As a possible sign of economic recovery, new business filings in Colorado in the second quarter were (not surprisingly) up substantially over 2020. And the most common type of new business entity being formed continues to be a limited liability company — an LLC.

People (even lawyers, who should know better) still call these entities “limited liability corporations,” but that’s not correct. Although LLCs have some things in common with corporations — notably a limitation on personal liability of the owners — corporations tend to be more formal and less flexible than LLCs. And corporations, unlike LLCs, may themselves be taxpayers.

In Colorado, LLCs are governed by a statute called the Limited Liability Company Act. They are created by filing online with the Secretary of State’s Office a short document called articles of organization. Although the act is complex and detailed, it is a default statute, meaning most of its provisions only apply if the owners of the LLC — called “members” — have not come up with their own set of rules for how their company will be organized and operated. The members do this through a document called an operating agreement, which serves as a contract between and among the company and its members. The act does, however, set some limits on the contents of an operating agreement. For example, an operating agreement cannot negate a provision in the act stating that members of an LLC owe the company a duty of good faith and fair dealing. Operating agreements, unlike articles of organization, are not filed with the secretary of state and are not a publicly available document.

The act allows LLCs to be managed on a day-to-day basis by the company’s members or by one or more managers. Most LLCs take the latter path and appoint managers to run the company. The members nonetheless reserve the right to make major decisions, such as taking out a loan or purchasing real estate.

As indicated above, LLCs themselves don’t pay income tax. They are a pass-through entity, meaning that each member of the company has a sharing ratio, and the company’s profit (or loss) passes through to the members based on these sharing ratios. The members then include the profit (or loss) allocated to them on their personal tax return. This pass-through allocation is made using an IRS form called a K-1. The LLC will issue a K-1 to each of its members at the end of the year.

So what’s the importance of conducting business through a legal entity that has limited liability? Well, let’s say you own 100% of Crazy Sports, LLC, a company that manufactures ropes used in bungy jumping. You have $50,000 invested in this business. Unfortunately, unbeknownst to you or anyone else, and not due to anyone’s negligence, a few of the ropes manufactured by this company have a little too much stretch in them, resulting in shortened careers for several bungy jumpers. Their heirs sue Crazy Sports, LLC for $6,000,000,000, the company goes broke and you lose your $50,000 investment. However, because of limited liability, that’s all you lose. Your house, car, children’s winter coats, baseball card collection, checking account, etc. are protected from the wrath of the company’s creditors. (To be thorough about this, the owners of an LLC, and all other limited liability entities, can still be sued for their own personal negligence or intentional misconduct that causes injury to another person or another person’s property.)

If you think you want to set up an LLC, you should see a lawyer knowledgeable about business associations. Creating an LLC, especially if it will have more than one member, should not be a do-it-yourself undertaking. Although articles of organization are simple, operating agreements are not.

Jim Flynn is with the Colorado Springs firm of Flynn & Wright LLC. You can contact him at moneylaw@jtflynn.com.