Limited Liability -company: Choice of entity considerations For a start-up company

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A limited liability company (LLC) is a hybrid entity, combining the best features of corporation with that of a partnership.  Typically, it provides businesses with the freedom to intervene in management affairs as in a partnership, while providing insulation from personal liability, as with a stockholder of a corporation.  The limited liability phenomenon began with Wyoming in 1977,[1] in response to a need for “a business association form bearing a lower tax burden than the corporate form, yet providing for more protection from liability than a limited partnership,”[2] and at present, all states have LLC legislation.Texas was the seventh state to permit the formation of limited liability companies and enact LLC legislation, resulting from a desire to make the state more economically competitive with others,[3] and more specifically, from efforts to be competitive with Delaware in terms of business legislation.

[4]  On June 16, 1991, the Texas LLC Act was filed without signature, following the IRS ruling on the Wyoming statute[5] that LLCs would be taxed as partnerships,[6] and thus motivating several attorneys to make a draft bill.  To this day, the LLC medium of business remains popular in the state.Under the TLLCA, LLCs may be formed to engage in any lawful purpose,[7] and possess the powers provided for a corporation under the Texas Business Corporation Act (TBCA) and those of a limited partnership under the Texas Revised Limited Partnership Act (TRLPA).[8]  Each LLC is required to maintain a registered office[9] and a registered agent.

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[10]An LLC may be formed by any natural person of legal age, or any other person regardless of place of residence, domicile, or organization, by signing the Articles of Organization and delivering the same and a copy thereof to the Secretary of State.[11]  The Articles of Organization serve as the company’s charter, much like the Articles of Incorporation for corporations.  The contents of the Articles of Organization are set forth in Article 3.02.

A[12] of the Act, which are mandatory.Although the Secretary of State can issue interrogatories to determine a company’s compliance with the Act,[13] the Secretary’s role is merely that of a ministerial filing officer, and as such, does not keep records of company ownership, and cannot entertain any complaints, nor conduct any investigations regarding an LLC’s internal operations.[14]  It is the company’s duty to maintain such records, while its internal affairs are governed by the statutory default rules, the company operating agreement, and/or member-agreed internal regulations.[15]B.


The Texas Business Organization Code (TBOC) was enacted in 2003, and became effective on January of this year. The TBOC applies to all new Texas corporations, partnerships, limited liability companies and other domestic filing entities formed on and after January first. It also applies to all foreign filing entities registering to transact business in the state. The TBOC does not immediately apply to domestic and foreign entities already in existence prior to the said date, save for the provisions on filing fees, but such entities will be automatically covered under the aegis of the TBOC on January 1, 2010, unless   s they opt to do so earlier.

[16]   Therefore, for any LLCs to be formed, the TBOC will be the governing law.The general provisions found in Title One of the TBOC, in addition to Title Three thereof which contains the provisions pertinent to LLCs, apply to the formation and operations of LLCs.  Under Title Three, an LLC may have one or more members,[17] and provides the qualifications for such members.[18]  A succeeding section shall be devoted to a more detailed discussion of the specific provisions of the Code.



When advising clients as to what form of business entity to choose, any lawyer should take caution to observe the proper protocol and act in accordance with the ethical standards in place governing an attorney’s conduct.  This is especially true when multiple clients are represented by the same lawyer, even if the said clients intend to form the same business together.

Many issues can arise from multiple representation, and the lawyer must take care that the standards of conduct embodied in the Texas Disciplinary Rules of Professional Conduct are observed.  These issues must be threshed out in the letter engaging him as counsel which the clients must sign.B.RULE 1.


lawyer is expected to keep information the client discloses to him in the strictest of confidences.  Under this rule, a lawyer is prohibited from doing any of the following: 1) revealing confidential information of a client or a former client; 2) using confidential information of a client to the disadvantage of the client unless the client consents after consultation; 3) using confidential information of a former client to the disadvantage of the former client after the representation is concluded unless the former client consents after consultation, or the confidential information becomes generally known; and 4) using privileged information of a client for the advantage of the lawyer or of a third person unless the client consents after consultation.[19]In a multiple representation scenario where the lawyer is counsel for the different parties who wish to put up an LLC, the lawyer owes this duty to each of the parties individually.  If, for example, the lawyer communicates with one client and receives information that is potentially harmful to the other client he represents, he has one of two options, i.

e., to withdraw his representation of one of them, or he must reveal the harmful information to the affected client with the consent of the other.C.RULE 1.


Another important factor for the lawyer to consider is conflict of interest between clients.  A lawyer is prohibited from representing opposing parties to the same litigation, for obvious reasons.  A lawyer is also prohibited from representing a person if the representation of such person: 1) involves a substantially related matter in which the person’s interests are materially and directly adverse to the interests of another client of the lawyer or the lawyer’s firm; or 2) reasonably appears to be or become adversely limited by the lawyer’s or law firm’s responsibilities to another client or to a third person, or by the lawyer’s or law firm’s own interests.[20]  If the interests of the organizers remain the same all throughout, the lawyer will have no problem.

But once a conflict of interest situation arises, the lawyer should withdraw representation.  He can, however, remain as counsel if he reasonably believes that his representation of the different clients will not be materially affected, or if after being fully informed of the existence of the conflict of interest, its nature, implications and consequences, all the parties consent to continued representation by the same lawyer.[21]D.RULE 1.


This particular rule involves transactions which in themselves generate unacceptable conflicts of interest,[22] such as when the lawyer obtains a direct proprietary interest in the subject matter of the litigation.  These prohibitions are imposed not only on the lawyer directly engaged by the parties, but also on the other lawyers in the same firm.  In general, this rule mandates that any and all transactions between the lawyer and the client must be fair and reasonable to the latter, who may consult independent counsel to determine whether or not these elements are present.  Therefore, when a lawyer is engaged by multiple clients to facilitate the start-up of their business, the lawyer cannot ask to be made a member of the company as his compensation, because in effect, he would be representing his own interests and could neglect that of the clients.


lawyer is not absolutely prohibited from representing a new client whose interests are adverse to that of a former client.  There are three circumstances in which such representation would be improper, and they are as follows: 1) when the potential new client questions the validity of the lawyer’s services or work product for the former client; 2) if the representation in reasonable probability will involve a violation of Rule 1.

