Key Takeaways:

  • An LLC partner, also known as a member, is an owner of an LLC and can join at formation or later per the operating agreement.
  • LLCs offer flexibility in management, limited liability protection, and pass-through taxation, avoiding double taxation.
  • Unlike general partnerships, LLCs must register with the state and protect members from personal liability.
  • Members are compensated through profit distributions rather than salaries and may be subject to self-employment tax.
  • LLCs can elect different tax treatments, including being taxed as an S corporation for potential tax savings.
  • LLC members can be added or removed based on provisions in the operating agreement or by amending it.
  • Different state laws may affect LLC operations, taxation, and management, so legal consultation is advisable.

An LLC partner or member is the owner of an LLC. You can become a partner of an LLC either at the time of its formation or at a later date through a specific procedure set out in the operating agreement.

Limited Liability Company

Members of an LLC can choose to manage the business themselves or appoint a manager. An LLC offers other flexibilities as well. It can have any number of members, and a corporation too can be its member. Unlike in the case of corporations, there are no requirements for management reporting or state-mandated memberships.

An LLC is not subject to corporate-level income tax. It passes on its profits and losses to its members, who then pay the taxes at an individual level. Thus, it helps avoid double taxation. You also receive tax relief when the performance of your LLC is poor because you can set off the business loss against your personal income.

Types of LLC Ownership Structures

LLCs can be structured in different ways depending on the needs of the owners. The two primary structures are:

  • Single-Member LLC: Owned by one individual or entity, treated as a disregarded entity for tax purposes unless it elects corporate taxation.
  • Multi-Member LLC: Includes two or more members, typically taxed as a partnership unless it opts for corporate taxation.

Additionally, LLCs can be classified as:

  • Member-Managed LLC: All members participate in daily business decisions.
  • Manager-Managed LLC: Members appoint one or more managers (who can be members or third parties) to handle business operations.

Understanding the right structure is crucial for compliance, tax treatment, and operational efficiency.

LLC vs. Simple Partnership

The LLC business structure is ideal for small and mid-size businesses. Unlike partnership firms, an LLC must register itself with the concerned agency of the state government (usually, with the secretary of state).

Unlike a simple partnership, an LLC keeps the personal assets and liabilities of the owners separate from those of the business. The LLC owners are protected against their personal liability, regardless of whether they are actively involved in the management of the company.

In terms of flexibility of operations and management, an LLC enjoys the advantages similar to a simple partnership firm. However, an LLC must file an informational report with the IRS in Form 1065. This report lists out each member's share in the annual earnings of the company.

Liability Protections for LLC Members vs. Partners

One of the key advantages of an LLC over a traditional partnership is liability protection. In a general partnership, each partner is personally liable for business debts and lawsuits. In contrast:

  • LLC members generally aren't personally liable for the company’s debts unless they personally guarantee a loan or engage in misconduct.
  • If an LLC is properly maintained (separating business and personal finances, adhering to legal formalities), the corporate veil protects personal assets from business liabilities.

However, in certain cases, a court may “pierce the corporate veil,” holding members personally liable if the LLC is found to be fraudulent or improperly managed.

Legal Status of LLC Members

Owners of an LLC are known as its members. They are not the partners or employees of the LLC. Being an owner of the business, you may work for an LLC, but that does not make you its employee.

Rights and Responsibilities of an LLC Partner (Member)

LLC members have specific rights and obligations that vary based on the operating agreement and state laws. These include:

  • Voting Rights: Depending on the LLC agreement, voting power can be based on ownership percentage or structured differently.
  • Profit and Loss Distribution: Members receive distributions based on their ownership stake unless otherwise agreed.
  • Fiduciary Duties: In some states, members owe a fiduciary duty to act in the best interest of the LLC and its members.
  • Exit Rights: The operating agreement should outline procedures for a member’s withdrawal, buyout terms, and transferring ownership.

State laws may override some LLC agreements, so consulting a business attorney is beneficial.

How Are LLC Members Paid?

LLC owners do not get salaries or wages. They have a fixed percentage in the profits of the company. The operating agreement sets out the ownership percentage of each member. The amount of profits an LLC member receives is treated as his personal income for the purpose of federal income tax.

