Business Formation: Forming an LLC (Limited Liability Company)
June 20, 2014
Forming a limited liability company is the focus of this installment of our series on business formation and choosing the right business structure. This article follows the one about forming a partnership. So, track back and read that one if you missed it.
What Is An LLC?
The cut-and-dried definition of an LLC is:
“A type of business organization that offers the limited liability of a corporation and the tax benefits of a partnership. The owners of an LLC are referred to as ‘members’, whose rights and responsibilities in managing the LLC are governed by an operating agreement. An LLC is legally formed by the filing of a document called the articles of organization with a state official, usually the Secretary of State.”
LLCs have certain characteristics of both corporations and partnerships or sole proprietorships, depending on the number of members in the LLC. LLCs are not corporations, though they do limit the liability of the members in a way similar to that in which corporations limit the liability of their shareholders. Unlike corporations, but like partnerships, however, LLCs can be structured to allow the pass-through of income taxation. Such legal entities are often called “flow-through entities,” “pass-through entities,” or “fiscally-transparent entities.” “Depending on the local tax regulations, this structure can avoid dividend tax and double taxation because only owners or investors are taxed on the revenue. Technically, for tax purposes, flow-through entities are considered “non-entities” because they are not taxed; rather, taxation “flows-through” to another tax return.”1
One of the most important things members of an LLC should be careful not to do is to commingle their funds with those of the LLC, because doing so weakens the veil between the LLC and its members that shields the LLC’s members from personal liability for the debts and obligations of the LLC. For additional information about the circumstances under which an LLC may be disregarded or liability might otherwise accrue to the members of an LLC for an LLC’s debts and obligations, interested parties should consult a business attorney.
An LLC is formed when its Operating Agreement is drafted and filed with [fusion_builder_container hundred_percent=”yes” overflow=”visible”][fusion_builder_row][fusion_builder_column type=”1_1″ background_position=”left top” background_color=”” border_size=”” border_color=”” border_style=”solid” spacing=”yes” background_image=”” background_repeat=”no-repeat” padding=”” margin_top=”0px” margin_bottom=”0px” class=”” id=”” animation_type=”” animation_speed=”0.3″ animation_direction=”left” hide_on_mobile=”no” center_content=”no” min_height=”none”][usually the Secretary of State]. An LLC is governed by its Operating Agreement and the LLC statute in the jurisdiction in which it was formed. The Operating Agreement is the:
“Governing contract adopted by members of a Limited Liability Company (LLC). It may be used to regulate nearly all aspects of the LLC’s affairs, including how the business is managed, how assets are used and how revenues are shared. An operating agreement will override any default rules presented by a state LLC statute, which controls in the absence of an operating agreement.”2
It is critical that your Operating Agreement reflect the unique organizational, financial, legal, and structural aspects of your business. Having a “one-size-fits-all” Operating Agreement is a bad idea, because usually one size does not fit all. When deciding how you are going to spend money to start a your company, spending good money to have a well-drafted Operating Agreement created by competent business attorney for your business is one of the best choices you can make.
In most jurisdictions within the United States, there are generally four major kinds of LLCs: LLC, PLLC, Series LLC, and L3C.
The “Standard” LLC
The standard LLC is the one described above in the “What is an LLC” section of this article.
In short, PLLCs are LLCs operated by licensed professionals in states where such operations are permitted. More specifically stated:
“A Professional Limited Liability Company (PLLC, P.L.L.C., or P.L.) is a limited liability company organized for the purpose of providing professional services. Exact requirements of PLLCs vary from state to state. Typically, a PLLC’s members must all be professionals practicing the same profession. In addition, the limitation of personal liability of members does not extend to professional malpractice claims.”3
Unless you have a professional license–such as a license to practice medicine, a license to practice law, a CPA license, etc., etc.–you should not consider forming a PLLC. Some jurisdictions, like California, do not permit LLCs to practice a licensed profession. For additional information about whether a PLLC is right for your business please consult a business attorney.
The Series LLC
A Series LLC is sometimes chosen by asset investors, like real estate investors, because the unique Series LLC structure “allows a single LLC to segregate its assets into separate series. For example, a series LLC that purchases separate pieces of real estate may put each in a separate series so if the lender forecloses on one piece of property, the others are not affected.”4 Typically, a Series LLC is not going to be ideal for the average business owner and is selected only by investors in large, individually expensive–and sometimes volatile–assets.
