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What is an LLC?

In order for you to become a Franchise owner you must become a member of an LLC. If you are not familiar with what an LLC is, below you will find some answers to common question. If you have questions that are not answered here you should definately seek the advice of a professional.

A limited liability company (LLC) is a relatively new business entity, at least in the United States. Its basic features are that its owners have limited liability for the entity's debts and obligations, similar to the status of shareholders in a corporation, and its income and losses are normally passed through to the owners as if it were a partnership. It is probably most like a limited partnership, without the requirement that there be at least one general partner liable for the debts and obligations of the partnership.

An LLC is a statutory creation. That is, unlike general partnerships which developed under common law, an LLC, like a corporation, is created by filing a document (usually called Articles of Organization) with an officer designated by state law.

Business entities that bear strong similarities to limited liability companies existed in some European countries, but the first modern LLC statute in the was adopted by the Wyoming legislature in 1977. At first, the novel entity was slow to gain acceptance. The second state to enact a limited liability company act was Florida in 1982, five years after Wyoming's act. However, in the 1990's the popularity of the LLC snowballed and by 1997, every state and the District of Columbia had passed statutes allowing the formation of limited liability companies.

LLC Advantages

A limited liability company (LLC) has many advantages as a form of business entity:

- Pass-through taxation - under the default tax classification, profits taxed at the member level, not at the LLC level (i.e., no double taxation).
- Limited liability - the owners of the LLC, called "members," are protected from liability for acts and debts of the LLC.
- With "check-the-box" taxation, an LLC can elect to be taxed as a sole proprietor, partnership, S-corp or corporation, providing much flexibility.
- Can be set up with just one natural person involved or, in some states, one owner which may be an entity itself.
- No requirement of an annual general meeting for shareholders (in some states, such as Tennessee and Minnesota, this statement is not correct).
- No loss of power to a board of directors (although an operating agreement may provide for centralization of management power in a board or similar body).
- LLCs are enduring legal business entities, with lives that extend beyond the illness or even death of their owners, thus avoiding problematic business termination or sole proprietor death.
- Much less administrative paperwork and recordkeeping.
- Membership interests of LLCs can be assigned, and the economic benefits of those interests can be separated and assigned, providing the assignee with the economic benefits of distributions of profits/losses (like a partnership), without transferring the title to the membership interest (i.e., See VA and Delaware LLC Acts).

LLC Disadvantages

While a limited liability company (LLC) offers many advantages over other forms of business entity, there are also some disadvantages. Some of the drawbacks to selecting an LLC over another entity are:

- Earnings of most members of an LLC are generally subject to self-employment tax. By contrast, earnings of an S corporation, after paying a reasonable salary to the shareholders working in the business, can be passed through as distributions of profits and are not subject to self-employment taxes.
- Since an LLC is considered a partnership for Federal income tax purposes, if 50% or more of the capital and profit interests are sold or exchanged within a 12-month period, the LLC will terminate for federal tax purposes.
- If more than 35% of losses can be allocated to non-managers, the limited liability company may lose its ability to use the cash method of accounting.
- A limited liability company which is treated as a partnership cannot take advantage of incentive stock options, engage in tax-free reorganizations, or issue Section 1244 stock.
- There is a lack of uniformity among limited liability company statutes. Businesses that operate in more than one state may not receive consistent treatment.
- In order to be treated as a partnership, an LLC must have at least two members. An S corporation can have one shareholder. Although all states allow single member LLCs, the business is not permitted to elect partnership classification for federal tax purposes. The business files Schedule C as a sole proprietor unless it elects to file as a corporation.
- Some states do not tax partnerships but do tax limited liability companies.
- Minority discounts for estate planning purposes may be lower in a limited liability company than a corporation. Since LLCs are easier to dissolve, there is greater access to the business assets. Some experts believe that limited liability company discounts may only be 15% compared to 25% to 40% for a closely-held corporation.
- Conversion of an existing business to limited liability company status could result in tax recognition on appreciated assets.

What is a Series LLC?

A series LLC is the latest and by far most sophisticated form of business entity created. The concept is that a single entity may be formed in a state, but separate series or "cells" may be internally created within the LLC. The series LLC is an innovative concept that was created by the State of Delaware approximately nine years ago, but has just now been receiving more attention. The series LLC is essentially a single umbrella entity that has the ability to partition its assets and liabilities among various sub-LLCs or series. Each sub-LLC may have different assets, economic structures, members, and managers. The profits, losses, and liabilities of each series are legally separate from the other series, thereby creating a firewall between each series. In addition, it eliminates the administrative burden and expense of forming multiple LLCs. The structure is very similar to a parent corporation with subsidiaries only without the expense, formalities, and heavy taxation.

