Forming a limited liability company involves three steps:
Articles of Organization The legal existence of an LLC begins when its articles of organization are filed with the secretary of state or other designated official of the state in which the LLC is being formed. A business that has not filed articles of organization is treated as a sole proprietorship or partnership, and its owners do not enjoy limited liability. Articles of organization provide information to creditors and others about whether the LLC exists as a legal matter, who has authority to act for the LLC, and how to serve the LLC with process if a lawsuit is brought against it. The information that must be included in articles of organization varies from state to state, but generally includes the following:
Additional matters can sometimes be covered in articles of organization, but it is usually best to stick with the required information. Anything else can be dealt with in the LLC’s operating agreement, which unlike articles of organization is not part of the public record and does not require a filing with the state if it is amended. Alberty Publishing Form 1.1 is a generic form of articles of organization that can be modified to meet the requirements of the particular state in which it will be filed. But it is usually best to use an official form provided by the state if one is available. Such forms can often be obtained without cost from the secretary of state or other official and downloaded from the Internet. These forms are not only familiar to the state officials with whom they are filed but also provide a checklist of the information required in articles of organization filed in the state. Information about filing fees and the address to which completed forms are to be submitted for filing often appears on official forms. The name of an LLC must include the words “limited liability company” or an abbreviation. It also may not be the same as, or deceptively similar to, that of another LLC formed in or authorized to transact business in the state where the LLC is being organized, or of a corporation, limited partnership, or limited liability partnership formed or authorized to transact business in the state. The use of a name may also be foreclosed if it is a registered assumed business name. The availability of the LLC’s proposed name should be determined before articles of organization are prepared and filed. This can be done by a telephone call to the state official in charge of LLC filings or a visit to the official’s website. Most LLCs that operate active businesses have perpetual existence. A fixed term may be appropriate if the LLC is organized for the sole purpose of completing a joint venture or other project of limited duration. A member who wants a limit on the duration of his or her investment in the LLC or is concerned about the ability of the LLC’s members to get along on a continuing basis may also insist on a fixed term. The registered office of an LLC is the place at which process can be served on it. The registered office must be the regular business office of the registered agent, and this is the person who will be served. Because failure to respond promptly to a pending lawsuit can have serious ramifications, a member or manager of an LLC is often named as its registered agent. The lawyer for the LLC is another common choice. An LLC may be managed by its members or may be managed by one or more managers, who need not be members. In most states, an LLC’s form of management is determined by its articles of organization. If the articles fail to specify a form of management, it is typically treated as a member managed LLC. If an LLC is to be managed by managers, the names and addresses of the initial managers may need to be set forth in the articles of organization. Member management is the most common choice for small businesses. With this form of management, all members have the right to participate in the operation of the LLC and the authority to act for the LLC. This is similar to a general partnership and gives all members the greatest possible role in the affairs of the LLC. Management by managers may, however, be a better choice in the following circumstances:
The organizer can be one or more persons, who need not be members of the LLC. The lawyer for an LLC often functions as its organizer to expedite the filing of its articles of organization. Capital Contributions An LLC is created and becomes a legal entity when its articles of organization are filed. But assets are needed if an LLC is to be a functional business entity, and the initial assets must be contributed by its members. The assets required by a particular LLC will depend on the nature of its business. However, an attempt should be made to contribute sufficient assets to provide the LLC a reasonable chance of its being successful without the need for additional invested capital. If an LLC is undercapitalized, the members not only run the risk of losing their investment, but a court may apply the doctrine of piercing the corporate veil to hold the members of the LLC personally responsible for the LLC’s liabilities, depriving them of the shield of limited liability. Assets can be loaned or leased to an LLC by its members. But these assets are not considered in determining whether the LLC is adequately capitalized because they are not available for the payment of the LLC’s debts and liabilities. Title to contributed assets should be transferred to the LLC. If cash is contributed, it should be put in the LLC’s own bank account. Alberty Publishing Forms 9.1, 9.2, 9.3, and 9.4 are designed for use in transferring certain types of assets to an LLC. Not only does a transfer of title to assets minimize the risk of the LLC’s limited liability shield being pierced, it also protects members against the risk that their fellow members will renege on their obligations to make contributions. Once contributed, assets become the property of an LLC. Each of the members has an interest in the LLC as a member, but no direct interest in its assets. If a member wants a particular asset returned when an LLC is dissolved and its business wound up, the LLC's operating agreement can so provide. But the member needs to be aware that creditors of the LLC have a priority claim on all assets. Sufficient assets may or may not be available after creditors are paid to permit a particular asset to be distributed to a member. Operating Agreement An LLC is not required to have an operating agreement. In the absence of such an agreement, the management and operation of the LLC will be controlled by default rules set forth in the LLC statute of the state in which the LLC’s articles of organization were filed. The default rules deal with the governance of an LLC and define the rights and responsibilities of members and managers. While having an operating agreement is not necessary, it is highly desirable. An operating agreement serves four functions:
