Organizing Or Cleaning Up an LLC

Vol. 1, No. 3

Jean L. Batman founded Legal Venture Counsel, Inc. in 2004 to provide outside general counsel services to investors, entrepreneurs, and small businesses. Prior to forming Legal Venture Counsel, Ms. Batman was a Partner in the San Francisco offices of Duane Morris LLP, one of the country’s 100 largest law firms. As outside general counsel to a variety of companies and individuals, Ms. Batman provides business and financial legal services to privately held entities operating in a broad range of industries including real estate development, financial and professional services, manufacturing, software, retail, biotechnology/specialty pharmaceutical, and high technology.

 

From the book Advising the Small Business

 

What Is the Basic Structure of a Limited Liability Company?

The owners of the LLC are the “members” as defined in your state’s Limited Liability Company Act (the “Act”). The LLC may be managed by its members, or it may be managed by one or more managers elected by the members (the “managers”). The governing agreement for the LLC is called an “Operating Agreement” or “LLC Agreement.” In a member-managed LLC, each member has the power to bind the LLC. However, in a manager-managed LLC, no member has the power to bind the LLC (just as no shareholder of a corporation can bind the corporation); only a manager or authorized officer of the LLC can bind the manager-managed LLC.

The principal distinguishing feature of an LLC is the limitation of liability that the members of the LLC enjoy (like a corporation), as well as the pass-through income tax treatment enjoyed by the LLC and members (like a partnership). So long as the LLC is properly formed and in existence, and is properly operated, the members will not be personally liable for the LLC’s debts, obligations, and liabilities. In other words, if the LLC’s debts exceed the value of the LLC’s assets, the LLC’s creditors should not be entitled to seek repayment from the members’ personal assets.

Of course, a personal guarantee of an LLC obligation by an LLC member would give rise to personal liability of that member to the extent specified in the guarantee (as it would for a shareholder in a corporation). Failure by a member to remit employee withholding taxes can provide another basis for personal liability of a member (as it would for a shareholder in a corporation). Liability based on the personal tortious behavior of a member would of course provide the basis for personal tort liability of that member (as it would for a shareholder in a corporation). But generally, the LLC liability shield, like the corporation’s liability shield, should protect individual members from LLC debts, obligations, and liabilities.

 

What Are Membership Interests?

Membership interests are LLC members’ entire interest in the LLC, including the members’ economic interest in the company as well as their noneconomic rights, such as the right to vote or participate in the management of the company and the right to receive information concerning the company’s business and affairs.

 

What Are Economic Interests?

An economic interest is the right to receive distributions and allocations of profits, losses, income, gain, deduction, credit, and similar items of a financial nature from an LLC. However, an economic interest does not include any other rights of members, including—without limitation—the right to vote or participate in the management of the company, except as otherwise provided in the applicable LLC Act.

 

Should a Specific Number of Membership Interests Be Authorized?

In a manager-managed LLC (i.e., one in which some or all of the members are not involved in management), establishing a number of authorized membership interests (or “Units,” “Shares,” etc.) can be used as part of a structure that permits managers to admit new members without the need for member approval, much as authorized but unissued stock can be used by the board of directors of a corporation without the necessity of shareholder approval.

 

What Is the Role of a Member?

The members own the LLC and provide the capital with which the LLC commences its business. In a member-managed LLC, members by definition manage the business of the LLC. In a manager-managed LLC, members as a group often do not take an active role in running the business. Normally one or two members will be intimately involved in day-to-day operations of the LLC, and other members will be passive, nonacting investors. Beyond electing the managers and voting on certain key events in the LLC’s life, the members of a manager-managed LLC entrust management of the LLC to the managers (much like the shareholders of a corporation entrust management of the corporation to the directors and officers of the corporation).

The role of the members will depend on whether the LLC is member-managed or manager-managed. Whether held by members or managers, management duties include decisions about key policies, LLC transactions, and establishment of guidelines within which the business of the LLC will be conducted. The members can hire officers and employees to perform the LLC’s day-to-day business.

