Introducing the Limited Liability Company
The Cross Specie between A Corporation and Partnership
Think of a Limited Liability Company ("LLC") as a hybrid of a corporation, limited partnership and general partnership. It combines the tax advantages and management flexibility of partnerships with the limited liability shield of a corporation. In other words, the LLC is an unincorporated organization governed by contract, the terms of which are typically detailed in a document called the Operating Agreement.
Ever since Wyoming enacted the first Limited Liability Company statute in 1977, these hybrids have slowly but steadily become the business entity of choice for most real estate ventures. In 1991, Virginia adopted the Virginia Limited Liability Company Act, and by 1996, all states and the District of Columbia had adopted their own versions of LLC acts.
Don't Let the State Govern Your Business
The Importance of Customizing Your LLC's Operating Agreement
The hallmark of LLCs is the flexibility they afford in designing the management structure and internal relations among its members and/or managers. A well-structured operating agreement establishes the respective ownership percentages and the rights and duties of all members or managers, and the responsibilities of any non-member employees.
Furthermore, it avoids the possibility of future conflicts or deadlocks among members by mandating specific dispute resolution mechanisms. Accordingly, appropriate customization of the terms of the operating agreement is critical in order to maximize the LLCs varied benefits.
One would be remiss not to reemphasize this point, because failure to appropriately tailor an operating agreement to meet the specific needs of a business venture results in the LLC being governed by the default state law rules in which the LLC is formed. This can potentially result in disastrous consequences for the novice who is unaware of the ramifications of unwittingly allowing default state law provisions to govern his business.
Therefore, this article explains and discusses some key provisions in operating agreements that prudent real estate investors ought to carefully think about before forming their LLCs.
Ownership Structure and Membership Classes
Generally, the LLC may be owned and managed by one or more individuals, corporations, trusts, estates, or partnerships serving as members or managers. Each member or manager holds a "membership interest," which is typically expressed in shares, units or even percentages. Such membership interest gives the member or manager the right to a share of the profits and losses of the LLC along with the right to receive distributions of the LLCs assets.
One of the biggest advantages of an LLC over an S corporation is the availability of different classes or separate tiers of membership interests with different economic rights attached to each class. This is similar to the common and preferred classes of stock found in C corporations.
The S corporation, conversely, does not allow for the creation of more than one class of stock. This limitation becomes problematic in situations when external investors require the company to issue them preferred or special membership interests with distribution and liquidation rights.
LLC Governance Models
Choosing the Right Management Structure
Although creative real estate investors can utilize different models and variations in management structures to maintain a certain degree of control over their investments, the three most commonly utilized governance models adopted in LLC operating agreements are the corporate, general partnership and limited partnership models.
In addition, carefully drafted operating agreements should take into consideration voting rights and responsibilities, mechanisms for appointing, removing or replacing members or managers, and the procedures for conducting annual or special meetings, if any. Furthermore, the operating agreement should also detail the scope of duties and the standards of care applicable to the conduct of members or managers.
Corporate Model: The LLC can be structured like a corporation by having the members elect managers who form the board of directors. Additional managers can be elected to perform duties similar to those performed by corporate officers like the president, vice president, secretary and treasurer. Unlike a corporation, the LLC does not issue shares of stock or have any shareholders. Furthermore, the LLCs profits are not taxed at the entity level before being distributed to the members or managers, unless the LLC affirmatively elects to be taxed as a corporation.
General Partnership Model: Unlike a corporation that is based on centralized governance, this model adheres to a decentralized management structure in which all members have an equal say in the management of the business and share profits equally like partners in a general partnership. Members may not transfer or assign their individual membership interests in the LLC except with the consent of all non-transferring members. Furthermore, the withdrawal of any member causes the LLC to dissolve, which begins the process of winding up the business. During this time, all the assets and debts of the entity are liquidated, all creditors are paid off, and the LLC is eventually terminated.
Limited Partnership Model: Finally, an LLC structured like a limited partnership consists of members who designate managers, who may be nonmembers, to execute duties similar to that of a general partner in a limited partnership. Recall that a limited partnership consists of limited partners and at least one general partner. The limited partners are not personally liable for the debts of the business as long as they do not participate in management, whereas the general partner is in charge of managing the business and bears personal liability for all business debts. In this respect, the LLC is a comparatively superior entity because the managers in an LLC do not bear personal liability for business debts like the general partner in a limited partnership. Generally, LLCs that hold real estate tend to adopt this model.