Delaware Limited Liability Companies

General Discussion of Delaware LLCs

On July 22, 1992, Delaware enacted the Delaware Limited Liability Company Act, 6 Del. C. 18-101, et. seq. (the "Act"), which became effective on October 1, 1992.  Under the Act, a business can be formed as, or converted into, a limited liability company (an "LLC").  The LLC is a relatively new form of business entity designed to provide its owners/members with both the limited liability afforded to corporate shareholders and the pass-through income income tax advantages of a partnership.

In order to capture the many advantages of the well-known Delaware Revised Uniform Limited Partnership Act, 6 Del. C. 17-101, et. Seq. (the "LPA "), Delaware modeled the Act after the LPA.  Each LLC may have a limited liability company agreement, which is a written agreement between the members as to the conduct of the LLC's business and affairs.  The Act is designed to give LLCs a high degree of freedom and flexibility in the provisions which members may include in their agreement.  This a key feature that the Act shares with the LPA.  ( Click here for article on Delaware Limited Partnerships.)

The very essence of the LLC is the statutory grant of limited liability to all members and managers.  Like a corporation, liability is limited to the amount invested in the LLC.  But unlike a corporation, the profits and losses of an LLC pass through to the members.  Income of the LLC is taxed only once, rather than both at the entity level and at the personal level, as with corporations.  The advantages of an LLC over an S corporation include no limit to the number of members and the absence of a requirement that the members be permanent U.S. residents, or even natural persons.

Even though LLCs resemble partnerships in many ways, there are several important differences.  An LLC has no requirement for a general partner to be fully liable for all partnership debts; it has no net worth requirements similar to that required of a general partner; and a member may fully participate in management, whereas limited partners may not.

The Act has a series of provisions, known as default rules, that automatically apply for issues as to which the members' agreement is silent.  Most importantly, the Act's default rules, if used, provide a safe harbor ensuring that the LLC will be entitled to partnership tax status for Federal and State of Delaware income tax purposes.

Delaware LLCs are easily formed.  One or more persons can form an LLC by executing and filing with the Secretary of State a Certificate of Formation.  While a recent amendment to the Act permits an LLC to have only one member, caution should be exercised in selecting this option, as the Internal Revenue Service has not yet confirmed that a one-member LLC qualifies for partnership tax status even where all of the other elements are satisfied.  In addition to filing a Certificate of Formation, the members of an LLC must have either an oral or written limited liability company agreement.  Like Delaware corporations, the LLC must maintain a registered office and agent in Delaware.  However, the LLC does not need to do business in Delaware, nor must the LLC's records be maintained in Delaware.  A Delaware LLC may carry on any lawful business except for banking or insurance.  Notably, Delaware LLCs may provide professional services unlike LLCs in several other states.

Members' contributions may be in the form of cash, property or services, or a promissory note to contribute any of these in the future.  By comparison, several other states prohibit the contribution of services.  Furthermore, one can be a member in a Delaware LLC without making or being obligated to make any contribution at all.

As a default, management duties are vested in the members in proportion to their contributions, but the members may agree to elect managers, who may be members or outsiders.  Unless the limited liability company agreement otherwise provides, individual members have the ability to bind the LLC.  Profits, losses and distributions of an LLC are allocated in proportion to the members' contributions unless the limited liability company agreement provides a different allocation.  In the limited liability company agreement, members may utilize whatever classes of membership, rights and duties, and voting method they desire.

The Act provides for automatic dissolution upon events which generally terminate a partnership (that is death, retirement, resignation, bankruptcy, and so on) unless all of the remaining members consent to continue the business under a right to do so stated in the limited liability company agreement.  However, unlike other states the Act also provides that the LLC will not be dissolved upon such an event if the limited liability company agreement so provides.

Advantages of Forming an LLC in Delaware.

Many of the important features of the LPA that set it apart from similar acts in other states have been included in the Act.  Some of these advantages are ease of formation, ease of merger, freedom of contract and the Delaware Court of Chancery.

Confidentiality:  The Certificate of Formation for a Delaware LLC requires much less information than most other states and preserves confidentiality by excluding the names or contributions of the members.  Some states require the inclusion of the names of the initial managers, or members if managers are not used.  Other states go even further by requiring the names of all the members and the amounts of their contributions.  The Certificate of Formation must be filed with the Secretary of State of Delaware, but no local filing is required.

Merger:  A Delaware LLC may agree to merge or consolidate with one or more other business entities from Delaware or any other state or foreign country.  Thus, if an existing business will benefit by changing its form, it can readily convert into an LLC.  It should be noted, however, that there can be adverse tax consequences to conversion in certain circumstances.  An S corporation, for example, will likely not be able to convert to an LLC without causing the recognition of gain at the shareholder level.  Alternatively, a partnership (whether general or limited) will usually be able to convert without similar adverse tax consequences.  A tax advisor should always be consulted before conversion is undertaken.

Freedom of Contract:  Delaware's strong history of preserving the freedom of contract is maintained in the Act.  The Act specifically provides "[t]he rules that statutes in derogation of the common law are strictly construed shall have no application to this chapter."  6 Del. C. 18-1101. The Act also states that "[i]t is the policy of this chapter to give maximum effect to the principle of the freedom of contract and to the enforceability of limited liability agreements."  6 Del. C. 18-1101.  These rules of statutory construction combined with the many flexible provisions of the Act enable a Delaware LLC to adapt to the ever-changing needs of a business entity.  And to the extent that advances in the law of LLCs allow for more flexibility, Delaware LLCs will be able to take full advantage with confidence that the Delaware courts will respect LLC Agreements.

Judicial expertise: Perhaps the greatest advantage of the Act is its grant of jurisdiction to Delaware's Court of Chancery over most LLC matters.  The Court of Chancery is renowned for its expertise and fairness in adjudicating complex business issues.  Also, the Act allows members to bring derivative actions in the Court of Chancery in the same way corporate derivative actions are brought.  Few other states specifically grant members the right to file derivative action suits.