Over the last 20 years, limited liability companies have become the preferred way of doing business for many small and medium-size enterprises. That is primarily due to the fact that LLCs are easier to form than corporations. Unfortunately, that simplicity lulls many people into trying to do it themselves or working with forms provided online. Sure, if your LLC is only going to operate a kid’s lemonade stand for a couple of months over the summer, that might be good enough. But for most people engaged in real businesses with significant risks, it’s not.
A little background may help to explain what I mean. LLCs, like corporations, are mechanisms for shielding the people that own these LLCs and run the businesses from being personally liable for their activities, especially if things go badly. Thoughtful people may ask: why is that? Why shouldn’t you be personally liable for your own actions?
The answer is that states all have adopted LLC statutes which are meant to encourage people to start and run businesses without exposing themselves to personal liability. The catch is that there are many rules and traps for the unwary, so if you do something wrong, you may not have that liability protection just when you need it most. Here are a few of the basics that you should know to avoid that fate.
LLCs need Members. Members are the same as shareholders in corporations. While it is easy to start an LLC, you need to issue membership interests when you form the business, so as to avoid arguments later as to who owns what. Try to avoid issuing equal membership interests (such 50/50) so that unanimous agreement is not required to make a decision.
Evidence of ownership. Corporations issue stock. LLCs issue membership interests. They are quite similar – written certificates identifying your ownership of all or a portion of the LLC. Come the day that you might want to sell an interest in your business or even the entire business, having membership certificates will be crucial. A business that I represented a few years ago never issued certificates. When we went to sell the business, there was nothing to transfer to the new owners. We had to go back and document all the changes in ownership over a period of 10 years and issue certificates to cover them—just for the purpose of being able to sell the business.
LLCs need to have Operating Agreements. Operating Agreements take the place of bylaws and shareholders agreements for corporations. If you’re starting a business by yourself (commonly referred to as a “single-member LLC”), then a streamlined Operating Agreement may be sufficient. If more than one person is involved, the Operating Agreement will be much more complex. It will need to cover things such as how much of the business each person owns, how are profits or losses divided and who gets to vote on what. What happens if you hate your fellow members or if someone dies?
Capital contribution. Is the amount of money that you are investing in your new business adequate for the risks that are going to be assumed? Many people form their LLCs and show little or no investment of personal funds. However, if you’re going to be signing a lease, buying inventory, hiring employees or signing contracts, there is a practical need and a legal requirement for a financial cushion (capital) that is proportionate to those liabilities. If there isn’t, your creditors can argue that you personally benefitted from the business and undercapitalized it to their disadvantage.
Timely filings with the state in which the LLC was formed. Maryland and Virginia require annual filings. In the District, it’s every two years. If you fail to make this filing and to pay the required fee, then your LLC’s charter will be revoked and your LLC will be no longer be recognized. You would be wrong if you think this is uncommon. Each state in which I practice revokes thousands of charters every year. It’s why we try to monitor our clients’ filings closely.
As complicated as some of this sounds, I have only scratched the surface of these issues in the confines of this article. Please feel free to contact me by phone at (240) 778-2330 if you need more specific guidance on any of these topics.
