Limited liability companies have become the go-to entity type for many new business owners and entrepreneurs. Whether opening a hair salon, tutoring as a side hustle, joint venturing on a real estate investment deal, or structuring a hedge fund, limited liability companies (“LLCs”) are the most commonly used entity type for many businesses.
With good reason, first formed in Wyoming in 1977, LLCs are the ideal entity type in most situations. LLCs are known to be the hybrid between a corporation and partnership. LLCs afford their owners, called members, the benefits of a partnership and corporation without having to meet the complex formalities or maintenance requirements it takes to register, fund, and operate a corporation; like reporting board minutes. Nonetheless, it is important to determine for your particular business, would an LLC, Corporation, or Partnership be the best fit. An LLC does not fit all situations. Depending on the business’s operation model, financing strategy, owner’s exit plan, and other factors, many considerations must be taken into account before deciding an LLC is conducive to an owner’s vision and goals.
One of the most attractive benefits to an LLC is that they provide their members with protection from personal liability against company debts or claims. Just like a corporation, an LLC is a business entity that is separate from its owners. Unlike a corporation, which must pay its own taxes in addition to shareholder dividends, an LLC is typically a "pass-through" tax entity where the profits and losses of the business pass through to its owners, who report them on their personal tax returns just as they would if they owned a partnership or sole proprietorship. Owners of limited liability companies enjoy the limited liability factor of their company. Whatever debts or liabilities are created by the business entities become the responsibility of the company, not its owners. For instance, if an LLC defaults on a business loan, the owners are not personally liable for picking up the tab. (Unless of course the owner personally guarantees the loan.) Let’s consider another example – A grocery store owner who operates their business under an LLC wouldn’t normally be personally liable for slip and fall accidents that occur within the store.
Though LLCs provide their members with great protection, it is not absolute. Since the inception of LLCs, many courts have allowed what the legal world terms, “piercing the corporate veil,” in instances where a failure to follow corporate formalities and maintain proper operation is not adhered to. You also find many business owners unaware of the best use practices with forming and operating an LLC. The following will list some, though not all, of the common mistakes and oversights to avoid when forming and operating an LLC.
Follow proper filing formalities:
It is important that proper filing formalities are followed. Courts have many times permitted piercing corporate veils when certain formalities are not followed. Most often, you can find the instructions to forming an entity on your respective jurisdiction Secretary of State website. Some of the common steps to forming the LLC are:
- Determine who will be your registered agent (person who receives service of process for the company)
- Publication requirement - i.e., New York
- Pay formation fees
- Pay renewal annual fees
Hire an attorney:
It is important to understand the nuances of your industry. Every industry is different. Having the proper paperwork in place, drafting a solid operating agreement, and obtaining the necessary licenses for your line of work are critical to meeting any industry specific requirements. Hiring an attorney who not only knows the proper steps to forming the entity but the special circumstances that may be applicable to your industry is important.
Act fairly and legally:
Do not conceal or misrepresent material facts or the state of your finances to vendors, creditors, or other outsiders.
Don’t comingle business and personal assets:
Invest enough cash in the business so that your LLC can meet foreseeable expenses and liabilities. Being able to prove to any jury that you’ve maintained an operable business that consistently pays expenses and generates revenue is one way to establish legitimacy. Doing so while also keeping your business books separate from your personal finances is critical to maintain the separate existence of the LLC. Get a federal employer identification number, open up a business-only checking account, and keep your personal finances out of your LLC accounting books.
Obtain an operating agreement:
Having a formal written operating agreement lends credibility to your LLC's separate existence. The operating agreement is one of the most neglected aspects to owning and operating an LLC. Too often business owners and entrepreneurs would overlook this step or decide it is not necessary to have an operating agreement because they are the sole owner or they simply obtain one online. That is a big mistake. A properly drafted operating agreement is the central nucleus to your business.
You must know (1) What is in or (2) What is missing from your operating agreement.
- No member managed:
LLCs can either be members managed or manager managed. For most companies, it is ideal to have a manager managed LLC. A member managed LLC puts all exercise of control in the hands of the members. Every major decision will need to go through the members or board of members. A manager managed LLC affords the flexibility of either hiring out a manager to oversee the day-to-day of that company. Additionally, with most state filing you aren’t required to disclose the members of the LLC. For absolute anonymity, you can hire out the manager or shield your identity through another entity that serves as the manager.
- Forced distributions:
As an LLC owner you can distribute money to yourself, pay yourself by the hour, or salary. Provisions that require the company to distribute the profits on an annual basis to its members or distribute enough to cover their tax liability sound great, but can allow a judgement creditor to force distribution simply because it is enumerated within the operating agreement.
- Non-Pro Rata distributions:
If there are multiple members in your LLC, you don’t want to be required to give equal distributions. Let’s say you have a partner who has a charging order against them, or they’re going through a divorce, but yet you need a distribution to make another business investment, you’d be precluded by your operating agreement. If it is pro rata distribution and available is $100k, you could be obligated to give half of the distribution to your partner. However, the tax classification of your LLC may require you to make pro-rata distributions, so it’s important to work with an attorney and accountant when making these decision.
- Restrictions on transfer.
You want to restrict who can become a member of your LLC. In the event of a creditor or for estate planning purposes, you want to know who you’re getting into business with. Incorporating provisions to require members consent is more common and practical practice.
Structuring your business properly can save potentially thousands of dollars in attorney fees and having to deal with creditors coming after your hard-earned money. The well-oiled machine only works if it is protected. Being proactive with Asset Protection is the wise decision. At The Presser Law Firm, P.A., we specialize in building the best infrastructure to house our clients’ assets. Tailored to each individual’s goals, we can guide you and make your assets resistant to creditor claims. The Presser Law Firm, P.A. can be the architect to your well-oiled machine. Give us a call today.
