1.5 Limited Liability Companies

The LLC provides limited liability protection for members. Like the shareholders of the corporation, members can limit thier liability  to the capital the members have contributed, or have agreed to contribute, to the LLC. Unlike a genera partnership, no member of a LLC is burdened with personal liability by virtue of being a member. Note however, that a member, like a shareholder, may be personally liable for intentional acts committed by the member, or for any debts the member individually guarantees.

LLCs typically provide for their managment either by their members or by an independent third-party manager, who is usually not required to be a member of the LLC. The LLC will normally enter into an operating agreement with its members. The operating agreement sets forth the rights, preferences, and priviledges of the members and the duties and obligations of the manager, similar to a partnership agreement or the bylaws of a corporation.

Like a partnership the LLC is normally capitalized by contributions to its capital by its members. However, like a corporation, more than one class of interests may be issued in a LLC. Because of the broad manner in which the terms "security" is defined under state and federal securities laws, it is highly likely that membership interests in LLCs will be considered "securities". Therefore, the issuance of membership interests in LLCs will have to comply with applicable state and federal securities laws.

An LLC classified as a partnership for federal income tax purposes may be formed without either the members or the LLC incurring any tax liability. Specifically, LLC members who contribute appreciated property, and who are not in control of the LLC after the contribution, need not recognize gain. A LLC is taxed under the partnership rules contained in IRC 702-755.

As with a partnership, the tax consequences of a LLC may be passed through to the members, therby avoiding double taxation of teh LLCs income for federal and most state income tax purposes. Some states, howeverm have imposed a corporate tax on LLCs. In addition, special allocations of taxable items among the members are permitted. Further, like partnerships, LLCs are able to make operating and liquidating distributions of appreciated property without recognizing income.

(1) Single member LLCs lack of asset protection

Supporting Cases:

There are several reletively recent bankruptcy cases that make it clear that a single member LLC (regardless of the state in which it was formed) will not provide any asset protection when the member is a debtor in a bankruptcy court. As of may 25, 2008, federal bankuptcy courts in Idaho, Maryland, Idaho and Colorado have exercised powers over single member LLCs without any using any of the legal theories commonly used by courts. The courts did not pierce the veil or reverse veil pierce. Nor did they impose a constructive trust or a resulting trust. The alter ego theory was not used

Peppercorn Membership:

Before adding second member to your single member LLC just to solve the single member bankruptcy problem, consider the implications of the following statement by the Albright bankruptcy court:To the extent a debtor intends to hinder, delay or defraud creditors through a multi-member LLC with “peppercorn” co-members, bankruptcy avoidance provisions and fraudulent transfers law would provide creditors or a bankruptcy Trustee with recourse.

Members therefore cannot be added for the sole purpose of making an single member LLC a multimember LLC to provide the entity with charging order protections. The members must:

  1. Have sufficeint membership interest in the business (1% will not pass the "smell test")
  2. Have a valid purpose and job for the business

Possible solutions for single member LLC dilemma:

  1. Never file for bankruptcy. However, if you have a creditor problem you may not be able to stop your creditors from putting you into bankruptcy.
  2. Add a second member to your LLC so that it is a multi-member entity. However, you may still encounter problems when adding a member such as:
  • No court case has stated what the minimum amount of the LLC that the second member must own (see above peppercorn).
  • When you add the second member be sure that he or she pays a fair market value for the interest acquired.
  • The second member must be a "real" member for all purposes. Therefore the member must be entitled ot financial statements, have access to books and records, the right to vote on certain matters affecting the company, a right to get a share of the profits equal to the membership percentage owned, and all other rights of a member in an LLC.


(2) Multi-member LLC issues

When adding a second member to your LLC you will need to have a solid and comprehensive operating agreement that governs the rights and obligations of all of the members. The following are issues that will need to be addressed:

  1. What happens to a member's interest when he or she gets a divorced and the wron person acquires the interest? There should be options in your operating agreement for the purchase of a member's interest in the case of a member's divorce, death, default under the operating agreement, assignments of assets for the benefit of creditors, filing of bankruptcy, etc.
  2. What if you secong member decides to sell of give his or her interest in your company to a third party? You will need provisions regarding a first right of refusal in your operating agreement that gives teh LLC an option to match the terms/conditions of a proposed disposition or transfer of the other member's interest in the LLC
  3. In the case that another member in the LLC is sued and a creditor receives a judgment against the member. The creditor will serve your LLC with a charging order and may seek to become a member of your LLC and then attempt to exercise its rights as member. The issue of members with creditor problems will also need to be addressed within the operating agreement.
  4. In the case a member files for bankruptcy the trustee may step into the shoes of your second member and then exercise the rights of a member of you LLC (see Ehmann)