What is an LLC? Why and how to form a Limited Liability Company

by Pam Clark

Protecting your business assets is indisputably important. But for many small business owners, protecting personal assets is equally important, though unfortunately, often neglected. Creating a separation between your business and personal property is the first step for accomplishing this. This is where registering an LLC comes into play.

What is an LLC?

A Limited Liability Company (LLC) is a formal registration of a company with the department of State (usually) within the state the company is located. It essentially serves as an official entity that forms a legal separation between a business and its owner(s) [1]. Once an LLC is formed, all contracts and most legal liability is then associated with the LLC directly, not to the owner(s). In contrast, partnerships and sole proprietorships the owner(s) is personally responsible for all legal liability which can include personal property.

Why form an LLC?

The main reason to form an LLC is for the legal protection of personal property, by the owner, from the liability that a business assumes. With an LLC, most contract disputes and other legal liability is solely the responsibility of the LLC, so the business owner’s personal property (house, car, savings, etc.) is not at risk. This protection, sometimes referred to the veil doctrine, is limited, however [2]. Depending on the Jurisdiction, this protection can vary from state to state based on corporate shield laws.

LLC protection can even (in part) help protect business owners from a charging order, where creditors sue the members instead of the LLC directly. In this situation, the creditor has rights to “capital distributions”, but since not all LLC members must receive capital distributions this can sometimes result in a no gain situation for the creditor.   To make things worse, the creditor may still be responsible for paying taxes on the LLC’s income despite receiving no benefits. [3]

LLC and Taxes

Another advantage LLCs have is their flexibility for dealing with taxes. An LLC may pay taxes as a sole proprietor, partnership, C-corportaion, or S-corporation. Each has its advantages and disadvantages, although S-corporations are said to have the best tax benefits due self-employment tax savings [4], though this may depend on the company.

By default, the IRS treats LLCs as a “pass through” entity. If there is only a single owner, the LLC is essentially ignored and that person must file the entire LLCs earnings on their income tax return. If the LLC has multiple partners, they must file a IRS form 1065 and receive a K-1 (reporting their share of income or loss) to file with each of their personal tax returns.

If the LLC chooses to be taxed as a corportation (either C-corp or S-corp) they must file IRS form 8832. The reason why S-corporations are so highly regarded as a way to structure an LLC’ is that they have simplicity and flexibility of a partnership along with the tax benefits (self-employment tax savings) and structure of a corporation.

How to form a LLC

Where – The first step to forming an LLC is to decide in what state to register. Some claim that the two best states to form an LLC are Nevada or Delaware because of their pro corporation laws [5]. This, however, is generally more expensive and time consuming than simply registering in the state that the business resides. So as a matter of simplicity, most small businesses should simply register in their home state.

Each state has different requirements, so businesses must be sure to research exactly what is required in order to register successfully. Registering an LLC is done through the Department of State (or Secretary of State) in the state that the business is registering. Links to the DOS/SOS web sites can be found here: [6]

Pick a company name – The first step before submitting your articles of organization with the department of State is to choose a company name. Each state has specific requirements, but the general rules require the name to be unique, using nothing restricted (by trademark or other laws), and must end with “limited liability company” or the abbreviated: “LLC” or “L.L.C.”. [7]

Articles of organization – Filing articles of organization with the department of state is the first official step for registering an LLC [8]. It is a simple, yet quite specific format to follow, again, unique to each state. Be sure to follow the format exactly or the registration will be rejected. This is also the time where any filing fees are usually expected to be paid. Some small businesses choose to have a professional service take over at this point of the process so as to ensure the proper formatting and specifics are followed precisely.

Operating agreement – Most states require an operating agreement to be completed along with the registration of an LLC. The purpose of the operating agreement is to name the members, manager(s), tax matters partner, and develop terms for equity distribution. [9] While this isn’t something you usually need to submit to the DOS, it also isn’t a step to be taken lightly. It is particularly important for LLCs with more than one member to have a proper operating agreement with exit clauses to ensure the health of the company and fair share of equity to all members, particularly in their leaving. Hiring a lawyer to help draft the operating agreement is highly recommended for multi-member LLCs.

Designate registered agent – Another requirement of the formation of an LLC is the designation of the “registered agent”. Put simply, the company must choose a member of the LLC as the person for which all official correspondence is to be sent. For example, if a lawsuit is brought to the LLC, the registered agent will be the recipient of the subpoenas and other legal documents.

Other requirements – Be sure to comply with any other state requirements of forming an LLC. For example, New York State includes requirements of publication. [10] New LLCs in NY must submit “advertisements” for publication in recognized periodicals within the county of registration.  This publication must include a statement of intent, name of the company, and address. Failure to comply with this requirement will result in the loss of registered LLC status.

How to maintain maximum LLC protection

While the protection an LLC gives is a huge advantage, there are a number of actions that can weaken or even cause a company to lose this protection. In order to ensure this does not happen, there are a number of things that a company must ensure:

  1. Make sure all taxes are paid on time [11]
  2. Ensure the LLC registration and associated fees remain current (see your state’s requirements)
  3. Members must not commingle personal funds or property with those of the LLC
  4. Take steps to ensure that the company is always held out as a separate legal entity
  5. Keep detailed minutes of official company meetings for official records of all contract negotiations and dealings.
  6. Review the LLC’s operating agreement to be certain that none of the company’s actions violate that agreement
  7. Members should not use the LLC’s assets solely for personal use. [12]

Despite these steps, the protection that an LLC carries is not absolute. As well as the limitations of State Shield laws, members can and will be personally responsible for their own actions, even if on behalf of the company. There are well documented cases of corporate shield failing to protect members from cases of personal torts. [13] If a member of an LLC commits fraud, is personally neglectful, or is otherwise personally responsible for liability against another entity, LLC protections can quickly disappear.

Conclusion

For most small businesses, forming an LLC as a way to protect the personal property of its members is an absolute must. Understanding the nature, limitations, and ways to maximize this protection however, is equally important. Because each state has its own laws relating to the limits of these protections it’s important to do the proper research for the state in which the LLC is registered. Still despite the limits of these protections, the advantages are clear, so ignore them at your own risk.

References

[1] http://www.corpnet.com/blog/asset-protection-101-what-is-an-llc/
[2] http://www.llrx.com/features/veildoctrine.htm
[3] http://www.taxdeferrals.com/llc_is.htm
[4] http://www.mymoneyblog.com/s-corporations-vs-llc-income-tax-savings-benefits.html
[5] http://smallbiztrends.com/2011/06/best-state-incorporate-business.html
[6] http://www.coordinatedlegal.com/SecretaryOfState.html
[7] http://www.llcwizard.com/how-to-pick-a-company-name
[8] http://articlesofincorporationfacts.com/the-articles-of-organization-the-principal-document-to-file-for-an-llc/
[9] http://www.medlawplus.com/forminfo/llc.htm
[10] http://www.citmedialaw.org/legal-guide/forming-llc-new-york
[11] http://www.maginnislaw.com/2010/10/dont-risk-losing-your-corporate-shield/
[12] http://www.bernsteinlaw.com/pdfs/tricias_article_with_letter.pdf
[13] http://www.vannattorneys.com/contractors-beware-your-corporate-shield-is-cracked/

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