The members must also pay self-employment tax on the amount of business income they receive from their LLC. However, the inactive members who are not involved in the business or making decisions for the company may not have to pay the self-employment tax.

Tax Considerations for Active vs. Passive Members

Not all LLC members are taxed the same way.

  • Active Members: Those who participate in management and daily business operations typically pay self-employment tax on their share of the LLC’s income.
  • Passive Members: If a member is an investor and does not actively manage the business, they may not be subject to self-employment tax but must still report income on their tax return.

For tax efficiency, some LLCs elect to be taxed as an S corporation, reducing self-employment tax burdens while maintaining pass-through taxation.

LLC Taxation

For the purpose of federal taxes, an LLC is treated as a pass-through entity. It's the members and not the company who pay taxes on an LLC's income.

The IRS does not categorize LLCs under a separate type of taxation entity. It's up to an LLC to decide how it chooses to be taxed.

A single-member LLC can choose to pay taxes either as a sole proprietorship concern or as a corporation. Similarly, a multiple-member LLC can choose to file taxes either as a partnership firm or as a corporation.

How an LLC Can Elect Its Tax Status

LLCs have flexibility in choosing their tax treatment:

  • Default Taxation:
    • Single-member LLCs: Automatically treated as a sole proprietorship for tax purposes.
    • Multi-member LLCs: Default classification is a partnership under IRS rules.
  • Electing Corporate Taxation: An LLC can file Form 8832 with the IRS to be taxed as a C corporation or elect S corporation taxation by filing Form 2553.

Each tax election has different implications on tax rates, payroll taxes, and deductibility of business expenses.

Management Structure

The members of a multiple-member LLC may decide on the procedure for managing the company either by themselves (member-managed) or through a manager (manager-managed).

All the members of a member-managed LLC have equal rights of management. However, in case of a manager-managed LLC, the members usually appoint one or more members among themselves as "managers" for managing the affairs of the company.

Unless the operating agreement provides otherwise, most of the states consider an LLC as a member-managed company by default.

What Happens if an LLC Partner Leaves?

An LLC’s operating agreement should address the departure of a member. Options include:

  • Buyout Provisions: Remaining members may have the right to purchase the departing member’s interest.
  • Dissolution and Reformation: Some LLCs require dissolution and reformation if a member leaves unless otherwise stated in the agreement.
  • State Default Rules: If no operating agreement exists, state laws will determine what happens when a member exits.

Proper planning prevents operational disruptions and legal disputes.

Becoming a Partner (Member) in an LLC

You become a member of an LLC if your name is included in the articles of organization, filed with and approved by, the secretary of state or other designated agency of the state government.

If you're not a founding member of an LLC and would like to be added as one, you must seek its approval. The LLC operating agreement usually contains procedures for adding and removing members.

If there are no specific rules in the operating agreement for adding new members, you must convene a meeting of the members, and amend the operating agreement to make provisions for addition of members.

Can a Corporation or Foreign Entity Be an LLC Partner?

Unlike partnerships, which usually require human partners, LLCs allow:

  • Corporations, trusts, and other LLCs to be members.
  • Foreign individuals or entities to own part of an LLC, though certain tax implications and reporting requirements apply.

Non-U.S. owners should consult a tax advisor to ensure compliance with IRS rules.

Frequently Asked Questions

  1. What is the difference between a partner in an LLC and a partnership?
    LLC partners (members) enjoy limited liability, while general partners in a partnership are personally liable for debts.
  2. Can a new partner join an LLC?
    Yes, but the process depends on the LLC’s operating agreement. If no specific rules exist, members must agree to amend the agreement.
  3. Do LLC members receive W-2 wages?
    No, LLC members receive distributions, not salaries, unless the LLC elects corporate taxation.
  4. How does LLC taxation differ from a partnership?
    Both LLCs and partnerships use pass-through taxation, but LLCs have the flexibility to elect corporate tax status.
  5. Can an LLC have multiple types of owners?
    Yes, an LLC can have individuals, corporations, other LLCs, and even foreign entities as members.

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