Limited Liability Company PDF Print E-mail

A limited liability company (LLC) is a business entity that is essentially a hybrid of a corporation and partnership. An LLC is an entity having one or more members that is organized under the Beverly-Killea Limited Liability Company Act (Act) [Corp. Code § 17000 et seq.; see Corp. Code §§ 17001(t), 17050(b)]. The LLC form offers great flexibility: the Act is designed to assist the formation and operation of small, closely-held or operated business arrangements, but permits LLC structures that are attractive to larger, more complex business ventures. Areas in which the LLC structure are likely to be particularly useful include real estate, joint ventures (especially joint ventures with foreign partners and between corporations), high technology and venture capital, petroleum production, and theatrical investments.

A California LLC can have the income tax transparency of a partnership on both the state and federal level, avoiding the double taxation inherent in the use of a general corporation, without the restrictions imposed on S corporations, close corporations, and limited partnerships [see [e], below]. The use of a properly structured LLC can also limit the liability of its members, managers, and officers to their investments and commitments to invest in the LLC; this limited liability is similar to that enjoyed by corporate shareholders and limited partners, without the restrictions against management and control applicable to limited partners [see [b], below].

The formation and operation of an LLC is relatively simple. However, like a corporation or limited partnership, more formality in formation and operation is required than in either a general partnership or sole proprietorship. An LLC is formed by filing articles of organization with the Secretary of State, and must have an oral or written operating agreement [Corp. Code § 17050].

LLCs are prohibited from engaging in the banking business, the business of issuing policies of insurance and assuming insurance risks, or the trust company business [Corp. Code § 17002(a); but see Corp. Code § 17002(b) (subsidiary LLC may operate as licensed health care service plan)]. In addition, LLCs may not perform professional services; professional services are those services that may only be lawfully rendered under a license, certificate, or registration authorized by the Business and Professions Code, the Osteopathic Act, the Yacht and Ship Brokers Act, or the Chiropractic Action [Stats. 1994, ch. 1200, § 93; Corp. Code §§ 13401(a), 13401.3; see § 1B.31[2][b]].

Management and Control

The management and control of an LLC is extremely flexible. An LLC may be managed by all of its members, or by one or more managers [Corp. Code §§ 17150, 17151]. The managers may be some or all of the members, but need not be members or natural persons [Corp. Code § 17151(a), (c)]. All that the statute requires is that if the LLC is to be managed by one or more managers, the articles of organization must contain a statement to that effect. Neither the names of the managers nor the number of managers need be specified in the articles, but if management is vested in only one manager, the articles must so state [Corp. Code § 17151(b)]. Even if the articles do not vest management in a manager or managers, the articles or operating agreement may restrict or enlarge the management rights and duties of any member or class of members [Corp. Code § 17150]. The articles of organization or the operating agreement may restrict or enlarge the management rights and duties of any members or classes of members [Corp. Code § 17150].

Extent of Personal Liability

Members

A member of an LLC ordinarily is not personally liable for any debt, obligation, or liability of the LLC arising in contract, tort, or otherwise solely by virtue of that membership [Corp. Code § 17101(a)]. However, an LLC member is subject to liability under the common law governing alter ego liability [Corp. Code § 17101(b)]. Further, a member may agree to be obligated personally for any or all of the LLC's debts, obligations, and liabilities, as long as the agreement to be obligated is set forth in the articles of organization or in a written operating agreement that specifically refers to the code section (Corp. Code § 17101(e)) authorizing liability [Corp. Code § 17101(e)]. Furthermore, a member is personally liable under a court judgment or for an obligation of the LLC under the same or similar circumstances, and to the same extent, as a corporate shareholder may be personally liable for a corporate obligation, except that the failure to hold meetings or to observe formalities pertaining to those meetings does not tend to establish personal liability for members if the articles of organization or operating agreement do not require meetings [Corp. Code § 17101(b)].

Members are personally liable for tortious conduct, and are also personally liable pursuant to the terms of any written guarantee or other contractual obligation (other than an operating agreement) entered into by the member [Corp. Code § 17101(c)]. In addition, personal liability may attach to a member who is responsible for filing returns or paying tax for any unpaid taxes (and any interest or penalties) if the member willfully fails to pay or cause to be paid any taxes due [Rev. & Tax. Code § 6829(a), (b); see Rev. & Tax. Code § 6829(d) (''willful failure'' defined)]. However, personal liability may be imposed only if the Franchise Tax Board can establish that (1) the LLC had included tax reimbursement in the selling price of, or added tax reimbursement to the selling price of, tangible personal property sold in the conduct of its business, or (2) the LLC consumed personal property and failed to pay the tax to the seller or has included use tax on the billing and collected the use tax or has issued a receipt for the use tax and failed to report and pay use tax [Rev. & Tax. Code § 6829(c)].

Members are personally liable to the extent of any improper distribution received by a member (provided that the member had actual knowledge of facts indicating the impropriety of the distribution) [Corp. Code § 17254(e)]. Further, any member or manager voting for a distribution that violates the operating agreement or statute is personally liable for the amount of the distribution that exceeds the amount that could have properly been paid [Corp. Code § 17255(a)].

