The Limited Liability Company
Article on Securities Law
A series of articles provided by Michael T. Raymond, a securities attorney with the Detroit, MI, law firm Raymond & Walsh, and an Adjunct Professor at the Wayne State University Law School.
The purpose of this series is to acquaint readers with the basics of securities law. Securities law governs the raising of capital for business purposes.
8. LLC – Limited Liability Company
The Michigan House of Representatives is currently considering legislation (House Bill 4902) allowing the creation of a new business entity, the Limited Liability Company (LLC), which may be attractive to entrepreneurs and start-up ventures.
The LLC would allow individuals organizing a new company to take advantage of the benefits presently available to general partnerships, limited partnerships and corporations, combined. In addition, the LLC, under certain circumstances, may allow an entrepreneur to avoid federal and state securities regulations typically involved when raising capital.
Individuals may currently choose from various business forms in Michigan, including general partnerships, limited partnerships, and corporations.
A general partnership between two or more persons allows for pass-through taxation to the partners, but involves personal liability for partnership obligations. A limited partnership shields limited partners from personal liability and allows pass-through taxation to the partners, but restricts participation in management.
While a corporation provides the greatest protection against personal liability, income earned by the corporation is subject to double taxation, once at the corporate level when earned, and second at the investor level when distributed as dividends and/or paid as salary. However, individuals may elect to form an S-corporation under the Internal Revenue Code, allowing the entity to be taxed in a manner similar to a partnership, provided that it has no more than 35 shareholders.
In contrast, an LLC, as proposed, would (a) protect members from personal liability for the obligations of the LLC, (b) qualify for pass-through taxation, (c) allow for an unlimited number of members, and (d) provide for flexibility in management. Depending on its management structure, an LLC may not need to comply with certain securities laws applicable to capital formation.
To form the LLC, the founder(s) would file Articles of Organization with the Michigan Department of Commerce which, among other things, would include a description of the extent to which members are permitted to participate in the LLC’s management. Management rights of members may range from full participation to severely limited participation. This broad flexibility in determining a member’s management participation is a key distinguishing feature for the LLC.
The LLC’s management structure will most likely determine whether the LLC would be treated as a “partnership” for taxation purposes. IRS regulations generally provide that a business entity will be taxed as a corporation (i.e., subject to double taxation) if it has more than two of the following corporate characteristics — (a) limited liability, (b) centralized management, (c) continuity of life, and (d) the free transferability of ownership interests. One primary objective of an LLC will be to avoid having more than two of the identified corporate characteristics, thereby preserving pass-through tax benefits.
The Michigan legislation, as proposed, provides for limited liability for LLC members. Also, members can agree either to a centralized management structure, or to allow all members to participate in management.
With respect to the “continuity of life” element, the Michigan legislation provides that the LLC would automatically dissolve in the event of the death, withdrawal, expulsion, bankruptcy, or dissolution of any member (unless all remaining members agree to continue the business). However, the legislation also provides that an LLC’s life may be continuous under certain other prescribed circumstances. In order to avoid the “continuity of life” corporate characteristic (and the ensuing adverse tax result), the LLC’s charter should expressly require that action be taken to continue the business following the termination of a member.
Finally, the proposed Michigan legislation provides that a member may freely transfer his interest in the LLC, but such person is not released from personal liability, even if the assignee becomes a member. Through proper documentation, a member may be given the right to assign his interest in the profits but not his interest to participate in management, thereby strengthening the argument that the interest is not freely transferable. Thus, through careful planning and drafting, the LLC may be organized in a manner which allows pass-through tax benefits.
With respect to securities issues, it should first be noted that a member of an LLC does not receive “stock”. Rather, his “membership” interest is reflected in the Articles of Organization much in the same way that a partner’s interest is reflected in a partnership agreement.
Whether federal and state securities laws will treat this membership interest as a “security” depends in large part upon the level of member participation in management as granted by the LLC’s charter. If such interests do constitute “securities”, federal and state securities law compliance would mandate that their offer/sale be registered or exempt from registration. Conversely, if the interests are not deemed “securities”, these compliance concerns would not be relevant, thus enabling greater ease and cost savings in raising capital. Again, proper planning and drafting are of great importance.
While the adoption of the proposed legislation establishing the LLC as a legally cognizable entity in Michigan remains some months away from passage, and although several federal taxation and securities issues are unanswered, the limited liability company is expected to provide small businessmen with a valuable alternative for conducting business.