The assets of a particular series are protected from enforcement against the assets of the LLC or any other series if (1) the LLC agreement provides for the establishment of one or more series, (2) separate and distinct records are maintained for each series and its assets are accounted for separately from the other assets of the LLC or any other series (and the LLC agreement so provides), and (3) notice of such limitation of liability is set forth in the LLC's certificate of formation. See Del. Code Ann. tit. 6, Section 18-215(b).
However, a member or manager may agree to be obligated personally for any or all of the debts, obligations, and liabilities of one or more series. See Del. Code Ann. tit. 6, Section 18-215(c).

Series LLC's are definitely the advanced planning tool of the future. It offers tremendous advantages in planning for such businesses as hedge funds, venture capital funds, oil and gas deals, and fractional share arrangements. Complex business arrangements can sometimes be better managed by the use of a series LLC. As stated above, the first state to enact series LLCs was Delaware. The Delaware statute protects the assets of one series from the liabilities of another series. Other states which have enacted series LLCs stop short of these internal walls, but still gives each series what amounts to a separate business entity having separate rights, powers and duties from the other series, as well as different rights or obligations to participate in profits or losses.

Like LLCs in general, the Delaware series LLCs are not without certain risks. There are numerous unresolved issues regarding the series LLC, including, without limitation, tax issues and creditor/debtor issues (i.e., the interplay between the Federal Bankruptcy Code and state series LLC law.
Some practitioners have expressed concerns that the Internal Revenue Service will not permit the series LLC to file just one tax return for all the series combined. The California Franchise Tax Board's position is that each series in a Delaware series LLC is considered a separate LLC, must file its own Form 568 Liability Company Return of Income and pay its own separate LLC annual tax and fee if it is registered or doing business in California.

States which have adopted series LLCs (other than Delaware) are Iowa, Illinois, Oklahoma and Nevada. There are a number of other states that are considering series LLC legislation. The fact that a state has not adopted a series LLC statute does not prohibit one from forming a Delaware series LLC and having it registered to do business in the state, though there may be complications in doing so from state to state.

How Limited is Limited Liability?

One of the key advantages of a limited liability company (LLC) over a sole proprietorship or general partnership is the fact that the owners (members) of the LLC are not personally liable for the debts and claims of the business. Normally, that means that if the business is unable to pay a supplier, lender, landlord or other creditor, that person cannot go after the personal assets of the members of the LLC. The members may lose their entire investment in the business, but their other assets - car, home, and personal bank accounts - are safe from the creditors of the business.

Or are they? In truth, there are many exceptions to the rule of limited liability. Many LLC members will find that, due to the way the business was operated, the promised protection from the liabilities and claims of the business is not meaningful.

How Personal Liability Arises

A member of an LLC can be held personally liable for many different types of claims, but they typically arise under four different scenarios:

- Claims arising out of an act or omission by the member, such as the member's own negligence, fraud or illegal act
- Claims arising out of a contract, particularly one that was personally guaranteed by the member
- Claims based on the concept of "piercing the veil" of the LLC
- Liability for consenting to or receiving a distribution in violation of the LLC's operating agreement or the applicable LLC statute

These claims are not a result of choosing an LLC as a form of entity. All of these exceptions apply equally to shareholders in corporations and, in fact, the exceptions were developed first under corporate law.

Actions of a Member

Every member who actively participates in the business of the LLC runs the risk that his action or inaction will result in personal liability. This is particularly a risk of a service business in which the members provide the key service. If you are an electrician and you leave an exposed wire that electrocutes someone, your LLC is not going to protect you.
Similarly, if you make promises about your product or service that are not true, the first claim may be against the LLC for breach of contract, but if the LLC cannot perform or pay damages, the injured party may come after you for fraud or a similar claim based upon your own action.

Even if you have an employee who committed the action, you may not be out of the woods. If you personally hired the employee, the injured party may have a claim against you for negligent hiring if a reasonable person would not have hired that employee.

A special category of personal liability that may trip up a member of an LLC is failure to pay payroll taxes to the IRS. To protect these so-called "trust fund taxes," any person who had the ability to prevent the non-payment can be personally liable for the failure to pay these taxes. The IRS applies this provision broadly, so if you had power to direct which bills got paid and which didn't, you are probably liable.

Claims Based on Contract

Another, and probably more common, source of personal liability for many small business owners is the voluntary assumption of liability, usually by means of a personal guarantee. For many small businesses, particularly new businesses with no credit history, obtaining a loan without a personal guarantee is virtually impossible. Landlords, too, often insist on a personal guarantee, particularly if the lease requires the landlord to incur costs such as build-outs that it expects to recoup over the term of the lease.

