Chapter 14 - § 14.3 • ADVANTAGES AND DISADVANTAGES OF AN LLC

• Jurisdiction: Colorado

§ 14.3 • ADVANTAGES AND DISADVANTAGES OF AN LLC

When considering the formation of an LLC, it is very important to consider all of the advantages and disadvantages of the LLC structure. The following is a discussion of several advantages and disadvantages.

• Many practitioners who have a strong tax background often let the tax advantages or disadvantages drive the decision of when a pass-through entity, such as an LLC, is appropriate, commonly referred to as "the tax-tail wagging the dog."
• Similarly, non-tax attorneys often minimize or do not understand the tax pros and cons of the LLC and focus solely on the liability protections and flexibility afforded LLC members.

However, it is important to remember that each situation is different and these advantages and disadvantages (both tax and non-tax) must be considered in light of the specific facts at hand. In addition, depending on who is the attorney's client — the LLC or one or more of the members of the LLC — what may be advantageous or disadvantageous to others may not be so to the client.¹¹

On the non-tax side, important considerations include the availability and extent of limited liability to the owners and management of the LLC, the flexibility available to the owners of the LLC to structure the economic and non-economic relations, and the complexity created by the formation and continuing operation of the LLC. Tax considerations include not only how the LLC will be taxed (disregarded entity, partnership, S corporation, or corporation), but also the difference in tax treatment depending on the number of members and the treatment of self-employment taxes. The complexity that arises because of both the contractual flexibility of the LLC and the potential tax treatment should be thought through before recommending such structure.

§ 14.3.1—Advantages

Non-Tax Advantages

Limited Liability

One of the biggest advantages of using an LLC is the limitation of the owners' and managers' liability. Specifically, § 7-80-705 of the LLC Act states, "Members and managers of [LLCs] are not liable under a judgment, decree, or order of a court, or in any other manner, for a debt, obligation, or liability of the [LLC]." The statute makes it clear that (subject to certain statutory exceptions¹² ) a creditor of the LLC should only be able to reach the assets actually owned by the LLC and promises by members and assignees for future contributions,¹³ and that a creditor should not be able to reach those assets owned separately by the members, such as a member's home or savings accounts, unless the creditors can maintain a "piercing the veil" claim or the actions are based on the defendant's negligence.

In one 2013 case, creditors attempted to enforce the LLC's rights under § 7-80-606(2) to recover allegedly unlawful distributions from members.¹⁴ The Colorado Supreme Court interpreted that section, which refers to the member's liability "to the limited liability company" for unlawful distributions, as precluding a direct claim against the member by creditors.¹⁵

This limitation of personal liability for the LLC's obligations is the same as that afforded to shareholders of a corporation, and the LLC Act provides that corporate law shall be used by the courts in determining the limits on its application and whether the veil of limited liability should be pierced.¹⁶ Thus, simply forming the LLC is not enough to take advantage of the limited liability provided by the LLC Act. Rather, the owners of the LLC will need to make sure that the separateness of the LLC is respected. Otherwise, the Colorado courts will, likewise, not respect the separateness of the LLC and will, instead, hold the members personally liable for the obligations and debts of the LLC.

In this book, Chapter 22, "Piercing the Corporate Veil," provides an extensive discussion of the factors considered by the courts when deciding whether to pierce an entity's limited liability, and other sources are also available, including one published by one of the authors of this chapter.¹⁷ It is in the best interests of any owner or manager to operate the entity in a manner to avoid a piercing claim. To do so, the owners of the LLC will want to follow reasonable formalities even though the LLC Act itself provides that "the failure of a limited liability company to observe the formalities or requirements relating to the management of its business and affairs is not in itself grounds for imposing personal liability on the members for liabilities of the [LLC]."¹⁸ These formalities are more extensively described in Exhibit 14D, but include:

• Drafting and conducting operations in accordance with an operating agreement, even if there is only one member;
• Maintaining financial records and bank accounts for the LLC that are used for business purposes and that are not commingled with funds from other businesses or the owners' or managers' personal funds and accounts;
• Filing annual reports with the Colorado Secretary of State;¹⁹
• Preparing and filing income tax returns for the LLC (or on schedule C if a single-member LLC) that are consistent with the operating agreement;
• Maintaining normal business insurance, contracting in the name of the LLC, and, for all intents and purposes, treating the LLC as the separate entity it is; and
• Documenting decisions related to major events and transactions (consent or meeting minutes).