Managers and Officers

In general, managers and officers of an LLC are not personally liable for any debt, obligation, or liability of the LLC solely by virtue of that status [Corp. Code § 17158 (a)]. However, a manager may agree to be obligated personally for any or all of the LLC's debts, obligations, and liabilities if the agreement to be liable is set forth in the articles or a written operating agreement that specifically refers to the code section (Corp. Code § 17158(b)) authorizing liability [Corp. Code § 17158(b)(1)]. Furthermore, a manager may agree to be obligated pursuant to the terms of a written guarantee or other contractual obligation (other than an operating agreement) entered into by the manager [Corp. Code § 17158(b)(2)]. In addition, managers owe the same fiduciary duties to the LLC and its member as partners owe to a partnership and the other partners of that partnership, and may be held personally liable for any breach of that duty [Corp. Code §§ 17153, 17155(a); see Corp. Code § 17005(d) (modification of fiduciary duty in written operating agreement)]. Managers are similarly liable for unpaid sales taxes [Rev. & Tax. Code § 6829; see State Board of Equalization v. Wirick (2001) 93 Cal. App. 4th 411, 413, 419, 112 Cal. Rptr. 2d 919 (Rev. & Tax. Code § 6829 applied to former chief financial officer of corporation, despite fact that he had resigned position over one year before corporation ceased business; because present tense in statute includes past tense, section covers former officers as well as those in charge when corporation ceases); see also [i], above], and for voting for an improper distribution [Corp. Code § 17255; see Corp. Code §§ 17254, 17353]. Although the liability of managers for tortious conduct is not mentioned in the Act, as is the liability of members [Corp. Code § 17101(c)], presumably managers would also be personally liable for tortious conduct. LLC managers may also be subject to fine or imprisonment for failure to warn employees of, or to abate, serious concealed workplace dangers [Penal Code § 387].

Availability of Capital

The capital requirements of an LLC ordinarily are satisfied through equity contributions from its members. In addition, loans secured by LLC property or the personal guarantees of members are often used. Because liability can essentially be limited to the amount of the investment [see [b], above] and the availability of different classes of members to provide flexibility among investors [see [a], above], LLCs can be attractive to capital investors.

Continuity of Existence

In general, an LLC does not have perpetual existence [see Corp. Code §§ 17051(a)(2), 17350]. For example, an LLC may be dissolved by the vote of a majority in interest of the members, or a greater percentage as specified in the articles of organization or written operating agreement [Corp. Code § 17350(b)]. Further, the articles may specify a time certain for, or events that cause, dissolution, in which case the LLC is dissolved as of the specified time or on the occurrence of the designated events [Corp. Code §§ 17051(c)(3), (4), 17350(a)]; these provisions are somewhat illusory because the organizational documents may be amended. Finally, an LLC is dissolved on the entry of a decree of dissolution [Corp. Code § 17350(c); see Corp. Code § 17351]. However, the importance of continuity of existence, or more accurately the lack thereof, has diminished since the liberalization of the federal entity classification rules. Effective January 1, 1997, partnership tax status is a matter of election rather than of counting corporate characteristics [see Treas. Reg. §§ 301.7701-1-301.7701-3; see also [e], below].

Taxation

Prior to 1997, the tax classification of an LLC--that is, whether the LLC was taxed as a corporation or as a partnership--was determined by weighing the number of corporate versus noncorporate characteristics possessed by the LLC [see, e.g., Rev. Proc. 95-10 , § 4, 1995-1 C.B. 501 (now obsolete)]. These characteristics were (1) continuity of life; (2) centralized management; (3) limited liability for the obligations of the business; and (4) free transferability of interests. If partnership tax treatment was desired, it was important to structure the LLC so that at least some of these corporate characteristics were avoided.

This, however, is no longer the case. Under liberalized classification rules that took effect on January 1, 1997, an LLC with two or more members may elect to be taxed either as a corporation or as a partnership. An LLC with a single owner (i.e., a qualifying trust) may elect either to be taxed as a corporation or to be disregarded as an entity separate from its owner [Treas. Reg. § 301.7701-3(a)]. If an LLC does not make an election, it will be taxed as a partnership if it has two or more members, or will be disregarded as an entity separate from its owner if it has only one member [Treas. Reg. § 301.7701-3(b)(1)]. Note that existing LLCs that do not make an election will retain the classification that they would have claimed under the pre-1997 regulations [Treas. Reg. § 301.7701-3(b)(3)].

California generally conforms to the federal entity classification rules under Treas. Reg. § 301.7701-2 [see Rev. & Tax. Code § 23038; see also FTB Notice 92-5 ]. The classification of a business entity as an association taxable as a corporation is determined under FTB regulations, which must be consistent with the federal regulations in effect on January 1, 1997, that classify a business entity as a partnership or an association taxable as a corporation, or disregard the separate existence of the business entity [Rev. & Tax. Code § 23038(b)(2)(B)(i)]. The classification of an eligible business entity as a partnership or an association taxable as a corporation is the same as the classification of the entity for federal tax purposes; if the separate existence of the LLC is disregarded for federal tax purposes (for example, because the LLC has a single owner), the separate existence will be disregarded for California purposes [Rev. & Tax. Code § 23038(b)(2)(B)(ii), (iii)]. However, if an eligible business entity was properly classified as an association taxable as a corporation for any income year beginning with the 60-month period preceding January 1, 1997, the entity continues to be an association taxable as a corporation until it elects to be classified the same as the entity is classified for federal purposes; this rule does not apply to any entity that was not doing business in California, did not derive income from California, and had no California resident owner during the 60-month period preceding January 1, 1997 [Rev. & Tax. Code § 23038(b)(2)(C)].

LLCs still are subject to the annual minimum franchise tax [Rev. & Tax. Code §§ 17941, 23153, 23038(b)(2)(B)(iii)] and must pay a graduated entity level fee based on total income from all sources reportable to California [Rev. & Tax. Code §§ 17942 (fee applicable to income of $250,000 or more), 23038(b)(2)(B)(iii)].

 

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