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Selection and Application of LLC in the Investment and M&A in the U.S.

Selection and Application of LLC in the Investment and M&A in the U.S.

The design of transaction structure plays a critical role in the scheme of overseas merger and acquisition (M&A), while the establishment of special purpose vehicle (SPV) is an essential part in the design of transaction structure of overseas M&A. Key factors that need to be considered in the process of establishing a SPV include establishment procedures, company management, taxation, acceptance of investment, etc.

For the investment in the U.S., Limited Liability Company (LLC) is an important form of organization. 

  1. Overview of Limited Liability Company (LLC)

Limited Liability Company (LLC) is quite different from the company we usually call limited company. LLC is usually considered as a unique legal entity with the right to sign contracts, hold properties, and file and respond to suits independently. Its owner or contributor is legally referred to as member rather than shareholder. Just like joint-stock company, LLC has the advantage that its owner only undertakes limited liability. In terms of taxation, however, LLC may choose to pay taxes as a partnership to avoid the double taxation on its revenue. Besides, LLC features extremely flexible organization, administration and management. LLC is an important option for foreign investors to invest in entities in the U.S.

  1. Origin and Development of Limited Liability Company (LLC)

LLC has a history of only 40 years in the U.S. In 1977, the first LLC in a real sense in the U.S. was legally incorporated in Wyoming. Then, it was gradually spread to other states and accepted by the laws of different states in the U.S. The one closely followed Wyoming was Florida. However, in the next ten years, the legislation on LLC was at a standstill. That’s mainly because it was still not clear whether LLC can enjoy the tax treatment of partnership. In 1988, Internal Revenue Service released a loose interpretation on the tax exemption conditions of LLC. Such a decision caused enormous response and became the strong driving force to accelerate the legislation on limited liability company in all states.

In 1994, a model law named Uniform Limited Liability Company Act (hereinafter referred to as ULLCA) was established in the U.S. In 1996, some important amendments to this model law were promulgated. By then, limited liability company, as a new organizational form of enterprise, has fully consolidated its position in the U.S.

III. Advantages of Limited Liability Company (LLC)

The significant development of LCC in recent 30 years is inseparable from its unique advantages over other forms of enterprise. The advantages of limited liability company mainly include:

(1) Flexible operating mode

The operating mode of LLC is relatively flexible and different from either company or partnership. It can be classified into LLC operated by member and that operated by manager. In the so-called LLC operated by member, the business of the company is directly operated by the members. Each member is its representative with the same right to manage and execute the business. Unless specifically mentioned in law, any problem related to the company business should be decided by the majority of members. This is actually the business mode of partnership. In the LLC operated by manager, it is the manager’s exclusive authority to execute the business of the company. The manager here could be either a member of LLC or not. Except for things which have to be determined by the majority of the members according to the law, any matter related to LLC business can be solely determined by the manager. If there is more than one manager in LLC, the decision should be made by the majority of the managers. In the LLC operated by manager, normally, the member doesn’t have the right to operate business. If any member operates business on behalf of LLC without authority, LLC is entitled to deny it. In this case, LLC shall not be held accountable for the damage of third parties. Therefore, it is necessary to be stated in the Articles of Association of LLC that whether the company is operated by member or manager. Otherwise, it shall be presumed as being operated by member to protect the interests of the bona fides third party.  

So from the perspective of internal management, LLC is the freest form. The member of LLC can choose whether the company is operated by all members or by manager. As to corporation, according to the principles to separate the operating right and management right, shareholders need to transfer the management right of the corporation to directors. LLC has no arrangements on the board of directors or the board of shareholders. LLC members are not required to hold plenary meetings on a regular basis. It requires at least one officer and one manager to set up LLC. A person can be appointed as both the officer and the manager at the same time. It is not required to appoint a secretary. The above-mentioned staff members don’t have be local residents. People with an address in local state to receive possible legal instruments are qualified. LLC is simpler and more convenient for the management of operation.

(2) Limited liability of member

The establishment of LLC enables the properties of the member to be independent of the properties of the company. The member only needs to undertake limited liability within the amount of contribution. Just like the shareholder of company, member of LLC doesn’t undertake direct liability for the debts of the company. However, the two have obvious differences: shareholders have to strictly abide by legal procedures of operation and are not allowed to directly take part in the corporate affairs. In LLC, there are no requirements on the operators (both member and manager) of LLC in terms of operation procedures. ULLCA particularly emphasizes that: failure to abide by normal legal operating procedures is not the excuse for the member or manager of LLC to undertake personal liability. It means that the member of LLC enjoys more privileges and preferences than shareholders of ordinary company. In fact, member of LLC directly operates the corporate business like partnership. This is one of the main reasons to develop LLC as a new form of business organization.

(3) LLC has flexible options of taxation

Another feature of LCC relies on its taxation system. According to the U.S. tax code, LCC can choose to pay taxes as a corporation or a partnership. In 1996, Internal Revenue Service modified the taxation system of LLC and granted LLC the right to choose to pay taxes as a corporation or a partnership according to the tax code. If the former is chosen, LLC shall be subject to double taxation, but it can be engaged in open transactions in the open market, like fund raising and assignment of shares. If the latter is chosen, LLC can enjoy the single tax as a partnership, but it is not allowed to be engaged in open transactions. Seen from taxation, LLP and LLC are both pass-through entities. Taxes are only collected from partners of LLP and members of LLC rather than the enterprise level. Therefore, it is single tax. In corporation, the taxes are collected from both enterprise and shareholders. Therefore, it is double tax.

  1. Establishment of Limited Liability Company (LLC)

According to the ULLCA, one or more people can submit the Articles of Association to the Secretary of State for filing and establish LLC with one or more members. Once LLC is established, it becomes an entity independent of member and enjoys independent property ownership right. To establish LLC, there should be public articles of association to prove its status. Meanwhile, member of LLC can sign internal operation agreement. In case there is a conflict between the articles of association and the operation agreement, the internal operation agreement prevails for assignees of internal relationship and member interests; the articles of association prevail for external parties. Besides, the law endows the operation agreement with great autonomy in operation. Unless otherwise restrained by the law, legal regulations on LLC can be modified. In a certain sense, ULLCA is only the default rules or supplementary rules when there are no regulations in the agreement.

Taking California for example, the procedures to incorporate a LLC in California are: filling a LLC-1 Form and submit it to the state government of California and a LLC-12 Form; apply for a Tax ID number with Internal Revenue Service (IRS); apply for opening a bank account after obtaining a certified copy of the company. The incorporation of LLC requires an agent with California Address to receive possible legal instruments. Agent can be an individual or a company in a certain range.

According to the Uniform Limited Liability Company Act, one or more people can submit the Articles of Association to the Secretary of State for filing and establish LLC with one or more members. Seen from the legislations of most states, there are no special restraints on the qualification of LLC founder, who can be any person with legal capacity or agent of the member of proposed company. There are no restraints on the quality of LLC member. Either natural person or legal person, either person from local state or person from other state and even foreign country is qualified. There are also no restraints on the number of members when LLC is founded. It is feasible for a LLC to have only one person. Therefore, sole proprietor can also use the form of LLC.

Generally speaking, among all forms of enterprises, LLC has the minimum restraints on the conditions of foundation, so it is also a form of enterprise with the broadest applicable scope. By far, LLC is deemed as the perfect form of enterprise to combine the limited liability barriers of traditional corporation and the flexible management and tax treatment of partnership. Therefore, the organizational form of LLC is neither a company nor a partnership. As a “hybrid” which combines the corporation system and partnership system, it is the “third path” combining the advantages of both systems.

By Yang Feixiang