05 (which contains the obligations a lawyer owes his former client; or 3) if it is the same or a substantially related matter.[23]  The impropriety of these situations can be cured by obtaining prior consent from the clients.  The lawyer should thus take care to secure such consent from any of his former clients who may have adverse interests to that of his current clients forming the new business organization.F.


When a lawyer is engaged to represent an organization, he is counsel for the entity itself, and not for its individual members, directors, officers, employees, shareholders, or other constituents.[24]  Because an organization is an artificial being, however, it can only act through its intermediaries.  Therefore, because the lawyer represents the organization, he must make sure that the intermediary he deals with legitimately represents his client.

He may also represent the intermediary, but the moment a conflict of interest situation arises as when the intermediary has interests adverse to the organization (say, when he wishes to file a derivative suit against the corporation), the lawyer should advise the intermediary to obtain independent counsel.



Because of the new federal tax check-the-box system, many factors aside from the potential tax liabilities must be explored by business entity organizers in order to facilitate the formation of the chosen business entity.

These factors include ownership, personal liability, restrictions, management, obligations, transferability of interest, funding, and conversion.  This part briefly discusses these different factors vis-à-vis an LLC.B.


An LLC is formed by one or more members.

[25]  The ownership of these members on the LLC is represented through their interest therein, which can have several classes, each of which has certain identified rights, powers and duties.[26]  Membership interest is in the nature of personal property,[27] and like any personal property, may be transferred by assignment either in whole or in part,[28] subject to certain limitations.[29]  Any person may become a member or may acquire membership interest, unless otherwise legally incapacitated to do so.  Furthermore, to become a member of an LLC or to acquire membership interest therein, one need not make a contribution to the company, nor otherwise pay cash or transfer property to the company, nor assume an obligation to make a contribution or otherwise pay cash or transfer property to the company.


As mentioned, an LLC is the product of a unique blend of what are considered the best features of a corporation and a partnership.  The feature that it inherited from corporations and which makes it an attractive medium for doing business is the limited liability it affords to its members.  Specifically, members or managers are not personally liable for any debt, obligation or liability of the LLC, including any such debt, obligation or liability arising from a judgment, decree, or court order, except to the extent or manner that the company agreement otherwise provides.

[31]  As in a corporation where a stockholder is only liable for the corporation’s debts and obligations to the extent of his shareholdings therein, in an LLC, a member or manager is only liable to the extent of his or her interest in the company, and his or her personal property is insulated from any claims by company creditors.  However, unlike in corporations where a creditor who obtains shareholdings as payment for the corporation’s debt can exercise all the rights pertaining to a shareholder, in an LLC, a creditor that forecloses on any membership or management interest therein is only limited to the rights of an assignee of the said interest.[32]  This assignee interest does not entitle the creditor to vote or force distribution on the said interest, and in that way, the LLC and its assets are protected.[33]  Although it is still debatable as to whether or not the corporate doctrine of “piercing the veil” applies to LLCs,[34] should the courts subsequently rule in the affirmative, this would constitute an exception to an LLC member’s protection against personal liability.


Restrictions on an LLC include the limitations of the general powers that it may exercise, following the provisions of the TBOC.[35]  Aside from these general powers, LLCs also have the power to incur indebtedness[36] and make guarantees.[37]  All these powers, however, must be exercised in light of the expressed purpose of the business as embodied in the articles of organization or the certificate of formation of the company.

[38]  In addition, LLC certificates should contain certain supplemental data that is required by the Code,[39] such as whether or not it will have managers.  The names of all LLCs must contain the phrase “limited liability company” or “limited company” or their abbreviations.[40]  Chapter Eight of the TBOC on indemnity and insurance does not apply to LLCs unless its governing documents adopt the said provisions.[41]Under the TLLCA, LLCs could only be profit-making entities, because the provisions of the TBCA and the TRLPA, which applied to LLCs, prohibited the formation of such entities for non-profit purposes.

However, with the subsequent enactment of the TBOC, this restriction was lifted, and currently non-profit LLCs may be formed.


Depending on what an LLCs certificate of formation provides, the company may be managed by the members themselves, or by managers,[42] which shall be considered the company’s governing authority.  The business and affairs of the company shall be managed according to the provisions in the company agreement and the Code.

[43]  Generally speaking, members of LLCs have an active role in management decisions, a feature which it inherited from partnerships, as opposed to corporations which exercise centralized management through the board of directors.  An LLC may have one or more managers that need not be Texas residents nor members of the LLC,[44] who may be removed with or without cause by the members in a meeting called for the said purpose.[45]


As previously stated, members generally do not have the obligation to contribute cash or property to the company.

[46]  However, once the member makes a promise in writing and signed by him that he is to make a contribution, this becomes an enforceable promise[47] on his part akin to an obligation to the company, and failure to comply therewith entails certain consequences,[48] such as a reduction of his interest.  A member may also be obliged to comply with a conditional obligation upon the fulfillment or waiver of the condition imposed upon said obligation.[49]


The nature of a member’s interest as private property has previously been discussed.

[50]  Such interest may be assigned wholly or partially, but the assignee is not entitled to participate in the management and affairs of the company, or become a member thereof, or exercise any rights of a member.[51]  However, any assignee has certain rights and duties,[52] one of which is to become a member after all the members have consented thereto.  Also, under the Code, the company can transact interest exchanges[53] to acquire all outstanding shares or interests in the company.  Unless otherwise provided in the certificate of formation, the LLCs existence is perpetual[54] and if not dissolved,[55] the membership interest can be transferred to ensure the continued existence of the company.


The funding for an LLC may come in the form of contributions in cash or property by the members, or through investments by third parties.  The capital influx for LLCs is encouraged by the limited liability protection it offers, because the member will be more willing to risk making the investment because generally, it is not his entire net worth that is at stake.I.


