The limited liability company (LLC) is a fairly new innovation in business law. For centuries, corporations served as the primary legal structure for businesses seeking limited liability protection. While corporations offer important protections for business owners, they also come with rigid formalities and complex rules.
In response, innovative state legislators created the limited liability company. The idea was to give entrepreneurs and small business owners a simpler, more flexible alternative to corporate rigidity. We now have a highly versatile business entity that offers the best of both the corporate and sole proprietorship/partnership worlds.
Let’s explore how the LLC came to be and the way it works compared to other types of business entities.
The Rise of the LLC and Tennessee’s Adoption
The LLC originated in Wyoming in 1977. It was inspired in part by European business forms like the German GmbH. The goal was to combine the liability protection of a corporation with the tax and management flexibility of a sole proprietorship or partnership.
Tennessee first adopted its Limited Liability Company Act in 1994. The original Act offered a more accessible way for small business owners to operate while still protecting their personal assets.
In 2006, the General Assembly passed the Revised Limited Liability Company Act. The Revised Act improved upon the original Act by clarifying governance rules, enhancing member protections, and broadening structural flexibility.
Both sets of LLC law still exist alongside each other. But for entities formed after 2006, the Revised Limited Liability Company Act is generally what governs.
Some states, including Tennessee, allow for formation of the PLLC—professional limited liability company. This type of entity is a common choice for lawyers, doctors, architects, CPAs, and similar professionals.
The LLC Combines Aspects of Other Types of Business Entities
An LLC blends features of several other types of business entities that have existed for many years.
Corporation and LLC
Unlike a corporation, an LLC is easier to manage. Corporations require regular meetings, bylaws, a board of directors, and detailed corporate formalities. Corporate entities must follow the legal requirements for operation and cannot create a shareholder agreement that contradicts the law.
A limited liability company, on the other hand, can have member (owner) management, or management by hired managers. An operating agreement typically sets forth internal governance rules. Oftentimes, the operating agreement can have different rules than the default rules in the Revised LLC Act. There’s also no need for a board of directors or formal meetings.
Corporations and LLCs both have ownership units. For corporations, it’s shares of stock. For LLCs, it’s a membership interest, usually expressed as a percentage. These ownership units can be transferred to another person fairly easily.
Sole Proprietorship and LLC
Compared to a sole proprietorship, a limited liability company provides a legal separation between the business and its owner. A sole proprietor is personally liable for business debts and lawsuits. There is no distinction between the business and its owner. When the owner dies, the business also ceases to exist.
But an LLC limits that personal liability by creating a legal separation. Creditors can only go after the company’s assets, not the owner’s home, car, or personal accounts (assuming proper operation). This allows entrepreneurs to still take some risks with their enterprises without risking everything.
The LLC also continues to exist when a member dies. A member may also transfer the membership interest to a beneficiary as part of the member’s estate plan. Because ownership in the business is divided into measurable units, this enables easier transfer of the business’s ownership to another person or entity.
Partnership and LLC
A partnership historically left the partners personally liable for the partnership’s obligations. Though this rule has been modified over the years to allow for greater distinction between the partners individually and the partnership as an entity.
But a limited liability company provides clear limited liability protection for all members. Like a partnership, LLCs can be taxed as pass-through entities. This allows for simpler tax reporting and avoiding double taxation that corporations often deal with.
An LLC with multiple members typically should have an operating agreement, just as a partnership should have a partnership agreement. This will detail important things like ownership interests, management powers, and buy-sell provisions upon death.
Tax Treatment of a Limited Liability Company
A single-member LLC is a disregarded entity for federal income tax purposes by default. This means that income and expenses go directly to the member’s personal return on a Schedule C.
Federal tax law treats a multi-member LLC as a partnership under Subchapter K. The LLC files a partnership tax return and will issue the members a K-1 form for their share of profits and losses.
