1
Chapter 38
Limited Liability Companies
and Special Business Forms
INTRODUCTION
The most common forms of business organization when two or more persons are involved are the partnership
and the corporation. In this chapter, the basic features of business forms that combine the tax advantages of the
CHAPTER OUTLINE
I. The Limited Liability Company
State statutes govern limited liability companies (LLCs). Some of these statutes are based on the Uniform
Limited Liability Company Act (ULLCA) or the revised version (Re-ULLCA).
A. THE NATURE OF THE LLC
LLCs are legal entities apart from their owners, who are called members. An LLC can sue or be sued,
enter into contracts, and hold title to property [ULLCA 201].
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2. What Liability May Be Imposed
3. Other Similarities to Corporations
LLCs are entities apart from their owners. An LLC can sue or be sued, enter into contracts, and
B. THE FORMATION OF THE LLC
To form an LLC, the articles of organization must be filed with a central state agency.
1. Contents of the Articles
2. Preformation Contracts
With respect to the preorganization contracts of LLCs, courts generally apply the well-established
C. JURISDICTIONAL REQUIREMENTS
For jurisdictional purposes, an LLC is a citizen of every state of which its members are citizens.
D. ADVANTAGES OF THE LLC
1. Limited Liability
CASE SYNOPSIS—
Case 38.1: Hodge v. Strong Built International, LLC
Donald Hodge was hunting in a deer stand when the straps on the stand failed, causing the stand and
Hodge to fall to the ground. Hodge was injured in the fall and died as a result. Strong Built International, LLC,
was the maker and seller of the deer stand, and Ken Killen was Strong’s sole member and manager. Hodge’s
children Donald and Rachael Hodge filed a suit in a Louisiana state court against Strong and Killen, alleging
products liability. The court issued a summary judgment in Killen’s favor. The Hodges appealed.
the stand in any capacity but that of member and manager of the LLC. “The plaintiffs have submitted nothing
to show that Mr. Killen’s actions are something more than his duties as a member/manager of the LLC.”
A state intermediate appellate court affirmed. Under the state LLC statute, “no member [or] manager,
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Notes and Questions
obligation of th4 firm? Normally, the liability of the members of a limited liability company (LLC) is limited to
One of the advantages of the LLC is that its members enjoy limited personal liability for the
company’s obligations. In view of this fact, does the possibility that a court may hold an LLC member
personally liable for the LLC’s obligations reduce the utility of the LLC form of business organization?
One of the main attractions of the LLC is that it offers limited liability to its owners. If the courts routinely
disregarded the LLC form and held members personally liable, it certainly would diminish the utility of this
organizational form. The courts, though, rarely pierce the veil of an LLC (or a corporation) and only do so
If Strong Built had had more members, how might that have affected the result in this case? The
numbers of members would not likely have changed the result in this case, although it certainly would affect
Why is the liability of the members of LLCs limited with respect to the firm’s debts and other
obligations in the first place? The liability is limited to encourage business activity. If the member of an LLC
were liable for the firms’ transgressions and obligations whether or not the member knew of or participated in
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Are there other rules that apply to corporations that should be applied to LLCs? If so, which ones
and why? If all of the principles that govern corporations should also apply to LLCs, should all
distinctions between these two business forms be done away with? If not, why should any
distinctions be retained?
ADDITIONAL CASES ADDRESSING THIS ISSUE —
Limited Liability
Cases in which courts were asked to “pierce the veil” of a limited liability company (LLC) and avoid the
members’ limited liability include the following.
• Hollowell v. Orleans Regional Hospital, 217 F3d 379 (5th Cir. 2000) (under Louisiana law, the LLC veil
may be pierced where the LLC is operating as the alter ego of its members or where the members are
committing fraud or deceit on third persons through the LLC).
entity warranted any different analysis and stated that, where one company pays a major obligation of another
and both are owned by the same person, that payment may evidence domination).
corporation, whereby the court may ignore the corporate fiction and hold the individual members or member
2. Flexibility in Taxation
An LLC offers the tax advantages of a partnership. LLCs with two or more members can elect to be
3. Management and Foreign Investors
Advantages of LLCs include its flexible operations and management characteristics.
E. DISADVANTAGES OF THE LLC
These include the lack of uniformity among state LLC statutes and the lack of case law.
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ENHANCING YOUR LECTURE—
LIMITED LIABILITY COMPANIES IN FOREIGN NATIONS
Limited liability companies are not unique to the United States. Many nations have business forms that
provide limited liability, although these organizations may differ significantly from domestic LLCs. In
Germany, for example, the GmbH, or Gesellschaft mit beschrankter Haftung (which means “company with
limited liability”), is a type of business entity that has been available since 1892. The GmbH is now the most
widely used business form in Germany. A GmbH, however, is owned by shareholders and thus resembles a
U.S. corporation in certain respects. German laws also impose numerous restrictions on the operations and
business transactions of GmbHs, whereas LLCs in the United States are not even required to have an
operating agreement.
persons who will manage the business affairs.
