Limited Liability Companies

The limited liability company (LLC) has become the dominant business form for new ventures in the United States, and for good reason. It offers a powerful hybrid structure that shields owners from personal liability while providing unparalleled flexibility in management and taxation. For the bar examinee and practicing attorney alike, a deep understanding of LLC law—from its foundational defaults to its intricate contractual possibilities—is essential for advising clients on entity selection, formation, and governance.

The Hybrid Nature of the LLC

At its core, the LLC is a statutory creation designed to blend the most attractive features of corporations and partnerships. Its primary advantage is limited liability, a corporate characteristic. This means that the members (owners) of an LLC are not personally liable for the company’s debts and obligations. If an LLC defaults on a loan or faces a lawsuit, the creditors’ recourse is generally limited to the company’s assets. This protects members’ personal homes, bank accounts, and other property.

Simultaneously, the LLC adopts the tax flexibility of a partnership. By default, an LLC is a "pass-through" entity for federal tax purposes; it files an informational return, but the profits and losses "pass through" to the members’ individual tax returns, avoiding the double taxation associated with C corporations. Critically, members can affirmatively elect to be taxed as a corporation if it better suits their financial strategy. This ability to choose your tax regime is a defining feature of the LLC’s flexibility.

Formation and the Operating Agreement

Forming an LLC is straightforward, but proper setup is crucial. The public act of formation requires filing articles of organization with the appropriate state agency (typically the Secretary of State). This document includes basic information like the LLC’s name, principal address, registered agent, and sometimes whether it will be member-managed or manager-managed. Filing these articles creates the LLC as a legal entity separate from its members.

The far more important document is the private operating agreement. While not always required by statute, it is the cornerstone of the LLC’s governance and the examination of any bar exam question. The operating agreement is a contract among the members that governs the internal affairs of the company. If the operating agreement is silent on an issue, the state’s default LLC Act rules will fill the gap. A key bar exam strategy is to always check the operating agreement first; it will almost always control over default statutory rules. This agreement details capital contributions, profit/loss allocations, voting rights, procedures for adding or removing members, and the process for dissolution.

Management Structures: Member-Managed vs. Manager-Managed

The LLC statute provides two default management structures, a choice that must be clearly stated in the articles of organization. In a member-managed LLC, all members have actual and apparent authority to bind the LLC in ordinary business matters, similar to partners in a general partnership. This is the default rule under most statutes. For example, if Jane, a member of a member-managed bakery LLC, signs a contract for a new oven, the LLC is bound, even if her co-member objected.

In a manager-managed LLC, only designated managers (who may or may not be members) have the authority to bind the company. Non-manager members are akin to passive investors with no default agency power. This structure is preferred when investors want a return but do not wish to be involved in day-to-day operations, or when a specialized management team is needed. On the bar exam, carefully identify the management structure stated in the fact pattern, as it directly dictates who has authority to act for the LLC.

Fiduciary Duties and Transferability of Interests

The law imposes fiduciary duties on those in control of the LLC. In a member-managed LLC, all members owe the duties of care and loyalty to the LLC and the other members. The duty of care generally requires acting in good faith and with the care of an ordinarily prudent person. The duty of loyalty prohibits self-dealing, usurping company opportunities, and competing with the LLC. In manager-managed LLCs, these duties apply to the managers. The operating agreement can often alter these duties (e.g., eliminating the duty of care, or identifying specific actions that do not violate loyalty), but it typically cannot eliminate the implied contractual covenant of good faith and fair dealing.

Regarding transferability, a membership interest is divided into two rights: the financial right to profits and distributions (the "transferable interest") and the management right to participate in governance (the "membership interest"). By default, a member may freely assign their transferable interest, but the assignee only receives the economic benefit; they do not become a member with voting rights. To become a full member, the assignee must be admitted by a majority or unanimous consent of the other members as specified in the operating agreement. This default rule preserves the "close company" nature of most LLCs.

Dissolution and Winding Up

An LLC dissolves upon the first of several events: (1) the event specified in the operating agreement, (2) the affirmative vote or consent of the members per the operating agreement or statute, (3) the dissociation of a member (e.g., death, bankruptcy, or withdrawal) if it causes the LLC to have no remaining members for more than 90 days, or (4) a judicial decree. A key distinction from partnership law is that in many states, the dissociation of a member (like a partner leaving) does not automatically trigger dissolution unless it violates the operating agreement or leaves no remaining members.

Upon dissolution, the LLC enters the winding up phase. The company ceases normal business and liquidates its assets. The proceeds are distributed in a statutory order: first to creditors (including members who are creditors), then to members for unpaid distributions, then for return of capital contributions, and finally, any remainder is split according to profit-sharing ratios.

Common Pitfalls

1. Assuming Partnership Rules Apply: A major error is applying general partnership law by reflex. Remember, the LLC is a distinct statutory entity. Key differences include the lack of automatic dissolution upon a member’s dissociation and the significant contractual freedom to alter fiduciary duties in the operating agreement. Always start your analysis with the LLC Act.

2. Confusing Management Authority: Failing to distinguish between member-managed and manager-managed structures leads to incorrect conclusions about agency authority. In a manager-managed LLC, a non-manager member generally cannot bind the company, even if they own a majority interest.

3. Overlooking the Operating Agreement: The most common exam trap is applying default statutory rules when the facts provide an operating agreement with a different rule. Always ask: "What does the operating agreement say?" It is the governing document.

4. Misapplying Fiduciary Duties: Be precise about who owes duties. In a manager-managed LLC, non-manager members do not typically owe fiduciary duties to the same extent as the managers. Furthermore, recognize that the operating agreement may have permissibly modified the standard duties of care and loyalty.

Summary

• The LLC is a hybrid entity providing members with limited liability for company debts and the option for pass-through taxation, avoiding double taxation.
• Formation requires public articles of organization, but the private operating agreement is the critical contract that governs internal affairs and overrides default statutory rules.
• Management is either member-managed (all members have authority) or manager-managed (only designated managers have authority); this distinction controls agency power.
• Fiduciary duties of care and loyalty are imposed but can often be modified by the operating agreement, offering flexibility not found in corporate law.
• Dissolution is not automatically triggered by a member’s exit and follows a specific statutory process for winding up and distributing assets.