A record of proper organization and contribution of adequate assets may be desirable if a creditor of an LLC seeks to pierce the corporate veil of the LLC and satisfy its claims out of the members’ individual assets or if a member seeks to recover assets contributed to the LLC. An operating agreement is a convenient place to create and maintain this record. Owners of closely-held businesses often want to be sure that third parties with an agenda different from theirs cannot acquire an interest in the business. At the same time, the owners may want to be able to liquidate their interests in the business if they should withdraw, die, or become disabled. An operating agreement can address these potentially conflicting concerns by giving the LLC or the other members a right of first refusal to purchase the interest of a member that is to be sold or transferred. The operating agreement can also require that the LLC or the other members purchase a member’s interest on withdrawal, death, or disability at a price and on terms that have been agreed to in advance. The ability to change statutory default rules is important because these rules can be inconsistent with the expectations and desires of an LLC’s members. For example, the statutory default rule in some states is that LLC members share profits equally. If one member contributes more capital than the others, he or she may expect a greater share of the profits. Other state default rules divide profits in accordance with capital contributions, and while this will be consistent with the expectations of members of LLCs to which all members contribute capital, the rule will be unworkable if one or more members contribute services in exchange for an interest in profits of the LLC. It is important for single member LLCs, as well as those with two or more members, to have operating agreements. The member of a single member LLC controls its management and is entitled to all of its profits, so changing statutory default rules may not be a concern. Preventing transfers of interests is also not a concern in the context of a single member LLC. But a single member LLC's operating agreement can provide evidence of proper organization and a roadmap for operating the LLC. These functions of an operating agreement are important because members of single member LLCs are particularly susceptible to losing the shield of limited liability. In addition, third parties dealing with an LLC, such as banks making loans, may require the LLC to have an operating agreement regardless of how many members it has. Operating Agreement Forms The specific terms of an LLC’s operating agreement depend on the form of management chosen, the desires and expectations of the members, the nature of the LLC’s business, and the income tax results sought. The terms can also be affected if the LLC will be owned by members of a single family, will engage in providing professional services, or will make an election to be taxed as an S corporation. Alberty Publishing offers 12 operating agreement forms, each of which contains terms that are commonly used in a particular situation. A list of the forms, and a brief description of the situation for which each is designed, is set forth below. Forms 2.1 and 2.2 Forms 2.1 and 2.2 are operating agreements for LLCs with one member. Both are appropriate for single member LLCs, regardless of the nature or size of its business. Form 2.1 is designed for use if the LLC is managed by its member, and Form 2.2 is for a manager managed LLC. The latter contains provisions dealing with the rights and responsibilities of managers, but the forms are otherwise the same. As discussed above in connection with articles of organization, an LLC’s form of management is generally determined by its articles of organization. Forms 2.3 and 2.4 These operating agreements are designed for LLCs with two or more members. Form 2.3 is for a member managed LLC, and Form 2.4 is for an LLC that is managed by one or more managers. Form 2.4 is somewhat longer than Form 2.3 because of the need to deal with the rights and responsibilities of managers as well as those of members. Both forms assume that the LLC makes straight-up allocations. With such allocations, each member’s share of the LLC’s profits, losses, and distributions is proportionate to his or her capital contribution. For example, if one member has a 50% interest in profits, losses, and distributions and two other members each have a 25% interest, the first member must have contributed half of the LLC’s capital and the other members must each have contributed one-fourth in order have straight-up allocations. The type of allocations made by an LLC affects how its members are taxed on its income and losses. Straight-up allocations are always respected for tax purposes, and there is no risk that the IRS might allocate income and loss between the members in a manner other than that set forth in the operating agreement. No special provisions in the operating agreement are required. Forms 2.3 and 2.4 are not necessarily intended for LLCs with a limited number of members or limited assets. The forms are designed for use by any LLC with straight-up allocations, regardless of the nature or size of its business. This is the case with Forms 2.5 and 2.6 as well. Forms 2.5 and 2.6 If an LLC makes special allocations, its operating agreement must, at a minimum, contain a qualified income offset to insure that the allocations of profits and losses to members cannot be changed by the IRS. Although the term “special allocations” sometimes connotes complex allocations made to obtain tax advantages, special allocation provisions need to be incorporated into the operating