FOR CRITICAL ANALYSIS
Clearly, limited liability is an important aspect of doing business globally. Why might a nation
limit the number of member-owners in a limited liability company?
II. LLC Management and Operation
A. MANAGEMENT OF AN LLC
B. FIDUCIARY DUTIES
Managers owe fiduciary duties of loyalty and care to the LLC and its members [ULLCA 409(a), (h)].
C. THE LLC OPERATING AGREEMENT
Members decide how to operate the business. Operating agreements may contain provisions
concerning—
• Management, including the selection and removal of managers.
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• The division of profits.
CASE SYNOPSIS—
Case 38.2: Mekonen v. Zewdu
company. The plaintiffs appealed.
Green Cab Taxi and Disabled Service Association LLC is a taxi service company in King County,
Washington. The operating agreement requires the members’ payment of weekly fees. Members who do not
pay are in default and must return their taxi licenses to the company. A member in default cannot hold a seat
on the board or withdraw from the company without the consent of all of the members. Dissatisfaction with
Green Cab’s management resulted in the election to the board of several members who were in default.
Other members forced the board to dissolve and hold a new election. Disaffected members, including Shumet
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Notes and Questions
issued taxi licenses to Green Cab. Prevented from doing business for almost year after its formation, the
How does the financial situation of an LLC influence its operation? The financial situation of an LLC
is a ground for the provisions of its operating agreement and the basis for disputes among its members. In the
responsibilities, but they most likely could not agree to unreasonably restrict a member’s right to information,
Could the operating agreement of an LLC reduce or eliminate the fiduciary duties that a member-
manager might owe to the firm? Although state law differs on which duties apply, and to whom, the answer
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members of an LLC. Presumably, a manager of a manager-managed LLC always has a fiduciary duty to the
company, just as any manager of any business organization has a fiduciary duty to the company or
Why wouldn’t a manager always owe a fiduciary duty to the members of an LLC? One would think
that the principle of fiduciary duties by a manger to the members of an LLC would go without saying. But,
in the management contract what the duties of the manager are.
ENHANCING YOUR LECTURE—
HOW DO YOU CHOOSE BETWEEN LLCS AND LLPS?
One of the most important decisions that an entrepreneur makes is the selection of the form in which to
do business. To make the best decision, a businessperson should understand all aspects of the various
NUMBER OF PARTICIPANTS
During the last decade or so, new forms of business organizations, including limited liability partnerships
LIABILITY CONSIDERATIONS
obligation of the firm. In some states, the partners are individually liable for the contractual obligations of the
The members of an LLC are not liable for the obligations of the organization. The liability of the partners
in an LLP varies from state to state. About half of the states exempt the partners from liability for any
DISTRIBUTIONS FROM THE FIRM
share of the profits. In many states, a member of an LLC must repay so-called wrongful distributions even if
Members and partners are generally paid by allowing them to withdraw funds from the firm against their
MANAGEMENT STRUCTURE
Both LLPs and LLCs can set up whatever management structure the participants desire. Also, all
unincorporated business organizations, including LLPs and LLCs, are treated as partnerships for federal
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on their individual income tax returns. Some states impose additional taxes on LLCs.
THE NATURE OF THE BUSINESS
a certain profession and the liability of the owners are prescribed by state law.
The business in which a firm engages is another factor to consider in choosing a business form. For
FINANCIAL AND PERSONAL RELATIONSHIPS
personal attributes can be significant factors, as may fundamental business concerns such as the expenses
members will not accept personal liability for the debt.
Despite their importance, the legal consequences of choosing a business form are often secondary to the
financial and personal relationships among the participants. Work effort, motivation, ability, and other
CHECKLIST FOR CHOOSING A LIMITED LIABILITY BUSINESS FORM
1. Determine the number of participants, the forms a state allows, and the limits on liability the state
provides for the participants.
3. Consider the business in which the firm engages, or will engage, and any restrictions imposed on that
type of business.
4. Weigh such practical concerns as the financial and personal relationships among the participants and the
willingness of others to do business with a particular organizational form.
III. Dissociation and Dissolution of an LLC
Dissociation occurs when a person ceases to be associated with the carrying on of a business. A member of
an LLC has the power, but may not have the right, to dissociate from the firm. Events that trigger dissociation
under the ULLCA are the same as those under the Uniform Partnership Act.
A. EFFECTS OF DISSOCIATION
On dissociation, a member’s right to participate in the firm’s business ends. The duty of loyalty also
ends, and the duty of care continues only with respect to events that occurred before dissociation. The
member’s interest in the firm must be bought out according to the LLC agreement, or for its “fair” value.