The low-profit limited liability company (“L3C”) form was designed for “use as a potential vehicle for any definable revenue stream generated for a socially beneficial purpose.”5 Social entrepreneurship firms are what many first think of when they think of L3Cs. There are relatively few L3Cs in operation in the U.S., and it is a comparatively “young” form of LLC, the first one having been formed in Vermont in 2008. According to the Americans for Community Development:
“The L3C embodies the operating efficiencies of a for-profit company along with a reduced regulatory structure. As an LLC, it can bring together foundations, trusts, endowment funds, pension funds, individuals, corporations, other for-profits and government entities into an organization designed to achieve social objectives while also operating according to for-profit metrics.”
The L3C is not going to be a great fit for many companies, but for those who focus on Doing Well By Doing Good–and for those who make program-related investments (PRIs) in such companies–the L3C can be an exceptionally beneficial business structure. The question you should ask yourself is: which is your focus–making a profit or accomplishing some socially beneficial purpose while, at least, breaking even from your enterprise’s primary revenue stream?
Why and How to Form an LLC
The best reason to consider forming an LLC vs. forming a corporation, partnership, or some other form of business, is because of the flexible, yet resilient, structure of the LLC form. An LLC’s Articles of Organization, and to a greater extent its Operating Agreement, can clearly define many different roles and positions within your business. If you simply need to maximize the limitation of your liability, you may prefer a corporation. If you simply want an extremely nimble pass-through taxation entity, a partnership or an LLP might be a better choice for you. If, however, you need to balance your competing interests in remaining nimble while achieving a reasonable degree of liability limitation with respect to your members, an LLC is likely to be a good choice.
Forming an LLC starts with having a competent business attorney draft your Articles of Organization and your Operating Agreement. You should have an actual attorney draft these important document. Do not try to Do-It-Yourself (DIY), because you will not correctly draft these documents, and the mistakes you make can cost you more in the long run than it would cost you in the short term to have a competent business attorney do it correctly for you.
Getting your Articles of Organization and Operating Agreement from some website or “legal service” online is an equally poor choice, because such document dumps basically have the same relation to an actual law firm that the Salvation Army has to a retail store like Macy’s. You’re going to get something used that was designed for someone else or was designed to be a one-size-fits-all solution, but that does not actually meet your needs, because it was not designed specifically for your business with your business’s unique legal concerns in mind. Perhaps worse, at some point in the future, if you have a problem, there is no one for you to hold accountable, and you are still likely to spend even more money on having an attorney untangle your DIY / template Articles of Organization and Operating Agreement than you would have spent having a competent business attorney draft them in the first place. Do a favor for Future You, and don’t cut corners. Have a competent business attorney draft your Articles of Organization and Operating Agreement correctly the first time.
Other Considerations When Forming an LLC
Every LLC will have an interest in establishing a strong trade name, often the most visible part of a business’s brand aside from its logo. LLCs, like other business entities, can use trade names that do not include the names of the members. Registering your LLC’s trade name with the Secretary of State in the state in which you do business may be necessary. In some states, like Tennessee, it is not necessary to register your LLC’s trade name with the Secretary of State, but it may still be desirable to do so. You should consult a business attorney to help you make this decision.
You should also have your business attorney get an Employer Identification Number (EIN) from the Internal Revenue Service (I.R.S.) for your business. The LLC’s members will want to use the EIN to open bank accounts and other accounts in the name of the business. Like any business, an LLC should maintain separate business accounts for operations, payroll, etc.
Having both an accountant and a business lawyer as part of your team are essential, even if you cannot afford to put either on your payroll. An attorney who serves as “general counsel” is the chief lawyer for a business; if that lawyer is independently contracted, and not on the business’s payroll, he is said to be “outside general counsel” for the business. Outside general counsel services are crucial to a business’s success, because legal services are necessary for every business, and are one area where cutting corners will usually result in expensive problems later. Taking a proactive, preventive approach to your legal issues can seem costly, but the preventive approach is often far less expensive than the alternative—litigation. Obviously, unless you’re a CPA, you also need an accountant for similar reasons. It’s better to pay a little for bookkeeping services in advance than pay a lot when you get audited, later.
In addition to reiterating the need for having both outside general counsel and a CPA on your team, is the necessity of a written business plan. A business without a written business plan is like an ancient sailing ship on the high seas without a map. It might be a sunny day with wind in your sails when you start out, but a storm is coming, and you’re going to get tossed around a bit. You better have a way to figure out where you are when that happens. A well-written, thorough business plan will keep you oriented on your priorities and help you stay on track, come what may.
The Series Continues
Please bookmark www.ExecutiveLP.com and return over the next couple weeks as we continue the discussion on our blog about choosing the proper form or structure a business can take. If you need legal counsel—and we believe every business does—please contact Executive Legal Professionals and let us know what concerns you have. We will quickly follow-up with you and do all we can to see your legal needs are efficiently and effectively addressed by a qualified legal professional. If your need is urgent, please call Executive Legal Professionals at +1.615.669.6566.
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