Existing entities could opt to convert themselves into an LLC in order to obtain its benefits.  Conversion can bring about certain tax advantages and business asset protection, as well as an increase in the value of the business enterprise.[56]  In a conversion, there is no break in the operations, nor any interruption of the existence of the converted entity, and all rights, interests and title to property remain, and obligations, liens and liabilities continue to exist without diminution or impairment, with respect to the converted entity.[57]  Existing entities may want to convert into LLCs because of the management flexibility and limited liability it offers.


When LLCs were first introduced by Wyoming in 1977,[58] the IRS issued a ruling stating that LLCs would be taxed as partnerships[59] with pass-through provisions, and not like a corporation which is subject to double taxation.  Since then, many changes in federal tax law have occurred, and the new system involves the freedom of choice for any organizer as to how the entity wishes to be taxed, subject to certain conditions, under the current federal check-the-box regulations.

[60]Under the regulations, the entity must be a business entity separate and distinct from its owners for federal income tax purposes.  As mentioned, under check-the-box entity classification, many private business enterprises, no matter what their organizational characteristics, can choose among three applicable tax regimes (Subchapters C, K, and S) in determining their income tax liabilities.[61]This has been critiqued as being unfair to other taxpayers, such as state law corporations and public firms, which are not given the same choices.[62]  Because of state legislative responses to check-the-box entity classification liberalizing existing forms of business organization by making them more akin to corporations, many inequities are said to have arisen.

[63]  Many states have amended their LLC acts to eliminate statutory restrictions intended to address previous restrictions regarding the continuity of life, centralized management, and free transferability of interests, providing owners with the flexibility to adopt the corporate characteristics in their operating agreement.[64]Additionally, states, such as Texas, now allow one member LLCs, resulting in LLC statutes becoming more similar to corporation statutes. However, under current federal and state tax law, LLCs and the corporations do not enjoy the same choices with respect to taxability.The critique of the federal check-the-box regulations further states that “state law corporations offering limited liability protection to owners are generally subject to entity taxation unless they elect to be taxed under the provisions of Subchapter S.

Unincorporated limited liability vehicles (e.g., the LLC) offering the same liability protection to owners have three tax regimes (Subchapters C, K, and S) from which to choose.  Seemingly similar organizations are not treated similarly for tax purposes under current tax law.

”[65]Moreover, the current tax law was also cited to be “inefficient in that the available choices create unnecessary costs and complexities,” because “businesses must understand and compare three complex regimes before choosing one that minimizes overall taxes. These planning costs are ongoing under current law, as firms are later permitted to switch tax classification with relative ease and without changing their non-tax characteristics.  Thus, the current tax classification system fails to achieve the important policy objectives of equity and efficiency. One would search in vain to find federal policies underlying the tax distinctions between state law corporations and unincorporated corporate look-alikes.

Likewise, one would search in vain to find policy objectives supporting the choices and complexities under the check-the-box entity classification system. As the current system is the antithesis of sound tax policy, new proposals for taxing businesses are beginning to appear. The preeminent policy issues continue to be whether business firms should be subject to entity taxation and, if so, which firms should be subject to an entity-level tax.”[66]The critique offered highlights the attractiveness of forming an LLC as a start-up business entity, whatever it might say about the flaws of the current federal tax system.

This is so because LLCs enjoy all of the benefits and none of the supposed limitations or inefficiencies of the current federal check-the-box system.The default rule[67] in the regulations provide that if a domestic entity has two or more members, it is a partnership; otherwise, i.e., if there is only one member, it is disregarded as a separate entity from that of its owner.

To change this default classification or to change an entity’s current classification, it may file an election with the IRS, signed by each member, officer or manager duly authorized, as the case may be.   Formerly, four characteristics were considered: 1) continuity of life;[68] 2) centralization of management;[69] 3) limited liability;[70] and 4) free transferability of interest.[71]  If the entity possessed two or more of these characteristics, it would be classified as a corporation for federal income tax purposes.LLCs that have two or more members will typically be classified as a partnership for federal income tax purposes, unless it makes an election to be classified as an association to be taxed as a corporation.

A single-member LLC will be disregarded as a separate entity, unless it elects to be taxed as a corporation.  The Texas LLC is a flexible statute; it allows its members to vary the regulations, allowing for greater organizational flexibility, and thus enabling the LLC to be classified as an association and be taxed as a corporation, not a partnership.Aside from these basic rules, there are other issues that must be discussed with respect to the federal taxation of an LLC.  Among these are the issue of Texas franchise or margin taxes, to be discussed more fully in a separate section.

The subsequent portions of this section will examine contributions of property, treatment of liabilities, contribution of services, and organization and syndication expenses in light of the rules provided under the Internal Revenue Code with respect partnerships, under which an LLC may choose to be classified under the check-the-box regulations, i.e., under Subchapter K of the Internal Revenue Code (IRC).The IRC provides that a partnership, as such, is not liable for federal income tax, but the persons carrying on the business as partners are liable for the said tax only in their separate or individual capacities.

[72]  This is meant when partnerships are described as having “pass-through” taxation for federal tax purposes, i.e., the tax liability passes through the entity to get to the members.To determine a partner’s income tax, he must separately take into account his distributive share of the following: the partnership’s 1) gains and losses from sales or exchanges of capital assets held for not more than one year; 2) gains and losses from sales or exchanges of capital assets held for more than one year; gains and losses from sales of property described in section 11231 (relating to certain property used in a trade or business and involuntary conversions); and 4) charitable contributions.

[73]  Additionally, to determine his gross income, he must take into account his distributive share in the gross income of the partnership.[74]A partner’s taxable income is determined the same manner as that of an  individual under the IRC, with the difference that for partners, his distributive share must be stated separately, and some deductions are not allowed.[75]


With respect to the contribution of property, the general rule is that a transfer of appreciated property in exchange for an interest in an LLC that is classified as a partnership does not result in any gain or loss to be recognized by the transferor, the LLC, or any of its members.

