While many business owners may have been led to believe that becoming a limited liability company (LLC) is simple and easy, it is still important to proceed carefully.
Specific to the United States as a type of company that is private and limited, an LLC can be described as a business structure that combines the limited liability of a corporation with the pass-through taxation of a sole proprietorship or partnership. It helps to protect the business owners from being directly or personally liable for the company’s debts.
There exists websites and companies that claim to offer standardized, or easy, LLC operating agreements in which some blanks are filled in on a few documents and then it’s complete. In fact, there are more than a few choices that have to be determined. How the business is described, how it is to operate, and who will be responsible for the management – are all important details that need to be put to consideration first and foremost.
Before starting that LLC paperwork, decide on these considerations:
The Percentage of Ownership
While it is commonly assumed that the ownership is divided in accordance with the amount of capital contributed, it is also important to look at the proportion of work, services, equipment, or the various additional resources contributed by the other members or owners.
Determine who will make the decisions for the daily business operations. Think about who will be in charge or who will be the manager – and who has the final say, or if certain decisions will have to be voted upon. It also has to be decided and documented how decisions will be voted on, whether by majority of all members or via the percentage of each member’s ownership.
The Voting Rights of Members
Those generic forms for creating an LLC often have a clause in which, when the members are put to a vote, all of the members must be in agreement for a decision to pass. This can lead to difficulty in the event that an unhappy member decides to stop an action simply by not attending the meeting or by not voting. Be clear on this detail so as not to suffer unintended consequences later. The way voting rights are assigned to LLC members in accordance to their determined levels of contributions matters.
Representations and Warranties
When any members state that they are providing things of value, or contributing certain amounts, there are legal concerns involved. Some of the most common causes of litigation in business activities are breached representations and warranties. A representation is an assertion and a warranty is a promise of indemnity if the assertion is false. It basically means that if a representation is broken, then the member is held responsible via the warranty and obligated to give what was promised. While a generic LLC document could dictate firm clauses within the representations and warranties section, working with an attorney can help to decipher and soften the language so that it benefits the goals of the LLC organization and makes for more reasonable expectations of all involved.
Be sure that the LLC agreement is clear about calls for cash or more investment from its members. Generic form LLC operating agreements can have this information somewhat hidden within all the legal verbiage. It means that a requirement for members of the LLC to contribute additional capital – that is more than their original investment – could be activated. Determine if such a clause is needed and how it is to be managed. Unsuspecting investors in an LLC may assume that, once they have made an initial capital contribution, that they will not have to readily contribute more. The provision of a capital call, if it were to be exercised by the majority members or the managing member, could cause expulsion or dilution of ownership if one of the members cannot afford to put in at the requested time. The LLC members that negotiate the operating agreement need to be aware of such provisions and fully discuss what terms on which capital calls can be made, or if they are to be made at all.
New Members Joining or Members Leaving
Determine the rules and provisions for assigning membership to a new investor or business owner. Other members will need to be advised if there is any affect on their voting share or ownership percentage. It is also important to clearly document the steps to be taken in the event that a member of the LLC wants to divest or leave. State whether the one who leaves has to sell their interest to the other members, or if they have the option of selling to a third party outsider. Depending on the type of business or company, it may be wise to also have the departing owner sign a confidentiality agreement or a non-compete disclosure agreement (NDA).
Force Outs and Buyouts
This can be a tough area to discuss for the business owners, but the LLC members need to decide and document how or why a member may need to be forced out, or when a buyout is required – and how it is all to be handled. Unforeseen circumstances such as bankruptcy, disability, or death can happen – so it is best to be prepared as an organization.
Disagreements will happen no matter how close the team or how airtight the agreement. Determine the steps to take to solve common disputes, and employ a program option of mediation and arbitration that is to be enacted prior to any mention of a lawsuit. Effective dispute resolution does not always have to happen in a courtroom. Matters can often be resolved without business litigation by conducting alternative dispute resolution processes.
The bookkeeping and accounting is very important when it comes to any business. Consider the methods the company will use, the banking entities, the tax preparation duties, and the inspection rights of all of the member owners. The entire LLC organization needs to agree on the overall management of investments, spending, profits, and losses. Determine if profits will be distributed to the members weekly, monthly, or quarterly – and what amount will be set aside for reinvestment or used as operating capital.
Income, Loss, Interest and Taxation
The owners of an LLC must still pay taxes. The business operating agreement decides how the income and losses are to be allocated for tax purposes and these provisions are important. LLC interest may be taxable to members who provide services and others may find that taxes may be owed on undistributed profits left in the LLC bank account at year end. The LLC itself does not have to pay federal income taxes, but some states impose yearly tax. Members report business income and losses on their personal tax returns, and each LLC member pays taxes on his or her whole distributive share – whether or not the LLC actually distributes all or a portion of the money to the members.
Changes and Amendments
Develop a process in which changes to the operating agreement may be made as necessary in the future. The amendment provisions should be amicable to all members so as to inspire continuous improvement to the company. The agreement should clearly explain the method in which changes are made, and how many members must consent to such changes.
A rule that determines how a dissolution vote is to be taken, and exactly how any assets of the LLC are to be disbursed, is clearly important. Decide in advance how the provision will be managed or activated in order to avoid lengthy disputes or legal issues – in case the business owners need to close the company or the LLC members come to having irreconcilable differences.
At The Floyd Law Firm PC, our firm is committed to helping large and small business owners make educated decisions concerning company formations and agreements. We work as a team when solving problems in business situations and we understand how to protect our client’s interests.
Beware of the standard and “easy to complete” LLC agreement forms. Consider consulting an attorney with experience in business law who may help you avoid signing contracts that may not be in the best interests of all involved.