In a previous legal guide, I discussed the benefits of the LLC as a business structure for the entrepreneur. In this post, I will specifically cover LLC governance and operation after its formation.
Governance of the LLC
When creating an LLC, you have the option of making a member-managed LLC or a manager-managed LLC. LLCs are member managed by default, meaning that the owners—or members—will govern the operation of the business.
Sometimes, however, the owners of the LLC wish to delegate management responsibility to others, whether a select group of owners or outsiders. This may be because the business’s majority owner does not want minority owners—such as investors—to have the ability to take on a management role in the organization. Making the LLC manager managed requires only including a statement to that effect in the LLC’s Articles of Organization.
The LLC affords great flexibility in determining the management structure of the business. Creating the proper management structure is very important and should be considered carefully from the outset. For this reason, drafting a proper operating agreement is critical from the beginning.
The LLC’s operating agreement governs the operation of the LLC and sets the proper expectations of governance for the owners. For this reason, a strong operating agreement, preferably drafted with the assistance of a competent attorney, is critical for the LLC. The operating agreement should be thorough and comprehensive to help avoid internal disputes between the owners down the road.
Without a proper operating agreement, there could be disputes as to how profits and losses should be divided and whether owners have the ability to sell their interest in the LLC to whomever they want. It can also serve to plan for contingencies, such as the divorce or untimely death an owner.
While an operating agreement may not be legally required, without one, organized and predicable management may be impossible. An operating agreement is a valuable tool for specifically defining the role of each individual involved with the enterprise.
Income Tax Ramifications
LLCs come with great tax flexibility. When forming an LLC, the owners have the option of being taxed as a partnership or a corporation. (Alternatively, single member LLCs have the option of being taxed as a disregarded entity, rather than a partnership.) If the LLC is taxed as partnership—or disregarded entity—profits and losses from the business will flow directly to the owners. If the LLC is taxed as a corporation, however, profits will be subject to taxation at the corporate level and then again at the personal level of the owners, though this may be avoided by choosing to be taxed as an S corporation. Every tax situation varies, and so this decision should be made in consultation with a competent tax professional.
One important note to recognize when choosing to be taxed as a partnership, however, is that each owner is taxed on his or her share of the profits, not on the profits actually distributed. Many businesses do not distribute all of their profits, choosing instead to withhold some or all of them to reinvest in the business. For tax purposes, however, it is irrelevant if the profits are actually distributed. Owners will be taxed on their shares regardless.
Consequently, an owner could owe federal income taxes even if he or she did not actually receive any money from the business. Some operating agreements plan for this by requiring at least enough of the profits to be distributed to cover any tax liability due. This, however, is not a requirement.
The LLC is an extremely flexible and useful means to serve the entrepreneur’s purpose. While not right for every situation, its benefits are extraordinary, particularly for businesses just starting out. A business attorney should be able to help any budding entrepreneur choose the correct entity for his or her particular situation.