In addition, the LLC should ensure that it holds itself out to the world as an LLC by including the LLC suffix from its name on all communications, letterhead, signage, and business cards. If the owners desire to carry on business with the LLC's name but without the LLC suffix or, for example, under the entity's Internet address, it is strongly recommended that those names be registered with the Colorado Secretary of State as "trade names" of the entity, pursuant to article 71 of title 7 of the Colorado Revised Statutes. By taking these steps, all people who deal with the LLC will know immediately that any recourse sought will only be available from the company itself and not from its members.²⁰

Unfortunately, courts are sometimes confused by LLCs in a manner they are not confused in the corporate setting. Of course, corporations have been in commerce for hundreds of years, and LLCs only since the mid-1990s. One of the principal areas for court confusion is the limited liability protecting the owner of a single-member LLC. Courts in Colorado²¹ and elsewhere have treated single member LLCs as a sole proprietorship. One case out of Wyoming justified this position noting that a single member LLC was disregarded for tax purposes and should be treated similarly for liability purposes.²² The 2016 Colorado legislature adopted C.R.S. § 7-80-107(3), which provides: "A limited liability company's status for federal tax purposes does not affect its status as a distinct entity organized and existing under this article."²³

In addition, it is important to remember that the limitation on a member's liability relates only to the business of the LLC and not to any damages caused by the negligence of the member.²⁴ Thus, if the members or managers of the LLC are in a business with a high risk of being accused of a negligent act (such as the law, medicine, accounting, construction, or other dangerous activity), separate insurance to cover that potential liability should be obtained. In few, or perhaps no, cases should an LLC, or for that matter any business, proceed without adequate insurance. "Adequate" will be defined by the facts and circumstances of the business and industry, but business owners and operators should have insurance coverage that is at least customary for their industry.

Ease of Formation and Privacy

The actual formation of an LLC in Colorado is quite simple, can be accomplished 24 hours a day, and requires the online filing of a one-page document and payment of a small fee. There is no waiting period or need for administrative approval. Upon filing, the Colorado LLC is formed. In addition, there is no statutory minimum capital for a Colorado LLC as there is for entities in other jurisdictions. Thus, those seeking to form an entity quickly may prefer a Colorado LLC over an entity in another jurisdiction that requires additional documentation, minimum capitalization, or approval from a governmental authority.

In addition, the requirements for the articles of organization of a Colorado LLC are quite minimal:

• The name of the LLC and its principal address (if any);
• The name and address of its registered agent;
• The name of the person forming the LLC (which need not be a member or manager);
• A statement that there is one or more members; and
• A statement whether the management of the LLC is vested in its members or managers.²⁵

Because the articles of organization are the only document that will be accessible by the public (other than the annual reports of the LLC, which contain even less information), it is possible to form an LLC in Colorado and not have the names of its members or managers be known.

Forming an LLC without entering into a properly drafted, written operating agreement is not advised. The statutory default rules are seldom acceptable for any multi-member operation, and a properly drafted operating agreement even has significant value in the single-member context. Even though the LLC Act contemplates that operating agreements may be oral,²⁶ the burden of proof of the terms of an oral operating agreement is not invalidated by Colorado's statute of frauds.²⁷

Flexibility

An LLC can be quite useful in those situations where the owners of the entity desire to have different rights, and even have those rights be disproportionate to the amounts of cash or property contributed by them to the LLC. Unlike under the S corporation rules of the Internal Revenue Code and the Treasury Regulations, there is no rule that an LLC have only one class of ownership interest. Rather, the members are free to...