Suppliers are sometimes more flexible on extending credit, especially after the business is up and running. Getting payment terms out of the gate, however, often requires a personal guarantee.

Even when the creditor isn't seeking a personal guarantee, a member of the LLC can inadvertently become a party to the contract by failing to clearly note his role. If she signs her own name and does not indicate that she is executing the contract on behalf of the LLC, it is very likely that a court will hold her responsible for the contract. Every contract should clearly indicate that the party to the contract is the LLC (full name!) and should indicate the role of the person who is signing (member or manager).

Piercing the Veil of the LLC

Even if a member avoids personal guarantees, he may find himself liable to creditors of the business under a theory developed under corporate law and known as "piercing the corporate veil." Although the factors that courts look at vary to some extent from jurisdiction to jurisdiction, the courts typically look at whether there is a unity of interest and ownership such that the separate personalities of the entity and the owner no longer exists and whether to respect the distinction between the owner and the entity would be an injustice.

In almost all cases of piercing the veil, there is either commingling or diversion of assets. Some other facts that courts examine in corporate cases include:

- Inadequate capitalization
- Failure to issue stock
- Failure to observe corporate formalities
- Nonpayment of dividends
- Insolvency of the debtor corporation at the time
- Non-functioning of other officers or directors
- Absence of corporate records
- Commingling of funds
- Diversion of assets
- Failure to maintain arm's length relationships among related entities
- Whether the corporation is a mere facade for the operation of the dominant shareholders

A possible benefit of an LLC over a corporation is that several of the commonly listed factors (failure to issue stock, failure to observe corporate formalities, and absence of corporate records) have no real counterparts in an LLC. However, as case law develops, the absence of those factors may simply shift emphasis on some of the other factors.

Distributions in Violation of Law or Agreement

LLC Acts typically prohibit an LLC from making certain distributions. For example, the final draft of the Revised Uniform Limited Liability Company Act provides that a limited liability company may not make a distribution if after the distribution: (1) the company would not be able to pay its debts as they become due in the ordinary course of the limited liability company’s activities; or (2) the company’s total assets would be less than the sum of its total liabilities plus the amount that would be needed, if the company were to be dissolved, wound up, and terminated at the time of the distribution, to satisfy the preferential rights upon dissolution, winding up, and termination of members whose preferential rights are superior to those of persons receiving the distribution.

A member of a member-managed limited liability company or manager of a manager-managed limited liability company who consents to an improper distribution is personally liable to the company for the amount of the distribution which is improper distributions. In addition, a person who receives a distribution knowing that it is in violation of the Act is typically personally liable for the portion of the distribution that is improper.

Is Limited Liability an Illusion?

Although it may seem that the exceptions swallow the rule, the LLC offers excellent protection from many types of liabilities. For example if you properly hire and train an employee who then commits an act of negligence or fraud, the LLC should shield you from personal liability. If you sell a product that, without your knowledge or fault, is defective, you should not have personal liability. Trade creditors who deal with the LLC without a personal guarantee should have no right to look to you for payment.

Shoring up Limited Liability

There are several things that you can do to strengthen the protection of limited liability within the LLC:

Business insurance: Carrying adequate business insurance won't change the fact that you are personally liable for your own negligence, but it can help by providing a source for payment. You might also consider a personal umbrella policy.

Avoid personal guarantees: Not all personal guarantees can be avoided but do not automatically consent to every guarantee. In many cases, landlords or vendors routinely request personal guarantees even where the facts do not dictate that one be provided. Learn to question the request.

Capitalize the business adequately: Provide adequate capital for the entity's intended purposes and document the capital infusion.

Keep the LLC separate from your personal business: No matter how small the business is, it should have its own bank account. Don't pay personal expenses from the business account. Instead, write yourself a check (called a draw) on the LLC account and deposit it in your account from which you pay expenses. Likewise, don't use personal checks to pay LLC bills. If the LLC needs funds, make a capital contribution or loan. And account for everything.

Act ethically: Don't attempt to mislead the LLC's creditors about the financial condition of the business.

Do not divert assets: If the business looks like it is going down, don't attempt to lessen your own loss by taking big draws or moving assets out of the LLC. That will only help open the floodgates to your personal assets.

If you act responsibly and take a few precautions, the limited liability of the LLC is still a major benefit over a sole proprietorship or general partnership.

Disclaimer

The information provided here is being provided by Ultimate Franchise Baseball for educational and informational purposes only and does not constitute legal advice. The information which is presented here is intended to make limited liability companies easier to understand, but weighing the tax, liability and operations issues requires a thorough understanding of the applicable law and cases. Anyone contemplating forming a limited liability company is urged to obtain proper legal advice.
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