[76]  Thus, the tax basis of the transferor in the LLC interest thereof and of the LLC in the transferred property is the basis the transferor had in the transferred property at the time of the transfer.[77]  Under certain circumstances, a member’s contribution of property may result in a net reduction in liability to that member in excess of the member’s tax basis in the contributed property.  In such a situation, the member will realize a gain to the extent of that excess.Specifically, with respect to contributed property vis-à-vis a partner’s distributive share, in general, the regulations prescribed by the IRC provide that income, gain, loss, and deduction with respect to property contributed to the partnership by a partner shall be shared among the partners taking into account the variation between the basis of the property to the partnership and its fair market value at the time of the contribution.

[78]If any property so contributed is distributed, directly or indirectly, by the partnership other than to the contributing partner within 7 years of being contributed, the contributing partner shall be treated as recognizing gain or loss  from the sale of such property in an amount equal to the gain or loss which would have been allocated to such partner by reason of the variation if the property had been sold at its fair market value at the time of the distribution, and the character of such gain or loss is determined by reference to the character of the gain or loss which would have resulted if such property had been sold by the partnership to the distributee, with appropriate adjustments made to the adjusted basis of the contributing partner’s interest in the partnership and to the adjusted basis of the property distributed to reflect any gain or loss recognized.[79]For partnerships, the general rule is that no gain or loss shall be recognized to the partnership or its partners when property is contributed to the partnership in exchange for an interest therein.[80] However, this rule does not apply to a gain realized on a transfer of property to a partnership which would be created as an investment company if the partnership is to be incorporated.[81]  Additionally, the general rule may not be made to apply to gains realized on the transfer of property to a partnership if such gain when recognized will be included in the gross income of a person other than a U.

S. persons.[82]In case of a sale or exchange of partnership interest in return for property, a gain or loss shall be recognized to the transferor partner and shall be considered a gain or loss from the sale of a capital asset, except as other wise provided in section 751 on unrealized receviables and inventory items.[83]C.


Depending on the election of the classification for federal income tax purposes, the liabilities of the company and the members are treated differently in one LLC or another.  By default, if two or more single persons or entities form an LLC, or if an LLC elects to be treated as a partnership under Subchapter K of the check-the-box regulations, the taxation of such LLC will be deemed to be a partnership. Thus, the LLC will be required to file a Form 1065 tax return (US Return of Partnership Income).[84]  All profits and losses will be reflected in this return, with the LLC taking advantage of partnership “pass-through” taxation and avoiding double taxation.

In a partnership, an increase in a partner’s share of the liabilities of a partnership or any increase in a partner’s individual liabilities by reason of the assumption by such partner of partnership liabilities, shall be considered as a contribution of money by such partner to the partnership.[85]  On the other hand, a decrease in a partner’s share of the liabilities of a partnership, or any decrease in a partner’s individual liabilities by reason of the assumption by the partnership of such individual liabilities, shall be considered as a distribution of money to the partner by the partnership.[86]  In the case of a of a sale or exchange of an interest in a partnership, liabilities shall be treated in the same manner as liabilities in connection with the sale or exchange of property not associated with partnerships.[87]The beauty of an LLC choosing to be taxed under a partnership classification for federal tax purposes lies in the fact that the LLC will be entitled to pass-through taxation, meaning its members and not the LLC as entity will be taxed, in the same manner as partners in a partnership, but at the same time, their liability for taxes, and for any other obligation, is limited to the value or amount of their membership interest.


The general definition of gross income includes compensation for services rendered, including fees, commissions, fringe benefits, and similar items as part of the gross income of a taxable entity.[88]  Additionally, under certain conditions, property transferred in connection with the performance of services, which may be in the form of membership or partnership interest or shareholdings, as the case may be, are specifically included as items of gross income.[89]In transactions between a partner and the partnership, if a partner performs services for a partnership or transfers property to the partnership, there is a related direct or indirect allocation and distribution to such partner, and the performance of such services or transfer and the allocation and distribution, when viewed together, are deemed to be that of a partner transacting with the partnership other than his capacity as a member of such partnership, and shall be taxed accordingly.


Start-up expenditures are any and all amounts paid or incurred in connection with investigating the creation or acquisition of an active trade or business, or creating an active trade or business, or any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business.[91]For partnerships, the general rule is that no deductions shall be allowed to the partnership or any partner for any amounts paid or incurred to organize the partnership or to promote the sale of an interest in such partnership.[92]  However, the partnership may elect to treat such fees as amortized deductions, deducted ratably over a period of not less than sixty months beginning the month in which the partnership begins its business.

[93]  Organizational expenses for partnerships are defined as expenses which are incident to the creation of the partnership, are chargeable to the capital account, and are of a character which, if expended incident to the creation of a partnership having an ascertainable life, would be amortized over such life.The implications of each of these federal tax issues point to the flexibility afforded in choosing an LLC as a medium for trade, business, or even a profession.  The different rules applicable to LLCs depending on the choice made by its organizers can cater to the different preferences held by the said organizers.  For example, if the organizers were previously partners in a partnership, the LLC and the operation of a business under it would not be unfamiliar territory.

Although there are several classifications to choose from, electing to be classified under Subchapter K is arguably the best suited and the most beneficial to an LLC, whose nature is to combine the most sought out features of a corporation and a partnership.  As mentioned, under Subchapter K, the LLC would be entitled to partnership pass-through taxation and not be taxable as an entity, but because of the fact that it is a limited liability company, whatever liabilities of the members would be limited to the amount or value of their contribution to the LLC.  This unique feature of LLCs taxed as partnerships for federal income tax purposes makes it the viable choice for putting up a business in Texas, especially with the amendment to the state’s franchise taxes including limited partnerships under its aegis.  With the almost uniform treatment of domestic entities with respect to margin taxes, the obtainable federal tax benefits makes an LLC classified as a partnership one of the most efficient means for conducting business.



Texas LLCs are governed by what are called “company agreements.

”  A company agreement is defined as any agreement, written or oral, of the members concerning the affairs or the conduct of the business of the LLC.[94]  In practice, if the governing body of the LLC is a group of managers, this agreement is called an LLC operating agreement.  It is in this agreement where the flexibility of the LLC as a business entity can be seen.  Anything that the agreement does not provide for will be supplied by the provisions in the TBOC.