CASE SYNOPSIS—
Case 38.3: Reese v. Newman
to exercise its discretion under the state statutes governing dissociation from, and the dissolution of, LLCs.
The court ordered dissolution. Reese appealed.
A state intermediate appellate court affirmed. In the dissociation statute, the use of the word “shall” in the
actions that lead to dissociation. In the dissolution statute, the use of the word “shall” likewise did not direct a
the trial judge has discretion to choose either alternative.”
Allison Reese and Nicole Newman, the owners of ANR Construction Management, LLC, could not
reconcile their difference of opinion over the company’s direction. Newman told Reese that she was going to
dissolve and wind-up the firm. Reese wanted only that Newman dissociate from ANR, so that Reese could
continue the business. This dispute led to Newman’s filing a suit in a District of Columbia court against Reese.
Following a trial, a jury found grounds for both ANR’s dissolution and Newman’s dissociation. The court chose
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Notes and Questions
Under what circumstances should the judge have excused himself or herself from hearing this
case and thereby from exercising discretion to arrive at a result? Why? Under the federal Code of
Conduct for United States Judges, judges may not hear cases in which they have any of the following.
• Personal knowledge of the disputed facts.
• Personal bias concerning a party to the case.
• Earlier involvement in the case as a lawyer.
• An economic interest in any party or subject matter of the case.
similar to those for federal judges.
With respect to recusal on the basis of an economic interest, generally, unless the judge participates in
the management of a fund or a proceeding could substantially affect the value of the interest, an economic
interest does not include the following.
• Securities held by a mutual or common investment fund in which the judge owns an interest.
• A deposit in a financial institution, mutual savings association, or credit union.
• Government securities.
An important reason for grounds for disqualification is that a judge should be neutral, and appear to be
neutral—this is a necessary element of justice, and an essential requirement for public confidence in judicial
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decisions.
The federal and the states’ codes of ethical conduct are based on the Model Code of Judicial Conduct,
which has been adopted, issued, and revised by the American Bar Association.
B. DISSOLUTION
A dissociating member does not normally have the right to force the firm to dissolve (although the other
members can dissolve the firm if they want and a court might order dissolution).
C. WINDING UP
On dissolution, any member who did not wrongfully dissociate can participate in winding up. After
liquidation of the assets, the proceeds are distributed in the following order—
IV. Special Business Forms
A. JOINT VENTURE
A joint venture is a relationship in which two or more persons combine their efforts or their property for a
1. Similarities to Partnerships
Generally, partnership principles apply to joint ventures. Joint venturers owe each other the
fiduciary duties of partners.
a. Liability and Management Rights
Members have equal rights to manage their project, unless specified otherwise, and are
b. Authority to Enter Contracts
Members have authority as agents to enter into contracts for the business that will bind the
joint venture.
ADDITIONAL BACKGROUND—
Joint Ventures and Federal Tax Laws
For tax purposes, the Internal Revenue Service (IRS) treats joint ventures the same as partnerships, with
a few exceptions. Generally, the income of a joint ventures (and a partnership) is not taxed to the firm, but
taxed to the members. There are certain reporting requirements that a joint venture must meet, however.
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• A joint venture can choose its own taxable year, but without the consent of the IRS, that year cannot
be different from the taxable year of a principal partner (a partner with more than a 5 percent interest in
the capital or the profits).
between the venture and a party outside the firm.
provisions of the Internal Revenue Code, on the agreement of all of the joint venturers
filing the informational tax return with the IRS.
2. Differences from Partnerships
Joint venturers have less implied and apparent authority than partners. Unless specified otherwise,
a joint venture terminates when the project for which it was formed is done.
B. SYNDICATE
A group of individuals getting together to finance a particular project, such as the building of a shopping
center or the purchase of a professional basketball franchise, is a syndicate. It may exist as a
C. JOINT STOCK COMPANY
A joint stock company is a hybrid of a partnership and a corporation—
• Ownership is in shares of stock.
D. BUSINESS TRUST
A business trust is created by a written trust agreement. Legal ownership and management of the
property of the business are in one or more trustees, and profits are distributed to beneficiaries.
E. COOPERATIVE
A cooperative is an association organized to provide an economic service without profit to its members.
2. Unincorporated Co-ops
Unincorporated cooperatives are often treated like partnerships.
ADDITIONAL BACKGROUND—
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Limited Partnership Associations (LPAs)
were allowed continuity of life and other corporate characteristics, such as officers, bylaws, capital stock, and
In the last decades of the nineteenth century, a partnership entity known as the limited partnership
association (LPA) was created. The first LPA statute was enacted in Pennsylvania in 1873, and before the
Because so few states had passed the statutes, this became a serious impediment to LPA business. Mean-
So why aren’t businesses rushing to form LPAs instead of LLPs or LLCs (limited liability
companies)? At the time of the LPA, courts refused to recognize, in a state other than the state in which the
LPA was formed, the limited liability of the LPA’s members unless the foreign state also had an LPA statute.