Whether the LLC is member-managed or manager-managed, certain matters under the Act must be submitted to the members for approval. For example, certain fundamental changes in the life of an LLC, such as a merger or liquidation of the LLC, require a vote by the members. These fundamental changes include amendment of the articles of organization, amendment of the operating agreement, merger or consolidation of the LLC, and winding up and dissolution of the LLC. The LLC’s operating agreement may designate additional matters requiring member approval to ensure that the members are in agreement on designated “major decisions.”

 

What Is the Role of a Manager?

Managers are elected by the members. At the outset managers can simply be specified in the operating agreement, which is of course approved and signed by all members. Thereafter, if the operating agreement so permits, members can hold annual or other regularly scheduled meetings to elect managers. Management duties include decisions about key policies, LLC transactions, and establishment of guidelines within which the business of the LLC will be conducted. Managers may perform these responsibilities themselves, or these responsibilities can be performed by officers and employees under the direction of the managers.

In performing these responsibilities, the LLC Act imposes on managers the same fiduciary duty with respect to the LLC and its members that a general partner owes to a general partnership and the other partners of that partnership. It is permissible to modify and otherwise refine the fiduciary duty of the manager in the operating agreement. Indeed, it is advisable to do so. Typically the operating agreement will specify fiduciary duties such as the “duty of loyalty” and the “duty of care” for LLC managers.

The duty of loyalty dictates that a manager must act in good faith and must not allow personal interests to prevail over interests of the LLC and the LLC’s members. A standard example raising these issues is a proposal for the LLC to enter into a transaction that either benefits a manager or involves the manager in a conflict of interest between the manager and the LLC or its members. Such transactions are often called “self-dealing” transactions. They are not prohibited, but such transactions must be predicated upon (i) full disclosure, (ii) proper approval from disinterested managers and members, and (iii) fairness to the LLC and its members.

The duty of care requires a manager to be diligent and prudent in managing the LLC’s affairs. This is sometimes referred to in corporate law as the “business judgment” rule. If a manager makes a decision, conscientiously and without fraud or conflict of interest, such manager will not be second-guessed by courts based on how that decision happens to work out for the LLC. A manager is not held liable merely because a carefully made decision turns out badly.

Like a corporation, the LLC members and managers can appoint officers for the LLC who serve at the pleasure of the managers, subject to contracts of employment (if any) such officers may have with the LLC. The officers perform the bulk of the day-to-day operation of the LLC’s business. Normally an LLC will want at least a general manager (or president), a chief financial officer, and a secretary. More than one of these offices can be held by the same individual. An LLC may have additional officers. These additional officers are either appointed by the general manager or another officer if such officer has been delegated authority to make such appointments. A summary of the standard duties of LLC officers is set forth in sample Form 7 A, First Correspondence to a Newly Formed LLC, any part of which could be modified by the managers.

 

What Formalities Must Be Observed?

Unlike the situation for a corporation, the observance of corporate formalities is not an important part of maintaining the shield from liability and other protections and advantages offered by the LLC form of doing business. The term “corporate formalities” normally means holding annual (or other regularly scheduled) meetings of the members and managers, providing written notice in advance of such meetings, preparing detailed minutes of matters decided upon at such meetings, and so forth. The LLC Act specifically states that the failure to observe such corporate formalities “shall not be considered a factor tending to establish that the members have personal liability for any debt, obligation, or liability of” the LLC where the articles of organization or operating agreement of the LLC do not specifically require such formalities to be observed.

This does not mean that LLC members are completely free to ignore the separate legal identity of the LLC. For example, members must always keep in mind that the LLC assets and funds are in the name of and owned by the LLC, not by the LLC’s members. Separating LLC assets from personal assets of the members is important.

 

1. Documentation of Policies and Major Decisions

Matters of general operating policy should be considered and authorized by the general manager or the managers of the LLC. Although there is no statutory requirement with respect to how frequently the managers should act, it is advisable that the managers meet at least quarterly. In addition, a specially convened meeting of the managers may be called if action is required before the next regular meeting of the managers. Action by the managers may also be taken by the unanimous written consent of the managers. Although it is likely that most manager actions will be taken by unanimous written consent without a meeting, it may prove useful to schedule regular managers’ meetings to address significant matters that have arisen on a quarterly—or, at least annual—basis. Manager meetings can be held either in person or by conference telephone so long as all managers in attendance can hear each other simultaneously.

