The LLC, as well as the LP, offers even greater protections through the changing order procedure. This will be further discussed in Chapter 4.
It is important to note that in an LLC, as with a corporation, you may become personally liable for certain debts of the company if you sign a personal guarantee. As an example, most landlords will require the owners or officers of a new business to personally guarantee that the lease payments will be made. If the business goes under, the landlord has the right to seek monthly payments against the individual guarantors until the premises are leased to a new tenant. Likewise, loans backed by the Small Business Administration will require a personal guarantee. The SBA’s representative will state that they will only loan to those persons committed enough to put their own assets at risk. In truth, as with any bank, they want as much security as they can get. Such personal guarantees are standard business requirements that will not change.
The important point to remember is that you are not going to sign a personal guarantee for each and every vendor agreement and customer transaction you enter. And in these matters, you will be protected through the proper use of an LLC. To obtain such protection it is important to sign any agreement as an officer of the LLC. By signing an agreement “Joe Doe” without adding “Manager, XYZ, LLC” you can become personally liable. The world must be put on notice that you are operating as an independent entity. To that end, it is important to include LLC—or Inc. if you use a corporation, or LP for a limited partnership—on all your stationery, checks, invoices, promotional literature, and especially written agreements.
UNLIMITED OWNERSHIP
One of the reasons people have a problem utilizing the S corporation is the limits on owners. An S corporation can only have one hundred or fewer shareholders. As well, some foreign citizens and certain entities are prohibited from becoming shareholders of an S corporation.
The LLC offers the flexibility of allowing for one member to an unlimited number of members, each of whom may be a foreign citizen, spendthrift trust, or corporate entity. And unlike an S corporation, you won’t have to worry about losing your flow-through taxation in the event one shareholder sells their shares to a prohibited shareholder.
FLEXIBLE MANAGEMENT
LLCs offer two very flexible and workable means of management. First, they can be managed by all of their members, which is known as member-managed. Or they can be managed by just one or some of their members or by an outside nonmember, which is called manager-managed.
It is very easy to designate whether the LLC is to be member- or manager-managed. In some states, the articles of organization filed with the state must set out how the LLC is to be managed. In other jurisdictions, management is detailed in the operating agreement. If the members of an LLC want to change from manager-managed to member-managed, or vice versa, it can be accomplished by a vote of the members.
In most cases, the LLC will be managed by the members. In a small, growing company, each owner will want to have an active say in how the business is operated. Member management is a direct and simple way to accomplish this.
It should be noted that in a corporation there are several layers of management supervision. The officers—president, secretary, treasurer, and vice presidents—handle the day-to-day affairs. They are appointed by the board of directors, which oversees the larger, strategic issues of the corporation. The directors are elected by the shareholders. By contrast, in a member-managed LLC, the members are the shareholders, directors, and officers all at once.
In some cases, manager management is appropriate for conducting the business of the LLC. The following situations may call for manager management:
1. One or several LLC members are only interested in investing in the business and want no part of management decision making.
2. A family member has gifted membership interests to his children but does not want them or consider them ready to take part in management decisions.
3. A nonmember has lent money to the LLC and wants a say in how the funds are spent. The solution is to adopt manager management and make him a manager.
4. A group of members come together and invest in a business. They feel it is prudent to hire a professional outside manager to run the business and give him management authority.
As with a corporation, it is advisable to keep minutes of the meetings held by those making management decisions. While some states do not require annual or other meetings of an LLC, the better practice is to document such meetings on a consistent basis in order to avoid miscommunication, claims of mismanagement, or attempts to assert personal liability. It should be noted that in Germany, where the first LLC format was adopted over one hundred years ago as the GmBH, a failure to prepare annual minutes can lead to piercing of the LLC veil. One can assume that states throughout the United States will adopt such a requirement in the future. (Colorado already has.) The safer practice is to prepare annual minutes for your LLC as you do for your corporation.
Rich Dad Tip
While all fifty states have adopted LLCs, so far only two Canadian provinces—Alberta and Nova Scotia—have provided for them. Investors in Canada frequently use a limited partnership instead of a ULC (Unlimited Liability Company), as LLCs are known in Canada. Canadians also tend to use a U.S. limited partnership when investing in the U.S. as LPs match up better for Canadian taxation.
DISTRIBUTION OF LLC PROFITS AND LOSSES/SPECIAL ALLOCATIONS
One of the remarkable features of an LLC is that partnership rules provide that members may divide the profits and losses in a flexible manner. This is a significant departure from the corporate regime whereby dividends are allocated according to percentage ownership.
For example, an LLC can provide 40 percent of the profits to a member who only contributed 20 percent of the initial capital. This is achieved by making what is called a special allocation.
To be accepted by the IRS, special allocations must have a “substantial economic effect.” In IRS lingo this means that the allocation must be based upon legitimate economic circumstances. An allocation cannot be used to simply reduce one owner’s tax obligations.
By including special language in your LLC’s operating agreement you may be able to create a safe harbor to insure that future special allocations will have a substantial economic effect. (As with ships at sea, a safe harbor for IRS purposes is a place of comfort and certainty.) The required language deals with the following:
1. Capital accounts, which represent the investment of the owner plus accumulated undistributed earnings, less accumulated losses, less any distribution of capital back to the owners. Each member’s capital account must be carried on the books under special rules set forth in the IRS regulations. Consult with your tax advisor on these rules. They are not unusual or out of the ordinary.
2. Liquidation based upon capital accounts. Upon dissolution of the LLC, distributions are to be made according to positive capital account balances.
3. Negative capital account paybacks. Any members with a negative capital account balance must return their account to a zero balance upon the sale or liquidation of the LLC, or when the owner sells his interest.
It should be noted that complying with the special allocation rules and qualifying under the safe harbor provisions is a complicated area of the law. Be sure to consult with an advisor who is qualified to assist you in this arena.
FLOW-THROUGH TAXATION
As has been mentioned throughout, one of the most significant benefits of the LLC, and