Under the TBOC, an LLC may have any legitimate business purpose.[95] Generally, the purpose provision in the company agreement is phrased as follows: the purpose of the Company is to engage in any lawful act or activity for which a Limited Liability Company may be formed under the Limited Liability statutes of the State of Texas.  Or, like a corporation, it can state a specific purpose, say, “to engage in the business of manufacturing tiles”, and can add the phrase “and such other purposes as may be necessary desirable in the pursuit of its business.

”C.MANAGERSAs mentioned, the LLC can be managed by either its members or by managers.  When it is to be managed by managers, the certificate of formation must so state, and must contain the names and addresses of the said managers.[96]  The company agreement should also contain this list of managers’ names and addresses, as an attachment.

Essentially, the company operating agreement should provide the  number of managers permitted, their qualifications, the mechanism by which they are chosen or removed, the extent of their powers, duties and responsibilities, the classes or kinds of managers, the manner by which vacancies are filled, and such other pertinent provisions.[97]When the LLC’s governing authority is a group of managers, the operating agreement should also contain a provision stating that members who are not managers shall take no part whatever in the control, management, direction, or operation of the company’s affairs, and shall have no power to bind the company. It may provide further that the managers may from time to time seek advice from the members, but they need not accept such advice, and at all times the managers shall have the exclusive right to control and manage the company, and that no member shall be an agent of any other member of the company solely by reason of being a member.D.


The nature of an LLC member’s interest and the extent to which it may be held answerable or liable for the company’s debts and obligations should be defined in the agreement.  More specifically, the powers, rights and duties that inhere to having membership interest should be set forth.  Also, the transferability or assignability of such membership interest, the means to do so and the effects thereof, should be indicated.  The rights and duties of any assignee of membership interest should also be provided.


The initial members are the ones that form the LLC, who are not required to make contributions in order to be considered members, but who may agree to make such contributions anyway.  After the company’s formation, the existing members may choose to accept new members, subject to the conditions found in the company agreement.  Usually, the provision in the company agreement about the admission of additional members states that no additional members may be admitted to the company through the issuance of the company of a new interest in therein without the prior unanimous written consent of all the members.

The members, of course, may adopt a different rule.


Contributions to the company whether in cash or in property and obligations to make such contributions are not essential qualifications for one to become a member of an LLC.[99]  However, generally members make capital contributions to the company to help start-up the business.

The members must agree as to the contributions of each at a pre-determined amount or value, if what is to be contributed is property.  The list of cash and property to be contributed by each member should be annexed to the company agreement.  This could serve as the written promise to contribute that can be enforced against the member.As for additional contributions, company agreements typically provide that members are not obligated to make further contributions to the company’s capital, save for certain given exceptions or instances.

This may be considered a conditional obligation and may likewise be enforced against the member when the exceptional circumstance occurs, or when the condition is waived.  The exceptions should be set forth in the agreement as well.


Generally, LLCs are allowed to have a perpetual existence.

The LLC, however, by agreement, can be voluntarily dissolved by its members.  Also, there are certain events found in the Code wherein the LLC, and other domestic entities, is required to wind up its affairs, following the procedures found in the Code.[100]  Additionally, there are only certain persons who are eligible to conduct the winding up of the LLC,[101] and unless the company agreement otherwise specifies, a majority vote of all the governing members or the managers, as the case may be, is required for the approval of voluntary winding up.[102]VI.



Formerly, an LLC with gross receipts of $150,000 or more was subject to Texas franchise tax.[103]  As a result, the LLC was subject to a franchise tax the greater of 1) 0.25% of its “net taxable capital”, wherein the net taxable capital equals member contributions and surplus, and 2) 4.

5% of its “net taxable earned surplus”, wherein the net taxable earned surplus is equivalent to the entity’s reportable federal taxable income plus manager and officer compensation, and other adjustments, with said amount being appropriable to the state based on the percentage of the LLC’s gross receipts from within the state, unless the LLC has more than one but not more than thirty-five members.[104]  An LLC with less than thirty-five members can eliminate officer and member compensation in 2), with limits as to unreasonable compensation.  One-member LLCs may not deduct officer compensation in computing 2),[105] but compensation to officers other than the member-manager may be deducted.Recently, with the passage of House Bill No.

3 (HB3) in May of this year, the franchise tax was reformed.  The legislature adopted a new “margins” tax applicable to more types of entities,[106] including limited liability partnerships, as a form of a modified gross receipts tax.  HB3 is entitled “An Act Relating to Certain Taxes Affecting Business; Making an Appropriation; Providing Penalties.”The new tax measures are noted for giving the Texas franchise tax more teeth.

Texas franchise tax had been known as a tax that could very well be avoided simply by transferring the property to a limited liability partnership, which was not subject to the said tax.[107]  However, for entities subject to the franchise tax, such as LLCs, sometimes the amount of the tax due was high enough for the members to consider converting the entity into a limited partnership, which was not subject to the tax.[108] However, the new margin tax applies more uniformly to almost all domestic entities, so the franchise tax is no longer a deterrent in forming an LLC.B.


This modified gross receipts tax or margin tax uses a rate of 1% in general, and ½% for retailers or wholesalers,[109] lower than the previous 4.5%.  The tax is computed as follows: 1) total revenue minus the greatest of either cost of goods sold (COGS), compensation, or 30% of total revenue equals the taxable margin before apportionment; 2) the taxable margin is then multiplied by a given apportionment factor; 3) from the said amount, allowable deductions or credits are subtracted; and 4) the amount obtained is multiplied by the given tax rate, at either 1% or ½%, and the resulting amount is the tax due on the margin. [110]  Generally, the margin tax is applicable to all entities doing business in Texas that enjoy protection from liability, including LLCs.

Only passive entities are not covered.  Passive entities are general or limited partnerships and trusts, whose federal gross income consists of at least 90% passive income, such as dividends, royalties, and the like.[111]Total revenue is defined in the statute to include total income as reported for federal income tax purposes without any COGS deduction.  The only deductions allowed for computing total revenue are for bad debts, foreign royalties, and dividends, distributive shares of income from partnerships, S corporations and LLCs, and dividends eligible for the federal dividends received deduction.

