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The limited liability company (or LLC) is a popular entity choice for many small businesses, but owners may have questions about what it means to own and operate an LLC.
Publications attorney Sandra Feldman cuts through the legal jargon and provides straightforward explanations of what an LLC is in the eyes of the state, the entity’s main benefits, the owner’s basic legal responsibilities, and why it is important to have a well-written operating agreement--even if the LLC has only one owner.
Greg Corombos: Hi, I'm Greg Corombos. Our guest this week on Expert Insights is Sandra Feldman, Publications Attorney at CT Corp. She joins us this week to talk about the importance of the LLC, how to understand it as a business entity, and what it actually means to own one. And Sandra, always good to have you with us. Thank you.
Sandra Feldman: Thank you, Greg, I appreciate the opportunity to talk to your audience about the limited liability company or LLC, as it's usually known. And in particular, I'm looking forward to talking to all the small-business men and women out there who actually own an LLC, because I think it's really important that they fully understand what an LLC is, and what it means.
GC: Well, let's dive right in. And what is it about the LLC that you think is most important for people to understand.
SF: There's a lot that's important to them to understand. But today I wanted to focus on three characteristics of the LLC as an entity that anyone who owns one should be aware of. First, that an LLC is a separate legal entity. Second, that it's a statutory entity. And third, that it is a contractual entity. If people can understand those three characteristics, I think it would go a long way to helping them really know what it means to own an LLC.
GC: What you say it's important to understand that an LLC is a separate legal entity. What exactly do you mean by that?
SF: Analogy that I like to use to explain that. You can kind of compare forming an LLC to having a child. Now the child exists because of the parents. But the child has its own identity in existence. It has its own name. One day it will have its own money, and it will buy, it will sell, and it will own things. It'll have its own rights and responsibilities.
So it’s kind of the same when people form an LLC. The LLC exists because of its owners. But the LLC has its own identity and existence. [unintelligible] a legal or artificial person. It has its own name, its own money. It can buy and sell and own property. It has its own rights and responsibilities.
Let me give you an example to illustrate. Let's take Bob and Carol. They're interested in buying the fast-food restaurant, but they're not interested in being liable for its debt. So they form an LLC. It’s the LLC that will enter into that franchise agreement. The LLC that leases the property where the restaurant sits. The LLC is listed as the employer on the workers' tax forms, and so forth. In other words, the business, namely, that fast food restaurant, is owned by the LLC. Bob and Carol may run the restaurant and make all the business decisions, but they don't own the business. The LLC does. Bob and Carol own the LLC. They are members, which is what LLC owners are called.
GC: And that's critical. Why is that so important to know that distinction?
SF: Because the LLC members have to respect the LLC’s separate existence. They have to understand that the LLC owns the business and not treat the business like they own it. For example, LLC members should never use the business’s money for personal purposes. They should never use its assets for nonbusiness reasons. If, say, the business has a car to make deliveries, the members shouldn't use that car to take their kids to school. The business needs money, and a member wants to provide it, the member should clearly document that as a loan to the LLC that has to be repaid, or as a capital contribution that will increase the membership ownership interest.
GC: Sandra, you've talked very specifically about how the people really running the business need to respect the separate existence of the LLC. What happens if they don't show respect for that separate existence?
SF: They can lose the privilege of limited liability. New businesses run up debts. And if the creditors don't get paid, they can sue. Now because the LLC owns the business, they have to look to the LLC for payments.
However, if the creditor gets a judgment against the LLC, but the LLC doesn't have the money to pay, the creditors can try to collect from the members. Now, what the creditor is trying to do is something called piercing the veil. That means that the creditors asking the court to disregard the LLC separate legal existence. Now, that sounds like a really scary proposition I know. But in fact, the courts do respect an LLC’s separate existence and the members’ privilege of limited liability, and they're reluctant to pierce the veil. But if the reason the LLC can't pay the judgment is because the members themselves disregarded the LLC separate existence, and let's say use the businesses profits for their own personal purposes. And particularly if they knew they were creditors that needed to be paid. Then, in the interest of justice, the court just might hold the members liable,
GC: Which goes against the whole point of having the limited liability protection in the first place. Sandra, you said it's also, you said it's important to know that an LLC is a statutory entity. We talked about it being a separate legal entity but also a statutory entity. What do you mean by that?
SF: Basically, that means that the benefits of doing business in the LLC form, and the main reasons why business owners would rather form an LLC than own the business themselves, exists only because they’re granted by statute. You could consider it a gift from the state legislatures. For example, what's one of the main benefits of the LLC? It's what we were just talking about, limited liability for the members. Well, members only have limited liability because the LLC statute will have a provision saying something like an LLC’s debts and liabilities belongs solely to the LLC and the members are not liable just because their members.
What's another benefit? The members’ right to manage the LLC with fewer restrictions and without that loss of limited liability, and members only have that because the LLC statutes have a provision saying something like management of an LLC’s business and affairs is vested in the members unless they decide otherwise. Corporations and limited partnerships don't have that. Other benefits, like financial flexibility or charging order protection, which protects the members from being forced to co-own with other members [unintelligible] also exist only because states authorize them in the LLC statute.
