Arlington, Virginia, Business Law Attorney Counseling Clients About LLC Issues
LLC Tax Issues
Transactions involving the conduct of the LLC’s business operations and transfers of membership interests generally give rise to significant tax consequences for members.
Before engaging in important transactions, members of LLCs and persons planning to form LLCs should contact business attorney James D. Fife about the tax consequences of those transactions and, when available, about alternative ways of structuring the transactions that will result in more favorable tax consequences.
Persons forming a new business organization should obtain advice that allows them to compare the income tax consequences of using an LLC to own and operate the business with the income tax consequences of selecting an alternative type of business organization.
It is also important for members of LLCs and persons planning to form LLCs to obtain accurate information about any of the following types of tax consequences that may be applicable to them based on their circumstances:
- The employment tax consequences of the ownership of an interest in an LLC that conducts business operations
- The income tax consequences of an LLC’s issuance of a membership interest in consideration for the member’s provision of services to the LLC
- The income tax consequences of the operating agreement’s provisions allocating taxable income and loss of the LLC under tax rules that may invalidate tax allocations or limit the current deduction of allocated tax losses
- The income tax consequences of transfers of assets by members of the LLC to the LLC
- The income tax consequences of transfers of assets by the LLC to members of the LLC
- The estate and gift tax consequences of a member’s gifts or bequests of membership interests to family members
Piercing the Corporate Veil
In numerous cases, courts have set aside the liability shield normally extended to shareholders and held shareholders personally liable for the obligations of corporations. Courts rely on a doctrine known as “piercing the corporate veil” as the basis for setting aside the liability shield of shareholders.
Courts apply the doctrine when it would be unjust or inequitable to permit shareholders to use the liability shield to protect themselves from liability for the corporation’s liabilities. Factors used by courts to justify piercing the corporate veil have included the following:
- Failure by corporate directors to conduct regular meetings and maintain records of votes approving corporate action.
- Violations of laws regulating corporate governance, including allowing a shareholder to make decisions that only directors have the legal authority to make.
- Failure to maintain the corporation as an entity financially separate from its shareholders, including commingling of corporate funds and shareholder funds and use of corporate funds to make direct payments of shareholders’ personal expenses.
- Failure of the shareholders to make adequate contributions to the capital of the corporation.
Piercing the LLC Veil
Although members of an LLC have a shield under Virginia law that provides them with protection from liability for the LLC’s obligations, that protection is not unlimited. If a court is required to decide whether a member of an LLC is to be held liable for a debt of the LLC, it should be expected that the court will rely on the same principles used by courts in deciding when to pierce the corporate veil and hold shareholders liable for corporate debts.
The Virginia Limited Liability Company Act contains numerous types of statutory provisions, including mandatory provisions and default provisions. A mandatory provision imposes rules governing an LLC that the LLC’s members cannot change. A default provision sets forth a rule governing an LLC that the members can alter. Members of an LLC can alter the rule contained in a default provision by incorporating a different rule in the LLC’s operating agreement or, in some cases, the LLC’s articles of organization.
The Operating Agreement
Under Virginia law, individuals may create an LLC by filing articles of organization with the Virginia State Corporation Commission. Individuals forming an LLC should execute an operating agreement before, or soon after, the filing of the LLC’s articles of organization. The drafting of an operating agreement is one of the most important matters to be addressed in the process of forming an LLC.
When an operating agreement does not address a particular issue, the relevant default provision of state law will be applicable. Reliance on statutory default provisions to define the rights and obligations of members is inadvisable for a number of reasons. As an initial matter, statutory default provisions are frequently incompatible with members’ objectives. Statutory default provisions are also subject to change by the state legislature without notice.
In addition, if a statutory default provision governs the rights of members with respect to a particular type of transaction because that type of transaction is not addressed in the agreement, it will be necessary for members to locate and interpret that statutory provision in order to understand how their rights are affected by such transactions.
It is appropriate for the members of an LLC to ensure that the LLC’s operating agreement addresses all of the issues that are of consequence to the members. In most cases, an operating agreement should include provisions that address the following matters:
- The governance and management of the LLC
- The voting rights of members of the LLC
- The admission, resignation, expulsion, and dissociation of members
- Distributions by the LLC to members, including interim distributions
- General rules providing for allocations of profits and losses to members
It is also prudent for the operating agreement to include provisions that address transfers of interests in the LLC, such as provisions requiring a member to offer his or her interest to other members before selling the interest to a third party. In addition, an operating agreement should include provisions governing the dissolution of the LLC, including provisions that specify the events that can cause dissolution and the consequences of dissolution.
In many cases, an LLC operating agreement should contain provisions that are designed to detail special situations. For example, it is frequently appropriate for the agreement to include provisions that give the LLC or members the right to buy the interest of another member on the occurrence of a specified event, such as the member’s death or incapacity.
If persons forming an LLC believe that the LLC may need additional capital in the future, it is important that the agreement include provisions that specify the conditions on which the LLC may require members to make additional capital contributions. Those types of provisions should also describe the consequences of a member’s failure to make any required additional contribution.
Many operating agreements include provisions for special allocations of items of income, gain, deduction, or loss. Special allocations are especially appropriate when members make contributions of capital or services that are unequal or not proportional to their percentage interests in the LLC.
To learn more about the benefits and issues related to forming and operating an LLC, please contact James D. Fife to schedule a consultation at this Arlington office.