foreign LLCs who wish to register in their state. This fee is usually, but not always, the same as the initial filing fee. Some states also charge an annual fee. New York, for example, bases its annual fee on the number of members in the LLC. New York s annual fee is $100 per member, with a minimum fee of $500 and a maximum of $25,000. Like fees, reporting requirements vary greatly from state-to-state. Many states, as set forth in the table below, do not require annual or biennial reports to be filed with the state. Some states require annual reports while others require biennial reports. Each state that requires a report sets forth the detail of what it must include and when it must be filed (e.g. on the anniversary of the company s formation). Under Georgia law ( ), for example, an annual report must be filed with the Secretary of State between January 1 and April 1 of each year and must set forth the following: The name of the company; The street address and county of its registered office and the name of its registered agent at that office in this state; The mailing address of its principal place of business; and Any additional information required by the Secretary of State that is necessary to enable the Secretary of State to carry out the provisions of this chapter. Establishment of a Limited Liability Company 2-7

27 Information in the annual registration must be current as of the date the annual registration is executed on behalf of the limited liability company or foreign limited liability company. Table 2.1 State LLC Registration and Reporting Requirements (Organizational fee as of November 2010) STATE FILING FEE REPORTING REQUIREMENT Alabama $40 Annual Alaska $250 Biennial Arizona $50 None Arkansas $50 None California $70 Biennial Colorado $50 Biennial Connecticut $120 Annual Delaware $90 None District of Columbia $150 Biennial Florida $125 Annual Georgia $100 Annual Hawaii $50 Annual Idaho $100 Annual Illinois $500 Annual Indiana $90 Biennial Iowa $50 None Kansas $165 Annual Kentucky $40 Annual Louisiana $75 Annual Maine $175 Annual Maryland $100 None Massachusetts $500 Annual Michigan $50 Annual Minnesota $160 Annual Mississippi $50 None Missouri $105 None Montana $70 Annual Nebraska $100 None Nevada $75 Annual New Hampshire $100 Annual New Jersey $125 Annual New Mexico $50 None New York $200 Biennial North Carolina $125 Annual North Dakota $135 Annual Ohio $125 None Oklahoma $100 Annual Oregon $65 Annual Pennsylvania $125 Annual (for some only) Rhode Island $155 Annual Establishment of a Limited Liability Company 2-8

28 South Carolina $110 Annual South Dakota $150 Annual Tennessee $300 Annual Texas $300 Annual Utah $70 Annual Vermont $100 Annual Virginia $100 None Washington $180 Annual West Virginia $100 Annual Wisconsin $130 Annual Wyoming $100 Annual Any foreign limited liability company that wishes to do business in a state is also subject to filing requirements. A foreign limited liability company is one that is organized in another country or another state. Such entities must file if they wish to engage in business within a different, foreign state. Beyond any annual or biennial reporting that may be required, each state also sets forth in statute the types of records that must be maintained by a limited liability company. All members generally have a right to access such records pursuant to other provisions of state law. Establishment of a Limited Liability Company 2-9

29 CHAPTER 2 REVIEW QUESTIONS The following questions are designed to ensure that you have a complete understanding of the information presented in the chapter. They do not need to be submitted in order to receive CPE credit. They are included as an additional tool to enhance your learning experience. We recommend that you answer each review question and then compare your response to the suggested solution before answering the final exam questions related to this chapter. 1. Which of the following is required to form a limited liability company in all 50 states: a) public notice advertising b) filing of Articles of Organization c) bonding of members d) all of the above 2. Like many other states, California does not require the Articles of Organization to set forth any specific powers of a limited liability company. a) true b) false 3. Which of the following rules apply to naming limited liability companies: a) limited liability companies cannot use proper names as part of their official name b) limited liability companies cannot have more than three words in their name c) the name must identify the limited liability company as such an entity d) limited liability companies cannot share the same name as a company in another state 4. Some, but not all states, require organizers to pay a fee for registering as a limited liability company. a) true b) false Establishment of a Limited Liability Company 2-10