Limited Liability Companies: Important Considerations to Make from Beginning (Part 2)
In my first post for the Biz Law Blog, I discussed the benefits of choosing a Limited Liability Company (“LLC”) as the entity for your business. In this post, I will discuss some important considerations for you when starting your business.
There are two basic structures of an LLC: single member and multi-member. The names of the structures are self-explanatory, but there are some significant differences between the two for you to consider. Additionally, state laws that govern LLCs must be considered when forming an LLC and drafting its operating agreement.
Although operating agreements are not required by many states, including Pennsylvania, we always advise LLC clients, especially LLCs with multiple members, to draft an operating agreement to govern the LLC. A single member LLC many not need an operating agreement initially, as the sole member is operating the business and making all decisions by itself, but it will become necessary in the future if any new members are admitted. Regardless, many other areas of the business world may require an LLC to have an operating agreement, such as a lender providing financing to an LLC.
For an LLC, the operating agreement is the controlling document of the business and is the equivalent of bylaws. Below are a few important topics to be covered in the operating agreement to avoid issues and document remedies for those issues that arise in business. The operating agreement should be amended to add and remove any members as needed, to make sure that all members are governed by the same terms without confusion. Keep in mind too that state laws can control certain aspects of your business where the operating agreement is silent. This is important, because that may not be what was intended by the members.
In a single member LLC, the sole member, whether another entity or an individual, has operational control over the LLC. However, in a multi-member LLC, the LLC can be member-managed or manager-managed. If an LLC is member-managed, the operating agreement must specify which members have management control. If a manager-managed LLC is chosen, the manager(s) (who can be members or not), manage the day-to-day operations of the LLC. The operating agreement can also limit the manager’s power and specifically require certain decisions to be made by a specified vote of the members.
Transfer of Interest or Withdraw
In a multi-member LLC, the members must decide how their ownership interests can be transferred and whether they can voluntarily withdraw. This is important because otherwise, you could be with someone you never intended to have as your business partner. You can choose if you want the business or other members to have a right to match any offers made for a member’s interest, and how interests are transferred upon the death or disability of members. Finally, the operating agreement should address the voluntary withdrawal of a member. This is important because a member could choose to withdraw, remove its capital from the business, and leave the LLC with a negative financial situation.
The operating agreement should discuss how and when distributions are made to the members. Improper distributions will be trouble for the owners. Additionally, having a mechanism for how distributions are calculated and made is a great way to avoid any potential issues among members if there is a disagreement or dispute.
With an LLC, several tax selections can be made. Initially, a single member LLC is taxed as a sole proprietorship, and a multi-member LLC is taxed as a partnership by default if no other tax election is made. By default, neither entity pays taxes on business income because the incomes and losses are passed through to the members. However, each LLC can make an election with the IRS to be taxed as a c-corp or an s-corp. We will discuss these and their impacts on the operating agreement in a future post.
Capital Contributions and Admission of New Members
There comes a time in many businesses when additional capital is needed, or they are seeking investors. The LLC’s operating agreement should discuss how and when this should be accomplished. Moreover, if an LLC needs additional capital and the members do not want to dilute their interests by admitting new members, the operating agreement can control the process on how capital is raised from the members.
This is not a popular discussion item, but the operating agreement should also cover the process of bringing the LLC to an end. Although the winding up of an LLC is not always adversarial, if one member of an LLC wants to dissolve it and the other member does not, the operating agreement can control that process.
If you are considering starting an LLC, feel free to reach out at my contact information below to discuss how I can assist you with the process.
This blog post is Part 2 of a two-part series on the Biz Law Blog on LLC’s. View Part 1 of the series, “Limited Liability Companies: Easy to Set-Up and Worth it to Protect You and Your Business”, here.
If you have any questions about this post or any other related matters, please email the Business Law Practice Group Co-Chairs, David Blatteis at email@example.com, Dolores Laputka at firstname.lastname@example.org, or Graham Simmons at email@example.com.