GC: Let's dig in a little more here. Why is it important for people to understand that point?
SF: The reason I point out that the benefits of the LLC are granted by statute is because, in return for those benefits, the LLC has to comply with whatever requirements are imposed on it by that statute. That probably sounds kind of scary, too. But in fact, the LLC statutes don't have many mandatory requirements,
GC: What kind of requirements do they have?
SF: The statutes vary based on the state. But in general, most states require an LLC to file an annual report with the state agency in charge of business entities. They'll also have to pay an annual franchise tax. And that's the state’s fee for allowing the LLC to exist and do business in the LLC form. The LLC will have to appoint and continually maintain in the states, a Registered Agent and registered office. If there are certain changes it makes and wants to make, like changing its name or changing its Registered Agents, or merge or converting, filings will have to be made with the state. LLCs also have to maintain some books and records in case the members want to inspect them.
GC: We’re talking with Sandra Feldman. She's a Publications Attorney at CT Corporation. And Sandra, you mentioned at the top there are three important takeaways of understanding an LLC as a business entity. We've talked about it being a separate legal entity. We've talked about it being a statutory entity. And you also say it's important to know that an LLC is a contractual entity. Why is that?
SF: Well when I say an LLC is both a statutory entity and a contractual entity, that probably sounds like a contradiction. But actually, it's not.
It's true, an LLC is created by statute, and it has to comply with certain statutory requirements. But the LLC statutes are mainly comprised of default provisions. And these provisions will apply only if the members haven’t been provided otherwise in their operating agreements. An operating agreement is a legally binding contract, and the parties are the members, the managers, if any, and the LLC. Now one of the great things about the LLC as an entity and one of the main advantages it has over the corporation is that the members can decide for themselves how they want to conduct the business and how they want to split their management responsibilities and their financial rights. And they do that in their operating agreements.
Greg, I can't emphasize enough how important it is to have a good written operating agreement.
GC: What makes a good operating agreement? What should go into it?
SF: Well, by a good operating agreement I mean, one that clearly sets forth the members' expectations and understanding the business and their relationship. They should probably avoid those general forms with boilerplate language that anyone can just download and use. An operating agreement should be drafted to meet the specific needs of that LLC and its members.
GC: Let's look at the flip side, then. What can happen if an LLC does not have a good written operating agreement, or in some cases, any written operating agreement at all?
SF: For one thing, an LLC and its members will be governed by the statutory default rules, which may not be what they intended.
Let’s go back to Bob and Carol for a minute. Let's say Carol put up 80% of the capital, and Bob only contributed 20%. But Bob was going to manage the restaurant, while Carol really wasn't going to be involved. So Bob, and Carol decides to split the membership rights equally. Now, let's say the governing LLC statute has a default rule saying that membership rights are split based on capital contributions. So if Bob and Carol want to avoid that default rule and share equally they need to say so in the operating agreement.
Something else an operating agreement is good for is preventing disputes among the members. A lot of lawsuits involving LLC members could have been avoided if the members anticipated and dealt with the issue that fighting over in the operating agreement. As an example, let's go back to Bob and Carol one more time. Let's say, Ted and Alice, Bob’s friends, are opening a fast-food restaurant near Bob and Carols’ and they ask Bob if he wants to go in with them. Bob agrees, and he becomes an investor. Well, Carol is not happy that Bob is investing in a competing restaurant, and she sues him for breaching his fiduciary duty. You know, that mess could have been avoided if Bob and Carol had included a provision in their operating agreement saying whether or not a member could have become involved in a competing restaurant.
GCL I'm loving the names here, Sandra. What about an LLC with only one member? Does it need a written operating agreement as well?
SF: That's a very good question, Greg. And yes, it's a really good idea for a single-member LLC to have a written operating agreement, too. For one thing, it shows respect for the LLC’s separate existence, since the member is entering into a contract with the LLC. And there are also statutory default rules that the member may not want to be governed by. For example, there are statutes that say anytime an LLC has no members, it has to dissolve. Well, if the member of a single-member LLC dies, the LLC has no members. And maybe that member wants the LLC and the business to continue upon his death. He can avoid the default rule by appointing a successor member in the operating agreement.
Also, there may be some facts about the business that the member wants to put in that agreement. Let's say the member wants the business to be run in a socially responsible manner and also gives part of its profits to charity. By putting that in the operating agreement, any new members the LLC might admit will be subject to it. The member can also show any prospective employees or business partners that he isn't just saying he's committed to social responsibility, he’s contractually obligated to be. Which is a commitment that's important to many people these days?
GC: Such a great amount of wonderful information here for our listeners and especially the business owners listening here. Sandra, thank you so much for your time and your expertise on this.
SF: Thank you, Greg. And really thank you for having me. I hope I helped some people to better understand what it means to be an owner of that business entity called an LLC.
GC: Absolutely. No doubt about it. Sandra Feldman is a Publications Attorney at CT Corporation. I'm Greg Corombos. And for more information on this topic, please call CT at 844-787-7782.
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