Taxpayers must take note of the definition given by the statue to COGS,[112] which may differ from the federal tax definition as to included and excluded items.In general, the total taxable margin is apportioned to Texas by multiplying the taxpayer’s total taxable margin by the ratio of its gross receipts from its Texas business over its gross receipts from its entire business.[113]Additionally, a taxpayer will be able to claim a credit against the new franchise tax for unused net operating loss carryforwards available as of the end of 2006, which must be elected by the taxpayer no later than March 1, 2007.[114]  This credit is not assignable, but any unused credit may be carried forward for up to twenty years, starting from the taxpayer’s first franchise tax return due after January 1, 2007.

[115]  For taxpayers that follow a calendar year, the new franchise tax will be effective on January 1, 2007.The new tax calls for a method of combined reporting,[116] for all taxable entities that are part of an affiliated group engaged in a unitary business.  Additionally, the new law provides a privilege period covered by the tax,[117] composed of an initial period beginning on the taxable entity’s beginning date and ending on the day before the first anniversary of the beginning date; a second period beginning on the first anniversary of the beginning date and ending on December 31 following that date; and  after the initial and second periods have expired, a regular annual period beginning each year on January 1 and ending the following December 31.  For the payment of the tax during the initial period, the payment is due within ninety days after the date that the initial period ends; payment of the tax covering the second period is due on the same date as the tax covering the initial period; and payment of the tax covering the regular annual period is due May 15, of each year after the beginning of the regular annual period;  however, if the first anniversary of the taxable entity’s beginning date is after October 3 and before January 1, the payment of the tax covering the first regular annual period is due on the same date as the tax covering the initial period.

[118]The new margin tax entails further study, as the finer details have not yet been threshed out through appropriate regulations.  However, it is safe to assume that the general framework of the new tax as outlined above will be followed.


The foregoing discussion briefly outlined the fundamental considerations and issues to be addressed in putting up an LLC as a medium for conducting business.

These fundamental considerations were pointed out as involving the evolution of an LLC as a business entity, followed by important issues with respect to counsel engaged to facilitate the formation process.  Next, important non-tax business considerations were discussed.  Several issues with respect to federal and state taxation were tackled separately, and the basic provisions for a company agreement were also provided. All this was done to provide an overview of the why’s and how’s in forming an LLC.

Although it may seem a bit complicated at times, many entrepreneurs choose LLCs as their business entities because LLCs provide flexibility in management as well as adequate tax incentives.  This paper is meant to be a primer on the different matters involved in choosing and forming an LLC as a mode of conducting a business, and is by no means intended to be an exhaustive discussion or examination of each and every issue that must be addressed or that could arise.  Whenever required, this paper has tried to provide an accurate comparison and contrast of the LLC vis-à-vis other entity choices, and has specifically examined the feasibility of putting up an LLC classified as a partnership for federal income tax purposes.In the end, it can be seen that although other entities are still viable choices as mediums for operating a business, the LLC certainly has its advantages, and will certainly be the entity of choice for many individuals who are considering putting up their own business.


[1] Carol R. Goforth. The Rise of the Limited Liability Company: Evidence of A Race Between the States, But Heading Where?. 45 Syracuse L.

Rev. 1193 (1995).[2] Marybeth Bosko. The Best of Both Worlds: The Limited Liability Company.

54 OHIO ST. L.J. 1752 (1993).

[3] Goforth, supra note 1, at 1225.[4] Ibid., at 1226.[5] Goforth, supra note 1.

[6] Ibid., at 1200.[7] Tex. Rev.

Civ. Stat. Ann. Article 1528n, Article 2.

01.A.[8] Ibid., Article 2.

02.A.[9] Ibid., Article 2.

05.A.(1).[10] Ibid.

, Article 2.05.A.(2).

[11] Ibid., Article 3.01.A.

[12] The law provides:“Articles of OrganizationArt. 3.02. A.

The initial Articles of Organization shall set forth:(1)  The name of the limited liability company;(2)  The period of duration, which may be perpetual;(3)  The purpose for which the limited liability company is organized which may be stated to be, or to include, the transaction of any or all lawful business for which limited liability companies may be organized under this Act;(4)  The address of its initial registered office and the name of its initial registered agent at that address;(5)  If the limited liability company is to have a manager or managers, a statement to that effect and the names and the addresses of the initial manager or managers, or if the limited liability company will not have managers, a statement to that effect and the names and the addresses of the initial members;(6)  The name and the address of each organizer, unless the limited liability company is being organized pursuant to a plan of conversion or a plan of merger, in which case the articles need not include such information;(7)  Any provision required by Part Eleven of this Act, if the limited liability company is a professional limited liability company;(8)  If the limited liability company is being organized pursuant to a plan of conversion or a plan of merger, a statement to that effect, and in the case of a plan of conversion, the name, address, prior form of organization, date of incorporation, formation, or organization, and jurisdiction of incorporation, formation, or organization of the converting entity;  and(9)  Any other provisions, not inconsistent with law, that the members elect to set out in the articles of organization for the regulation of the internal affairs of the limited liability company, including any provisions that under this Act are permitted to be set out in the regulations of the limited liability company.B. It shall not be necessary to set forth in the articles of organization any of the company powers enumerated in this Act.”[13] Supra note 7, Article 8.

01.A.[14] FAQs on Texas Official Website, at http://www.sos.

Site last accessed November 15, 2006.[15] Supra note 7, Article 2.09.[16] Information on the Texas Business Organization Code on Texas Official Website, at http://www.

shtml. Site last accessed November 15, 2006.[17] Texas Business Organization Code, Sec.101.

101.[18] Ibid., Sec.101.

102.[19] Tex. Disciplinary R. Prof’l.

Conduct, R.1.05(b).[20] Ibid.

, R.1.06(b).[21] Ibid.

, R.1.06(c).[22] The Rules provide:“Rule 1.

