|Business Credit Articles|
When considering selling a new account on terms, an experienced credit executive investigates the legal form of the enterprise requesting credit. Is the enterprise a corporation, partnership, joint venture or sole proprietorship? The form of enterprise is a factor in determining whether to extend credit. Over the last decade state legislatures have rushed to enact limited liability companies (LLCs) legislation for the purpose of attracting more business to their state. LLCs have become especially attractive as they combine two features of organizations: corporate form of limited liability to its "members", with the partnership form of pass-through taxation. Does the form of an LLC create special credit risks for a credit executive? What is the authority of an LLC member to enter into binding agreements on its behalf? Is there recourse against an LLC member in the event of default?
A. Brief History Of LLCs
The first LLC legislation in the United States was enacted in 1977. However, it was not until the IRS ruled in 1988 that an LLC would be classified as a partnership for federal income tax purposes, that there has been strong interest in LLCs. Over the last decade, all states have adopted LLC legislation.
B. Nature Of LLCs
1. Limited Liability of Members
Members, or owners, of an LLC have limited liability protection similar to shareholders of a corporation. However, it is possible to "pierce the corporate veil" of an LLC and hold a member personally liable for a LLC debt. As with corporations, it must be demonstrated that the LLC disregarded its LLC formalities to pierce the veil. Accordingly, a credit executive seeking personal liability for its debt should obtain a personal guarantee of the LLC's member or manager.
2. Binding the LLC
An LLC is controlled by managers, who in turn may appoint officers like a corporation. The LLC's articles of organization define whether it is (1) managed by members; or (2) managed by non-members, e.g., the owners of the LLC select managers to operate the business. With LLCs managed by members, the member may bind the LLC to ordinary course business transactions, whether or not the member has actual authority. With non-ordinary course transactions, the member must have actual authority. With LLCs managed by non-members, a member does not have actual authority to bind the LLC.
In determining whether to extend credit to an LLC, the credit executive should obtain the articles of organization and operating agreement of the LLC. The operating agreement is not a public document. These documents should identify the authority of parties to bind the LLC to agreements.
3. Tax Benefits
An LLC is taxed as a partnership. The LLC's income is subject to only one level of federal income tax. Only the LLC's members or owners are subject to federal income tax, not the business.
C. Some Distinctions Between LLCs, Corporations And Partnerships
An LLC is a separate legal entity, capable of suing and being sued. LLCs are not subject to the same formalities as corporations, such as the requirements for conducting meetings and electing directors and officers. Managers of an LLC can be removed in accordance with the terms of the operating agreement. By comparison, there are significant restrictions on the ability of shareholders of a corporation to remove its directors.
As noted, an important distinction between LLCs and general partnerships is that the partners of a general partnership are personally liable for the debts of the general partnership whereas the members of an LLC generally have limited liability. Both general partnerships and LLCs are managed by the partners or members (absent an agreement with a partnership). Partners acting in the ordinary course of business may bind the general partnership, a member of an LLC who is not acting as a manager cannot bind the LLC.
A general partner in a general partnership may dissolve the general partnership (absent an agreement), while a member of an LLC cannot. Limited partnerships must have at least one general partner who is liable for the debts of the partnership. LLCs have no such requirement.
Limited partners may jeopardize their limited liability status if they actively participate in the business of the limited partnership. However, all members of an LLC have limited liability, regardless of whether they actively participate in management of the LLC's business.
LLCs are formed by filing articles of organization with the secretary of state or other appropriate office. In comparison, general partnerships are formed by the agreement of the partners and are not subject to any filing requirements. An LLC must have an operating agreement (verbal or written), entered into by at least two persons, which governs the LLC.
D. LLCs In Bankruptcy
LLCs are eligible to file bankruptcy. Equally true, trade creditors of an LLC may file an involuntary petition, provided the established criteria for commencing a petition are met.