The great news is that a limited liability company isn’t stuck with these default tax treatments. It may choose one of the following tax classifications:
- S Corporation status by filing IRS Form 2553 (commonly used to avoid self-employment tax on a portion of income);
- C Corporation status by filing IRS Form 8832; or
- Remaining taxed as a sole proprietorship (single member) or partnership (multi-member).
This flexibility allows business owners to choose a structure that aligns with their business strategy and tax planning goals. And the tax classification generally doesn’t affect the flexibility of the limited liability company’s operations.
Maintaining Limited Liability Protection
While an LLC provides liability protection, that shield can be lost if the business doesn’t observe a few basic legal formalities. To preserve limited liability:
- Keep business and personal finances separate so that bank accounts, credit cards, etc. are in the LLC’s name and used only for business purposes;
- Sign contracts and legal documents in the name of the LLC, not in the member’s personal name;
- Maintain proper documentation, such as an operating agreement and member resolutions for major decisions; and
- Avoid using the LLC for personal expenses, instead being paid for services rendered or taking owner distributions.
In Tennessee, the courts look closely at whether the LLC operates as a legal entity that is truly separate from the members as individuals. If it does not, members may find themselves personally liable for the business’s obligations, including lawsuits.
Isn’t a Corporation Better for Liability Protection?
A common misconception is that a corporation provides stronger liability protection than a limited liability company. Both structures limit personal liability for business matters, also known as the “corporate veil.” But an LLC offers more robust safeguards.
In Tennessee, if a creditor obtains a judgment against an LLC member personally, the sole remedy is what’s called a “charging order.” This order entitles the creditor to receive the member’s financial distributions. But the charging order does not grant any control over the LLC’s operations or access to its assets.
On the other hand, creditors of a corporation’s shareholders can potentially seize the shares in the company with a judgment. The creditor would then have voting rights and a say in the company’s management.
Moreover, Tennessee LLCs benefit from express statutory provisions that minimize the risk of piercing the corporate veil. State law explicitly states that failure to observe formalities on its own isn’t a ground for imposing personal liability on LLC members. The statute on this subject reads as follows:
The failure of a domestic or foreign LLC to observe the usual entity formalities or requirements relating to the exercise of its powers or management of its business is not a ground for imposing personal liability on the members, holders, managers, directors, officers, employees or other agents of the domestic or foreign LLC. – Tenn. Code Ann. § 48-249-114(e).
Corporations are more susceptible to veil-piercing claims if they neglect corporate formalities, like holding regular meetings or maintaining detailed records. There isn’t a statute offering a relaxed standard for corporate formalities.
The good news is that piercing the veil is still a difficult thing to do in most situations. It’s good practice to maintain formalities regardless of whether you own a corporation or an LLC.
When to Form an LLC vs. a Corporation
A limited liability company can be a great choice for:
- Small business owners looking for liability protection without excessive legal compliance;
- Real estate investors seeking asset protection and tax flexibility;
- Family-owned businesses or professionals who want a simple structure with contractual freedom; and
- Entrepreneurs planning to grow and take on partners, but not necessarily seek outside investors.
But a corporation may be more appropriate for those who:
- Plan to raise capital through venture funding or public offerings;
- Intend to reinvest most profits in the business (to take advantage of lower corporate tax rates); or
- Operate in industries where regulators or investors prefer the corporate form.
A corporation with a Subchapter S election may be useful for service businesses or owner-operators who want to minimize self-employment taxes. But these business owners need to be comfortable with some fairly strict eligibility rules.
Final Thoughts on the Limited Liability Company
The development of the limited liability company has been a boon to small business in the United States. With a fairly simple filing process, flexible management, and multiple tax classification options, entrepreneurs can have a business entity that has legitimacy without risking their personal assets.
But small business owners still need to adhere to good practices with their LLC. Otherwise, the members may lose the limited liability protection. We discuss the risks of commingling personal and business finances in this article here.
Connell Law, PLLC assists small business owners with formation, contracts, and general legal consulting. To start your Tennessee small business right from the start, request a free consultation with us today.