08. Conflict of Interest: Prohibited Transactions(a) A lawyer shall not enter into a business transaction with a client unless:(1) the transaction and terms on which the lawyer acquires the interest are fair and reasonable to the client and are fully disclosed in a manner which can be reasonably understood by the client;(2) the client is given a reasonable opportunity to seek the advice of independent counsel in the transaction; and(3) the client consents in writing thereto.(b) A lawyer shall not prepare an instrument giving the lawyer or a person related to the lawyer as a parent, child, sibling, or spouse any substantial gift from a client, including a testamentary gift, except where the client is related to the donee.(c) Prior to the conclusion of all aspects of the matter giving rise to the lawyer’s employment, a lawyer shall not make or negotiate an agreement with a client, prospective client, or former client giving the lawyer literary or media rights to a portrayal or account based in substantial part on information relating to the representation.

(d) A lawyer shall not provide financial assistance to a client in connection with pending or contemplated litigation or administrative proceedings, except that:(1) a lawyer may advance or guarantee court costs, expenses of litigation or administrative proceedings, and reasonably necessary medical and living expenses, the repayment of which may be contingent on the outcome of the matter; and(2) a lawyer representing an indigent client may pay court costs and expenses of litigation on behalf of the client.(e) A lawyer shall not accept compensation for representing a client from one other than the client unless:(1) the client consents;(2) there is no interference with the lawyer’s independence of professional judgment or with the client-lawyer relationship; and(3) information relating to representation of a client is protected as required by Rule 1.05.(f) A lawyer who represents two or more clients shall not participate in making an aggregate settlement of the claims of or against the clients, or in a criminal case an aggregated agreement to guilty or nolo contendere pleas, unless each client has consented after consultation, including disclosure of the existence and nature of all the claims or pleas involved and of the nature and extent of the participation of each person in the settlement.

(g) A lawyer shall not make an agreement prospectively limiting the lawyer’s liability to a client for malpractice unless permitted by law and the client is independently represented in making the agreement, or settle a claim for such liability with an unrepresented client or former client with out first advising that person in writing that independent representation is appropriate in connection therewith.(h) A lawyer shall not acquire a proprietary interest in the cause of action or subject matter of litigation the lawyer is conducting for a client, except that the lawyer may:(1) acquire a lien granted by law to secure the lawyer’s fee or expenses; and(2) contract in a civil case with a client for a contingent fee that is permissible under Rule 1.04.(i) If a lawyer would be prohibited by this Rule from engaging in particular conduct, no other lawyer while a member of or associated with that lawyer’s firm may engage in that conduct.

(j) As used in this Rule, “business transactions” does not include standard commercial transactions between the lawyer and the client for products or services that the client generally markets to others.”[23] Supra note 19, R.1.09(a).

[24] The rules provide:“Rule 1.12. Organization as a Client(a) A lawyer employed or retained by an organization represents the entity. While the lawyer in the ordinary course of working relationships may report to, and accept direction from, an entity’s duly authorized constituents, in the situations described in paragraph (b) the lawyer shall proceed as reasonably necessary in the best interest of the organization without involving unreasonable risks of disrupting the organization and of revealing information relating to the representation to persons outside the organization.

(b) A lawyer representing an organization must take reasonable remedial actions whenever the lawyer learns or knows that:(1) an officer, employee, or other person associated with the organization has committed or intends to commit a violation of a legal obligation to the organization or a violation of law which reasonably might be imputed to the organization;(2) the violation is likely to result in substantial injury to the organization; and(3) the violation is related to a matter within the scope of the lawyer’s representation of the organization.(c) Except where prior disclosure to persons outside the organization is required by law or other Rules, a lawyer shall first attempt to resolve a violation by taking measures within the organization. In determining the internal procedures, actions or measures that are reasonably necessary in order to comply with paragraphs (a) and (b), a lawyer shall give due consideration to the seriousness of the violation and its consequences, the scope and nature of the lawyer’s representation, the responsibility in the organization and the apparent motivation of the person involved, the policies of the organization concerning such matters, and any other relevant considerations. Such procedures, actions and measures may include, but are not limited to, the following:(1) asking reconsideration of the matter;(2) advising that a separate legal opinion on the matter be sought for presentation to appropriate authority in the organization; and(3) referring the matter to higher authority in the organization, including, if warranted by the seriousness of the matter, referral to the highest authority that can act in behalf of the organization as determined by applicable law.

(d) Upon a lawyer’s resignation or termination of the relationship in compliance with Rule 1.15, a lawyer is excused from further proceeding as required by paragraphs (a), (b) and (c), and any further obligations of the lawyer are determined by Rule 1.05.(e) In dealing with an organization’s directors, officers, employees, members, shareholders or other constituents, a lawyer shall explain the identity of the client when it is apparent that the organization’s interests are adverse to those of the constituents with whom the lawyer is dealing or when explanation appears reasonably necessary to avoid misunderstanding on their part.

”[25] Supra note 17.[26] Ibid., Section 101.104.

[27] Ibid., Section 101.106.[28] Ibid.

, Section 101.108.[29] Ibid., Section 101.

109.[30] Ibid., Section 101.102.

[31] Ibid., Section 101.114.[32] Ibid.

, Sections 101.109 and 101.110, as the case may be.[33] Michael C.

Riddle et al. Choice of Business Entity in Texas. 4 Hous. Bus.

& Tax L.J. 292 (2004), at 306-307.[34] Steven C.

Bahls. Application of Corporate Common Law Doctrines to Limited Liability Companies. 55 Mont. L.

Rev. 43 (1994).[35] The Code provides:“Sec. 2.