agreement of any LLC that does not make straight-up allocations. Tax considerations can be the driving force behind special allocations. For example, the members of an LLC may each contribute an equal amount of capital and agree to share profits equally but to allocate all losses to a single member. This will yield tax savings if the member to whom losses are allocated is in a higher tax bracket than the others. But special allocations can also arise in rather simple arrangements that are not designed with taxes in mind. For example, a two-member LLC makes special allocations if one member contributes capital, the other contributes future services, and they agree to split profits equally because the members’ profit shares are not proportionate to their capital contributions. A concern with special allocations is that they could permit some members to enjoy the tax benefits associated with the ownership of an interest in an LLC without bearing the economic consequences. In order to prevent this, the IRS has authority to reallocate an LLC’s profits and losses between members unless its operating agreement contains a qualified income offset. Such a provision requires that a member’s shares of the LLC losses reduce the amount of his or her capital account and the amount a member receives when the LLC is dissolved and wound up or when his or her interest is purchased by the LLC is based on the member’s capital account. A qualified income offset also prohibits the allocation of losses to a member to the extent it would cause the member’s capital account to fall below zero. If a member has a negative capital account as a result of distributions, all future income of the LLC must be specially allocated to the member until the deficit is eliminated. Form 2.5, which is for a member managed LLC, and Form 2.6, which is for a manager managed LLC, contain a qualified income offset. Such a provision is often sufficient to avoid reallocation of the LLC’s profits and losses, but if the LLC has losses attributable to property acquired with indebtedness for which no member is personally responsible, the operating agreement must also contain a minimum gain chargeback. That type of provision is included in Forms 2.7 and 2.8. Forms 2.7 and 2.8 Forms 2.7 and 2.8 contain not only a minimum gain chargeback but also provisions creating a preferred return for certain members and protections for the person who puts the LLC and its business together. These operating agreement forms are designed for use in arrangements such as real estate syndications. Form 2.7 is for a member managed LLC, and 2.8 for a manager managed LLC. Either form can be used even if some of its features are unnecessary. For example, the operating agreement for a particular LLC may need a minimum gain chargeback and protections for the developer member but not a preferred return. In this case, the preferred return feature can be omitted. A minimum gain chargeback prevents the IRS from reallocating profits and losses arising from property acquired by an LLC with a loan from a third party on which no member has personal liability. From a tax law standpoint, the problem with such property is that members of the LLC may realize tax benefits in the form of depreciation or amortization deductions even though they have no corresponding economic burden. It is the lender who bears the burden of economic losses. In order to prevent the LLC members from enjoying tax benefits that exceed their share of the economic consequences, an LLC is treated as realizing income when the property is disposed of. This income is called “phantom income” because there is no economic benefit to the LLC. To understand how phantom income arises, imagine that an LLC buys property for $100 using a nonrecourse loan. Over a period of time, the LLC pays $25 of the principal due on the loan and takes depreciation deductions on the property of $50. The LLC allows the lender to foreclose a mortgage securing the nonrecourse loan at a time when the property is worth $60. In this case, the lender has both an economic and tax loss of $15, which is the difference between the outstanding balance of the loan of $75 and the amount realized on foreclosure of $60. The LLC has a taxable gain of $15, which is the difference between its tax basis in the property of $50 and the amount realized of $60. However, the LLC’s depreciation deductions of $50 exceed the sum of the amount it paid on the loan ($25) and its recognized gain ($15). The difference of $15 is treated as phantom income to the LLC. An LLC’s deductions on the property acquired with a nonrecourse loan do not remain with the LLC but pass through to its members and can be used to reduce the members’ income from other sources, thus reducing their individual tax liabilities. Phantom income of the LLC also passes through and increases members’ incomes and tax liabilities. If the LLC has one group of members when the property acquired and depreciated and another group of members when the property was foreclosed upon, the second group must report phantom income attributable to tax benefits enjoyed by the first group. Not only is this unfair, it may also result in the collection of insufficient tax to recapture the excess tax benefits that have been enjoyed if members of the second group have tax rates that are lower than members of the first group. A minimum gain chargeback in an LLC’s operating agreement seeks to solve this problem. It is a relatively long and complex provision that in effect allocates future phantom income of the LLC to members at the time the tax benefits are enjoyed that will produce the phantom income. The preferred return feature of Forms 2.7 and 2.8 gives one or more members an interest in the LLC that is akin to preferred stock. All income is allocated to and all distributions must be made to these members until they realize a fixed rate of return on their investments in the LLC. Thereafter, profits and distributions are allocated to members without a preferred return until they realize an equal return on their investments. Finally, profits and distributions are allocated to all members based on their capital contributions. This type of arrangement can be used if a developer and one or more investors participate in a real estate syndication. The arrangement allows the