What are Limited Liability Companies?
Limited liability companies ("LLCs") are authorized in North Carolina by Chapter 57C of the North Carolina General Statutes. LLCs are a hybrid entity comprised of various elements of traditional partnerships and traditional corporations. They are used for a variety of business applications, including both small and large businesses, holding companies for real and personal property, and even investment ventures. In addition, LLCs may be owned by a single individual, providing a means for that individual to own a business that provides limited liability without the necessity of other partners and without the burden of on-going corporate requirements. All in all, LLCs are relatively easy to create, are less burdensome than corporations to maintain, and allow a level of flexibility not available in a traditional corporation.
What Benefits does a Limited Liability Company Offer?
LLCs combine the primary benefits of a partnership, such as management flexibility and pass-through income taxation, with the primary benefits of corporations, particularly liability protection. This combination of benefits makes the LLC a very attractive business structure in the appropriate circumstance.
Perhaps the single most important benefit that LLCs offer, other than liability protection, is the option of pass-through income taxation. The owner of the LLC (owners of LLCs are called "members") pays taxes on business income only once – at the rates available to self-employed persons. To illustrate, a corporation may have to pay tax on the income of the corporation, and then the shareholder-owner would have to pay taxes on any distributions of the remaining income that the owner takes from the corporation. With an LLC, the income would "pass-through" to the member and would be taxed only once.
Another important benefit adopted from the partnership form of entity is the flexibility the member or members have in the LLC's management. At times, the management of a corporation can be very rigid and subject to substantial regulation. For small business owners and holding companies, this rigidity can outweigh the benefit of using the corporate form.
The most substantial benefit adopted from the corporation side of the equation is liability protection. An LLC offers a veil of liability protection which, absent the presence of personal guarantees, can be difficult, if not impossible, for a creditor of the LLC to pierce. If the creditor cannot pierce the LLC veil, the creditor cannot reach the personal assets of the members. This protection allows the members to engage in and fund business ventures which they otherwise avoid.
So What is the Downside?
North Carolina has defined a fiduciary duty as existing in all situations where there has been a special confidence given to another who, in equity and good conscience, is bound to act in good faith and with due regard to the interests of the person giving the confidence. In traditional partnerships, the partners are fiduciaries for one another and, therefore, owe one another fiduciary duties. From a theoretical standpoint, this is very important because it essentially means that, when the partners are acting on behalf of the partnership or with respect to partnership assets or funds, they are bound to consider the impact on their fellow partners. From a legal standpoint, this provides a cause of action for breach of fiduciary duty and possibly even constructive fraud (a species of fraud which arises in connection with fiduciary relationships) in a lawsuit brought by the partner who is harmed by a decision made by a fellow partner.
Recently, the North Carolina Court of Appeals held that, generally, members of an LLC do not owe a fiduciary duty to their fellow LLC members or to the LLC itself. In Kaplan v. O.K. Technologies, LLC, Kaplan was a minority member-manager of, and sole source of funds for, an LLC. When the LLC's prospects faded, Kaplan stopped funding the company and demanded repayment of his "loans." The other members of the LLC sued Kaplan for breach of fiduciary duty, alleging that Kaplan knew that he was the sole source of funds and, therefore, was in a position to take advantage of the situation. In the end, the North Carolina Court of Appeals analogized the situation to that of corporations, where the shareholders do not owe a fiduciary duty to their fellow shareholders or to the corporation. Likewise, LLC members generally do not owe a fiduciary duty to the LLC or their fellow members, and managers, like directors of a corporation, owe a fiduciary duty only to the LLC. The Court in Kaplan recognized that there are two exceptions to this general rule. First, majority members owe a fiduciary duty to the LLC's minority members. Second, the members are free to include provisions in the LLC's operating agreement that they owe a fiduciary duty to one another.
So What does this Mean?
This general lack of a fiduciary duty means that a member of an LLC is vulnerable to abuse by another member, or even the manager or member-manager. While this certainly does not foreclose all possible claims, it removes from the equation two substantial claims related to business decisions. Imagine the situation where an LLC member-manager uses LLC assets to change the direction of the business without the consent of the other LLC members (all with equal shares). If the acting LLC member-manager was operating in what the member-manager thought in good faith was the best interests of the LLC, he has breached no fiduciary duty to the company (absent a fiduciary provision in the LLC's operating agreement). Even though the acting member-manager excluded the other members from the decision-making process, the acting member-manager will not have violated any duty to the other members. In that case, the members would have little recourse against the acting member-manager. Alternatively, if the acting member-manager in fact does breach a duty to the LLC, the other members ostensibly would have no choice but to bring a derivative action on behalf of the LLC. This begs the question: isn't what is good for the LLC good for the members? Not necessarily. Assume it would be in the best interest of the LLC members to take the LLC's assets into asset preservation and cease business. This may not necessarily be in the best interests of the LLC, but it is in the best interests of the LLC members.
What Should Members do?
Prospective LLC members need to decide whether they actually want to have a fiduciary duty to other members. Having a fiduciary duty to fellow LLC members can limit business discretion, making the members more timid. Alternatively, LLC members may desire the added protections of fiduciary duties. If so, the members may want to set out in the operating agreement just what fiduciary duties will be owed to one another. Simply stated, the answer depends on a number of factors such as business purpose, number of members, how the LLC is managed, and the level of assets of the LLC. The best answer is that the general lack of fiduciary duties among members of LLCs is an important planning consideration prior to the formation of LLCs.
For further information about fiduciary duties of corporate directors, see "Good Faith, Due Care, and Loyalty: Responsibilities of the Nonprofit Director" by Adam M. Beaudoin.
© 2011, Ward and Smith, P.A.
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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.