In a previous post, I discussed the process of forming a limited liability company and the benefits of working with a business attorney to ensure that improper filings or flaws in the formation process do not jeopardize the benefits of limited liability. In this post, I will discuss business governance and potential tax ramifications of operating your business as an Arkansas limited liability company.
Managing the Limited Liability Company
An Arkansas LLC may be either member managed or manager managed. An Arkansas LLC is member managed by default, meaning that the members—that is, those holding equity interests in the LLC—manage the affairs of the business and may legally bind it—by signing contracts on behalf of the LLC, expending money for the LLC, etc.
If the members desire to delegate management responsibility to a manager or group of managers, they may do so. They need only include a statement to that effect in the Articles of Organization when forming the limited liability company. This is a particularly useful arrangement when the majority owner does not want minority owners—such as investors—to have the ability to perform management functions or otherwise bind the business. There is a great amount of flexibility in naming managers, as they can also be members but do not have to be.
Determining the proper management structure is important when forming an Arkansas LLC and should be considered whenever starting a business. For this reason, an operating agreement is a critical consideration from the beginning. The operating agreement governs the operation of limited liability companies, and so it is therefore important that every Arkansas LLC have a strong and comprehensive operating agreement, preferably one drafted by a business attorney.
This document should detail the responsibilities of each of the members and managers, if applicable, as well as provide the governing structure for the business. It should also provide the manner in which profits and losses are to be divided and whether members have the ability to sell their interest in the business. (What happens to a member’s interest, for example, if he or she gets divorced? Do the other members want to be forced to partner with the member’s ex-spouse? Or what happens when the member dies? Are the member’s children qualified to make decisions for the business?)
While an operating agreement is generally not required, organized and predictable management of the business may be impossible to achieve without one, particularly where there is more than one member. In addition, some organizations with which you may want to do business, such as banks, may require one.
Operating without an operating agreement can also create disputes that could easily be avoided. A strong operating agreement allows all parties to enter into the business with eyes wide open, fully aware of potential contingencies and risks involved with investing in or starting a business.
This may be particularly useful when it comes to the allocation of profits and losses. If one member invests $100,000 while another invests only his or her services—no capital—the first member may not be pleased when the profits are split 50-50. For this reason among many others, a strong operating agreement drafted by a business attorney plays an important role in avoiding potentially serious conflicts.
It is important to understand that many business disputes are not caused by malicious motives, greed, or even difficult personalities. Rather, genuine, honest misunderstandings are the root of many problems between business partners. In light of this, when starting a business, you should consider securing the services of a business attorney, who can draft a strong operating agreement that can significantly reduce the chance of misunderstandings and later disputes.
The Limited Liability Company and the Federal Income Tax
When forming a limited liability company, you have the option of being taxed as a partnership—or disregarded entity if you are the sole member of the LLC—meaning that profits and losses flow through the LLC to its members. This means that the profits of the LLC are not subject to taxation at the business level and then again at the personal level of the owners as the profits of corporations are.
Starting a business by forming an LLC is therefore a valuable way to avoid double taxation while maintaining the limited liability associated with the corporate form. In addition, it provides more flexibility than the S Corporation, which is also a pass-through entity but comes with various legal restrictions and risks of unexpectedly reverting to a C Corporation—that is, a corporation subject to double taxation—that may make the form unworkable for many entrepreneurs thinking of starting a business. (In fact, the LLC can elect to be taxed as an S Corporation.)
It is important to recognize, however, that members are taxed on their share of the business’s profits, not on the profits that the members actually receive. So—to use an overly simplified hypothetical scenario—if the share of a member in the 25% tax bracket is $100,000, that member will owe $25,000 in federal income tax, even if the LLC decides to retain all profits to reinvest in the business. This means that the member could owe $25,000 to the federal government without receiving a dime from the business. Here is another instance where a strong operating agreement is a must.
Through an operating agreement, members can insist that enough of the profits be distributed at least to cover any tax liability due. Alternatively, the operating agreement could state that the LLC is not required to make such distributions, thereby providing members with an understanding of the risks involved. Predictable distribution schedules of an LLC in Arkansas are highly dependent on the operating agreement, and so every limited liability company should have one.
The LLC is an extremely valuable tool available to the entrepreneur. While it may not be right for your specific circumstances, if you are starting a business, you should at least consider its benefits. A business attorney should be able to provide any additional information you need while also evaluating your specific circumstances to help you determine the best business entity for you and your organization.