investors to get their investments back, with interest, before the developer participates in profits or has the right to distributions, thus imposing the burden of failure of the project on the developer. The developer in a real estate syndication may want to be sure that he or she is not deprived of his or her expected returns by his or her compensation being reduced, by management agreements with the LLC being terminated, or by being removed as a manager of the LLC or expelled as a member. Such protections, which are included in Forms 2.7 and 2.8, may be particularly necessary if the developer has provided significant services in putting the syndication together for which the developer will be compensated only in later years after the venture becomes profitable. Form 3.1 If there are two members of an LLC and they are husband and wife, many of the provisions of a typical operating agreement for a multi-member LLC are unnecessary. For example, there are no tax allocation issues if the members file joint income tax returns, and decision-making is simplified if there are two equal members. Form 3.1 is designed for this situation. It is for a member-managed LLC with straight-up allocations but lacks many of the provisions of, and is a good deal shorter than, Form 2.3. Form 3.2 An individual may create a family LLC in connection with his or his estate planning. Real estate or other investment assets are transferred to the LLC, and gifts of interests in the LLC are given to other family members. Such an LLC creates a structure for managing the property both during the individual’s life and after his or her death and avoids the legal complications and expenses that would arise if undivided interests in the property were given to various family members. Interests in the LLC given to family members as gifts may also be valued in a favorable manner if minority interest or lack of marketability discounts are available. Form 3.2 is for a manager managed LLC with straight-up allocations. Manager management is used to allow the individual creating the LLC to retain control of the property or transfer it to others that he or she selects. Straight-up allocations are used in order to comply with the family partnership rules which might otherwise result in reallocation of the LLC’s income between family members. Provisions dealing with gift tax issues are also included in the form. The result is a form that is substantially longer than a simple operating agreement for a manager managed LLC with straight-up allocations such as Form 2.4. Form 3.3 Form 3.3 is quite different from the other forms because it is designed for LLCs engaged in providing professionals services in areas such as medicine, law, and accounting. Professional service businesses differ from most other businesses because capital is often not a significant income-producing factor and the current contributions of individual members to the LLC’s profitability may be easy to measure. This is a form of agreement for a member managed LLC with special allocations. Special allocations are made if the LLC’s profits are shared based on income production or other factors, rather than on capital contributions. This form assumes that income production will be an element of members' profit shares and assumes that these shares may be changed from year to year by agreement of the members, thus creating special allocations. Member management is provided for because professionals often want a say in how their practice is operated. But because professionals are busy people, day-to-day management of the LLC is the responsibility of a managing member selected by vote of the members. The agreement addresses cash flow distributions required to pay the living expenses of members while retaining cash for working capital and includes policies relating to vacation, sick leave, and professional education. These provisions are not ordinarily included in operating agreements for businesses outside the professional service area. The method of valuing interests of withdrawing, retiring, deceased, or disabled members reflects the fact that capital is not a material income-producing factor in many professional practices. The purchase price for a member’s interest also takes into account the fact that it may be more valuable if the member retires, dies, or becomes disabled than it would be if the member withdraws to join a competing practice and takes his or her goodwill along. Form 3.4 Form 3.4 is a specialized operating agreement designed specifically for limited liability companies that elect to be taxed as S corporations for federal income tax purposes. This arrangement may be attractive to business owners who want to use the informal management structure of an LLC and while taking advantage of an S corporation’s ability to defer or eliminate employment taxes. In addition, S corporations are taxed more favorably than LLCs in some states. A typical operating agreement is not suitable for an LLC making an S corporation election. There are a number of limitations on S corporations’ structure and operations that do not apply to LLCs. Unless these limitations are addressed in the operating agreement, an unplanned termination of the LLC’s S corporation election can result. This will cause the LLC to be taxed as a C corporation and it will not be able to regain S corporation status for five years. Form 3.4 is for a member managed LLC in recognition of the fact that the LLC form of organization is often used to gain a flexible management structure. Because an S corporation can issue only one class of stock and any special allocation would be considered a second class, this form provides for straight-up allocations. This form does such things as prohibit transfer of interests to members who do not qualify as S corporation shareholders or to members if the transfer would cause the LLC to exceed the 100 shareholder limit on S corporations. Additional Information Additional information about the contents of our operating agreement forms can be found on the Products & Prices page of our website. Just click on either “Operating Agreements” or “Operating Agreements for Particular Situations” and select the form about which you want additional information
Home | What's New
| Products
& Prices | Sample Form | Drafting
Coach | LLC Formation
|