Matters appropriate for manager action—which can be immediately approved by written consent or which might arise and be accumulated, pending approval by the managers—include the following:

 

  1. Appointment of officers, setting of salaries, and declaration of bonuses (at least annually, typically at a meeting of the managers immediately following the annual meeting of members).
  2. Appointment of manager committees, if any.
  3. Opening of LLC bank accounts and the designation and change of LLC managers and officers authorized as signatories.
  4. LLC borrowing and delivery of collateral in connection with such borrowing.
  5. Consummation of material contracts for the purchase or lease of significant assets or services or the disposition of LLC assets or for the rendition of services outside the ordinary course of the business of the LLC.
  6. Policy decisions with respect to the construction of material assets or the investment of material amounts in research and development projects.
  7. The adoption of pension, profit-sharing, bonus, and other employee benefit plans.
  8. The repurchase of LLC interests.
  9. Amendment of LLC bylaws (if any).
  10. Review of financial statements of the LLC.
  11. Appointment of auditors, if any.
  12. Any action that requires a member vote.
  13. The issuance and sale by the LLC of additional interests in the LLC.

 

In the case of any such actions, the secretary of the LLC should prepare minutes of the meeting at which such actions were approved or prepare the form of written consent evidencing any such manager or member actions.

 

2. Separation of Personal and Company Assets

It is important for any company to respect the difference between the company’s bank accounts, property, equipment, and other assets and personal assets owned by the company’s owners. An LLC, like a corporation or other legal “person,” is a separate legal entity with assets that are owned by the LLC. Any attempt by an LLC member to dispose of or use LLC property would be no more proper than an attempt by that member to dispose of or use another member’s personal property. Members must respect the fact that the LLC’s assets are the property of the LLC, not the members. Similarly, an LLC member should not intermingle such member’s personal assets with the company assets of the LLC.

The company’s books, records, and financial statements should be maintained clearly to reflect the separation of the company’s assets from the personal assets of the members. The company must conduct business in its own name (not in the individual name of any manager or member). All letterhead, business cards, bills, checks, invoices, and other company forms should show the company’s full legal name (and fictitious business name, if any) and the company’s current address, telephone number, and telefax number.

As a statement of sound business practice, the observations made about separation of personal assets from company assets are fairly obvious. There is an additional, less obvious reason to follow those rules.

Creation of an LLC shield from liability for LLC members inevitably gives rise to attempts to pierce that shield by creditors of the LLC. This has long been the case for the liability shield of corporations. As long as there have been corporations, there have been attempts to “pierce the corporate veil.” Published cases in which such attempts have been successful usually involve a recitation by the court of a dozen or so factors in support of the court’s ruling that the shareholders of the corporation should be held personally liable for the debts, obligations, or other liabilities of the corporation. At the top of this list of factors are (i) failure by the shareholders to respect the corporation’s separate identity (by intermingling corporate and personal assets) and (ii) some other form of misconduct by the shareholders with respect to the corporation.

Although the failure of an LLC to respect corporate formalities generally cannot be considered a factor “tending to establish that the members have personal liability” for any LLC debt, obligation, or liability (see the earlier discussion regarding observance of corporate formalities), this is not to say that LLC members can ignore the many years of corporation law developments in this area. LLC members and managers are well advised to bear in mind the foregoing observations about piercing the corporate veil.

 

3. Adequate Capitalization

The company should be adequately capitalized to carry on the company’s business activities. This is of course an obvious statement of sound business practice. A less obvious reason to assure that the company is and remains adequately capitalized concerns the case law, discussed above, related to piercing the corporate veil. One of the factors enunciated by some of the courts that have ruled that creditors of a corporation should be allowed to hold the shareholders personally liable for debts and obligations of the corporation is that the corporation was not adequately capitalized. Hence, adequate capitalization is an additional, important factor relating to the shield from personal liability provided by the LLC for its members.