TEACHING SUGGESTIONS
1. Ask students what sort of business organization they would use if they went into business for themselves
and the reasons for their particular selections. Does any single form of business organization appear to
be superior? What sorts of questions would one want to ask before selecting a business
organization?
2. In the absence of a written operating agreement, ask students what factors they would look for in
whether their source is a bank, a partner, or some other party? This and the next topic might also be
3. Inadequate financing can be the cause of the failure of any business. Have students determine for
themselves how much capital might actually be needed to start a small business by asking them to project a
budget covering the expenses. Initial expenses may include down payments for the purchase or lease of
4. After students have begun to realize what it can cost to start a business and what the rights and liabilities
are of the people who start it, ask them under what circumstances a lack of capital might be desirable (or at
least not a major obstacle) in beginning a business. A better mousetrap, more efficiency, creative marketing,
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Cyberlaw Link
Should online businesses adopt a limited liability form of business organization? Why or why
not? Which form of business organization would be best for a business that transacts deals only
online?
DISCUSSION QUESTIONS
1. Why are LLCs and partnerships attractive to businesspersons? For many businesspersons, these
business forms combine the tax advantages of partnerships with the limited liability of corporations. The income of the
2. Why might the members of an LLC prefer to put the terms of their operating agreement in writing?
Generally, LLC members should protect their interests by forming a written operating agreement. If there is no written
3. What is the difference between an LLC and a limited liability partnership (LLP)? An LLP is similar to an
4. Should fraud be required to pierce the veil of an LLC? Probably not. A showing of fraud or an intent to
5. In some circumstances, the principles of partnership law may be applied to a limited liability
company. Should the principles of partnership law apply to other forms of business entities? Reasons to
6. What is a joint venture? A joint venture is created when two or more persons or entities combine their in–
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7. What is a syndicate? A syndicate is created when a group of individuals get together to finance a particular
8. Discuss the principal characteristics of a joint stock company and a business trust. A joint stock
company has many of the characteristics of a corporation in that (1) its ownership is represented by transferable
shares of stock, (2) it is usually managed by directors or officers of the company or association, and (3) it can have
9. When might individuals choose to do business as a cooperative? Because a cooperative is organized
10. Why would a limited liability company (LLC) choose to be taxed as a corporation, rather than as a
partnership? After the Internal Revenue Service (IRS) ruled that LLCs could be taxed as partnerships, all of the
states issued statutes authorizing the form. LLCs are taxed as partnerships or, electively, as corporations. The ability
ACTIVITY AND RESEARCH ASSIGNMENTS
1. Experts predict that limited liability companies (LLCs) will replace both corporations and partnerships for most
small businesses as a result of Internal Revenue Service (IRS) regulations. The regulations allow a small business
that is not incorporated to choose whether to be taxed as a corporation or a partnership by checking a box on an IRS
form. Ask students to find and take a look at these regulations. Are there any restrictions? Why will these
regulations effect such a change?
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4. Ask students about running businesses on the Internet. Is it easier to start a business in “virtual” space
than in “real” space? Is it less (or more) expensive? What are the applicable laws? Perhaps most important
from a business person’s perspective, is it possible to turn a profit? How? Are there different consid–
erations for choosing an organizational form for doing business on the Net than there are for doing business
elsewhere? If so, what are they?
EXPLANATION OF A SELECTED FOOTNOTE IN THE TEXT
Footnote 6: Leslie Polk and his children, Yurii and Dusty Polk and Lezanne Proctor, formed Polk
Plumbing, LLC. After a couple of years, Yurii quit the firm, and Leslie “fired” Dusty and Lezanne. He denied them
In Polk v. Polk, a state intermediate appellate court reversed and remanded. Dusty and Lezanne were
managers of the LLC. The operating agreement provided that managers served until replaced or recalled by a vote of
the majority of the members. In other words, their employment was not at will. Because no vote was taken to recall or
replace them, their father did not have the authority to terminate their employment. His attempted “firing” of them was
in violation of the operating agreement.
Could the operating agreement of an LLC reduce or eliminate the fiduciary duties that a member–
manager might owe to the firm? Although state law differs on which duties apply, and to whom, the answer to this
Why wouldn’t a manager always owe a fiduciary duty to the members of an LLC? One would think that
the principle of fiduciary duties by a manger to the members of an LLC would go without saying. But, there is a
Suppose that Leslie owned a majority of the shares in Polk Plumbing. Could his “firing” of Dusty and
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Under what circumstances might the employment at-will doctrine apply to the members of an LLC?
The members of an LLC could be subject to the employment at-will doctrine if they worked for the firm and the
operating agreement did not restrict the conditions of their discharge, as in the Polk case. Employee members of an