101. GENERAL POWERS.  Except as otherwise provided by this code, a domestic entity has the same powers as an individual to take action necessary or convenient to carry out its business and affairs.  Except as otherwise provided by this code, the powers of a domestic entity include the power to:(1)  sue, be sued, and defend suit in the entity’s business name;(2)  have and alter a seal and use the seal or a facsimile of it by impressing, affixing, or reproducing it;(3)  acquire, receive, own, hold, improve, use, and deal in and with property or an interest in property;(4)  sell, convey, mortgage, pledge, lease, exchange, and otherwise dispose of property;(5)  make contracts and guarantees;(6)  incur liabilities, borrow money, issue notes, bonds, or other obligations, which may be convertible into, or include the option to purchase, other securities or ownership interests in the entity, and secure its obligations by mortgaging or pledging its property, franchises, or income;(7)  lend money, invest its funds, and receive and hold property as security for repayment if the loan or assistance reasonably may be expected to benefit, directly or indirectly, the entity;(8)  acquire its own bonds, debentures, or other evidences of indebtedness or obligations;(9)  acquire its own ownership interests, regardless of whether redeemable, and hold the ownership interests as treasury ownership interests or cancel or dispose of the ownership interests;(10)  be a promoter, organizer, owner, partner, member, associate, or manager of an organization;(11)  acquire, receive, own, hold, vote, use, pledge, and dispose of ownership interests in or securities issued by another person;(12)  conduct its business, locate its offices, and exercise the powers granted by this code to further its purposes, in or out of this state;(13)  lend money to, and otherwise assist, its managerial officials, owners, members, or employees as necessary or appropriate;(14)  elect or appoint officers and agents of the entity, establish the length of their terms, define their duties, and fix their compensation;(15)  pay pensions and establish pension plans, pension trusts, profit-sharing plans, bonus plans, and incentive plans for managerial officials, owners, members, or employees or former managerial officials, owners, members, or employees;(16)  indemnify and maintain liability insurance for managerial officials, owners, members, employees, and agents of the entity or the entity’s affiliate;(17)  adopt and amend governing documents for managing the affairs of the entity subject to applicable law;(18)  make donations for the public welfare or for a charitable, scientific, or educational purpose;(19)  voluntarily wind up its business and activities and terminate its existence;(20)  transact business or take action that will aid governmental policy;(21)  renounce, in its certificate of formation or by action of its governing authority, an interest or expectancy of the entity in, or an interest or expectancy of the entity in being offered an opportunity to participate in, specified business opportunities or a specified class or category of business opportunities presented to the entity or one or more of its managerial officials or owners;  and(22)  take other action necessary or appropriate to further the purposes of the entity.

”[36] Supra note 17, Section 2.103.[37] Ibid., Section 2.

104.[38] Ibid., Section 2.113.


In addition to the information required by Section 3.005, the certificate of formation of a limited liability company must state:(1)  whether the limited liability company will or will not have managers;(2)  if the limited liability company will have managers, the name and address of each initial manager of the limited liability company;  and(3)  if the limited liability company will not have managers, the name and address of each initial member of the limited liability company.”[40] Supra note 17, Section 5.056.

[41] Ibid., Section 8.002.[42] Ibid.

, Section 101.251.[43] Ibid.,Section 101.

252.[44] Ibid., Section 101.302.

[45] Ibid., Section 101.304.[46] Supra note 30.

[47] Supra note 17, Section 101.151.[48] Ibid., Section 101.

153.[49] Ibid., Section 101.156.

[50] Supra note 27.[51] Supra note 28.[52] Supra note 29.[53] Supra note 17, Section 10.

051.[54] Ibid., Section 3.003.

[55] Ibid., Chapter 11.[56] Riddle, supra note 33, at 312.[57] Supra note 17, Section 10.

106.[58] Goforth, supra note 1.[59] Supra note 6.[60] IRS Treas.

Regs. Sec. 301.7701-1, -2, and –3, January 1, 1997.

[61] Jeffrey A. Maine. Linking Limited Liability and Entity Taxation: A Critique of the ALI Reporters Study on the Taxation of Private Business Enterprises. 62 U.

Pitt. L. Rev. 223 (2000), at 238.

[62] Ibid.[63] Ibid.[64] Ibid., at 239.

[65] Ibid, at. 239-240.[66] Ibid., at 240-241.

[67] Internal Revenue Code, Sec. 301.7701-3(b)(1).[68] Former Treas.

Reg., Sec. 301.7701-2(b).

[69] Rev. Proc. 95-10 and Rev. Rul.

93-6, 1993-3 I.R.B. 9-10.

[70] Supra note 68, Sec. 301.7701-2(d)(2).[71] Ibid.

, Sec. 301.7701-2(e)(1).[72] Supra note 67, Sec.

701.[73] Ibid., Sec. 702.

[74] Ibid.[75] Ibid. Sec. 703.

[76] Ibid., Sec. 721 (a).[77] Ibid.

, Sec. 722, 723.[78]Ibid., Sec.

704.[79]Ibid.[80] Ibid., Sec.

721.[81] Ibid.[82]Ibid.[83] Ibid.

, Sec. 741.[84] Ibid.[85] Ibid.

, Sec. 752.[86] Ibid.[87] Ibid.

[88] Ibid., Sec. 61.[89] Ibid.

, Sec. 83.[90] Ibid., Sec.

707.[91] Ibid. Sec. 195.

[92] Ibid., Sec. 709.[93] Ibid.

[94] Supra note 17, Section 101.001.(1).[95] Ibid.

, Section 2.001.[96] Ibid., Section 3.

010.[97] Ibid., see Sections 101.301 to 101.

307.[98] Ibid., see Sections 101.108 to 101.

112.[99] Supra note 18.[100] Supra note 17, Section 11.052.

[101] Ibid., Section.101.551.

[102] Ibid., Section 101.552.[103] Tex.

Tax Code Ann., Section 171.001.[104] James and Moore, The New Texas Franchise Tax, Tex.

B.J. (Nov. 1991), at 1108.

[105] 34 Tex. Admin. Code, Section 3.562(g) (1998).

[106] House Bill No. 3, Section 171.0002.[107] Dechert LLP.

Texas Franchise Tax Gets Some Teeth. Dechert on Point, issue 1 (May 2006).[108] Riddle, Supra note 33, at 312.[109] Supra note 109, Section 171.0011.[110] Ibid., Section 171.101.[111] Ibid., Section 171.0003.[112] Ibid., Section 171.1012.[113] Ibid., Sections 171.103 and 171.1051.[114] Ibid., Section 171.111.[115] Ibid.[116] Ibid., Section 171.1014.[117] Ibid., Section 171.151.[118] Ibid., Section 171.152.

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