 

4. Signing on Behalf of the LLC

Whenever the LLC members, managers, or officers are signing agreements, documents, or correspondence on behalf of the LLC, care should be taken to include the LLC’s name in the signature block and to indicate the title of the person signing. An example of an appropriate signature block is included below:

 

[LLC name]

 

By:

 

Name: [name of individual]

 

Title: [Member, Manager, etc.]

 

Failure to include the LLC’s name in the signature block may lead, in the context of litigation involving a signed document, to including the person who signed the document in the lawsuit in his or her individual capacity.

 

5. Bylaws

The operating agreement and articles of organization of the LLC are the authoritative source of advice as to how to do certain things that will come up from time to time. For certain types of LLCs (normally those with a larger number of members), a form of bylaws similar to those applicable to a corporation may be advisable or useful.

 

6. Official Documents

A number of small LLCs have found it useful to designate one of the officers, usually the secretary, to be the recipient of all “official” correspondence concerning the LLC and its relationships with the various government agencies with which it deals. This helps to avoid forgetting to submit certain of the regularly filed forms, such as the annual statement of information and designation of agent for service of process, which are simple documents but can lead to trouble if they are not taken care of promptly.

 

What Are the Tax and Regulatory Obligations of an LLC?

 

1. Taxes

Federal and state income tax returns must be filed on or before the fifteenth day of the third month following the close of the taxable year, unless a timely extension to file is obtained. LLC members may be required to pay estimated federal income tax in installments (like a general partner in a partnership).

The LLC will be subject to an annual minimum franchise tax in each state in which it is organized and in each state where it is qualified to do business. The LLC may be subject to other state tax matters—such as the State Graduated Gross Receipts Fee, which is due in addition to the annual $800 franchise tax an LLC must pay in California.

The LLC will be required to withhold income tax and social security tax from taxable wages paid to its employees and deposited periodically with the appropriate Federal Tax Deposit Form. An Employer’s Quarterly Federal Tax Return (IRS Form 941) must then be filed before the end of the month following each calendar quarter. Any manager, officer, or other person obliged to withhold taxes may become personally liable for a 100 percent penalty if he or she fails to pay the withheld funds to the Internal Revenue Service.

The LLC may also be required to withhold state income tax from its employees’ taxable wages.

 

2. Renewals

Legal requirements, such as annual state filings and payment of annual fees in each state where it is qualified to do business, are required to maintain an LLC in good standing.

 

3. Employer ID

Every new employer must obtain a Federal Employer Identification Number (FEIN), which will be used on partnership information returns and certain other documents. A FEIN can be obtained by application to the Internal Revenue Service on Form SS-4.

 

4. More Taxes

If the nature of the LLC’s business includes the sale at retail of tangible personal property (goods), then the LLC may be subject to sales and use taxes and need to obtain a seller’s permit from the appropriate authority, such as [the California State Board of Equalization]. If the LLC owns significant personal property, it may be required to file a property statement with the county assessor and may be subject to a personal property tax. Forms may be obtained from the county assessor.

 

5. Business Licenses

Most municipalities require that businesses within their jurisdictions obtain a local business license.

 

6. Industry Regulation

Numerous regulated businesses cannot lawfully be conducted without special licensing or permits (e.g., general contractors, insurance sales, and cosmetologists). Make sure you know what regulatory requirements are unique to your business.

Although it is not intended to be exhaustive, the checklist included in Form 7 A, First Correspondence to a Newly Formed LLC, summarizes some of the legal requirements applicable to a new LLC. Some of the requirements arise as a consequence of forming the LLC; others apply to all new businesses regardless of the form of organization. Certain requirements are highly formal and technical; many must be satisfied within a specified time period. Care must be taken to comply with these matters as they arise because in many cases serious penalties can be assessed for failure to comply.

Advising the Small Business Book Cover

 

Advising the Small Business

 

Did you find this article helpful? Do you think more information like this would help you? More information is available. This material  is excerpted from Advising the Small Business, 2011, by Jean L. Batman, published by the American Bar Association General Practice, Solo and Small Firm Division. Copyright © 2011 by the American Bar Association. Reprinted with permission. All rights reserved. This information or any or portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. GP/Solo members can purchase this book at a discount.

 

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