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In recent years, the limited liability company (LLC) has become the go-to entity for small business owners seeking to separate their business and personal matters, while obtaining the protections that operating through a legal entity has to offer. In certain circumstances, an LLC can be a practical and cost-effective component of a comprehensive asset protection strategy, as well.
Unfortunately, some online services would have you believe that forming and receiving the benefits of an LLC is as simple as paying a small fee and filling out a few basic online forms. These services create the false impression that establishing an LLC is a generic process that neither requires nor benefits from a personalized approach. But, the truth is that there are several important reasons to seek personal, professional advice – and many of them have to do with deciding what goes into your LLC’s operating agreement.
Introduction to LLCs
What Is an LLC?
In order to understand what terms to include in your LLC’s operating agreement, it can be helpful to first gain a better understanding of the LLC itself. An LLC is a business entity that exists separate and apart from any one individual person. This is true even if you are the sole owner (or “member”) of your LLC. In fact, courts in jurisdictions throughout the United States have said that an LLC can and should be treated as a separate “person” for legal, tax, and financial purposes. This means that LLCs can sue, be sued, hold assets, and pay certain taxes. The terms of an LLC’s ownership, management, and operation are established in what is known as an operating agreement.
Importantly, LLCs exist under state law. Each state in the country has its own laws governing LLCs. While many of these laws are similar (and are based on the same “uniform” law), there are a number of important differences, as well. As a result, making an informed decision about the state in which to form your LLC is a critical part of the process.
Why Form an LLC?
Under the right circumstances, forming an LLC can have numerous benefits. The best way to think about these benefits is to compare them to the similar benefits (or lack thereof) available under other structures.
For example, compared to operating a business or owning property in your individual capacity, one of the most important benefits of forming an LLC in spelled out right in its name: Limited liability. This means that, with an appropriate operating agreement in place, forming an LLC can insulate the company’s owners from liability for its debts – including judgments in civil litigation. Likewise, while corporations also offer limited liability, LLCs offer a level of flexibility with respect to ownership and management structures that is not available with a C-corp. or S-corp.
Must-Have Clauses in Your LLC Operating Agreement
While you can find plenty of “forms” online, the reality is that no two LLC operating agreements should be exactly alike. From ownership and control to the reason you formed your LLC in the first place, there are several factors that will determine the necessary clauses for your LLC’s operating agreement. That said, there are a number of standard types of provisions that are appropriate for most LLCs:
1. Ownership and Capital Contributions
The operating agreement should identify the LLC’s original owner (or owners), as well as each owner’s capital contribution to the LLC. While a corporation has stocks, an LLC has “membership interests,” and owners are called members rather than stockholders. But, just like stockholders generally must “buy in” to receive their shares, members generally must make capital contributions in exchange for their membership interests.
2. Purpose and Limitations
The operating agreement should also state the LLC’s purpose, as well as any limitations on what it can and cannot do. While it will often make sense to leave an LLC’s purpose open-ended (e.g., “to operate a consulting practice and engage in any other business permitted under [state] law”), in some circumstances it can be important to limit an LLC’s purpose to avoid questions of authority down the line.
3. Member-Managed or Manager-Managed
An LLC can either be run by its members or by non-member managers. Most single-member LLCs (and many larger LLCs) are member-managed, though the manager-managed approach will be a better choice under certain circumstances.
Since an LLC is an independent entity with its own assets and accounts, you need to know who is entitled to receive what and when. Your LLC’s operating agreement should clearly specify when members are entitled to take distributions from the company’s profits, as well as how losses will be apportioned on members’ personal tax returns.
5. Limited Liability
While members’ limited liability is a function of state law, it still doesn’t hurt to spell out their limited liability in the operating agreement. In fact, since members can still be held liable for an LLC’s debts in certain circumstances, it is critical for the operating agreement to be clear on when the LLC will hold on to financial responsibility.
6. Books and Records
As a separate entity, your LLC should maintain its own books and records, and the operating agreement should spell out how, where, and by whom these books and records will be maintained.
7. Winding Up the LLC’s Affairs
Should you no longer need your LLC, it is important for the operating agreement to clearly detail the management of its final affairs. This includes who will be responsible for dissolving the company in the relevant jurisdiction, how the LLC will pay off its debts, and how any remaining assets will get distributed.
Key Clauses for Asset Protection
Just like an LLC’s limited liability protections can shield your personal assets from the LLC’s debts, transferring assets to an LLC can also help protect those assets from your personal creditors. Since the LLC is its own independent entity, its property is separate and distinct from your own. However, using LLCs for personal asset protection requires careful planning – and careful preparation of your LLC’s operating agreement. Some key operating agreement clauses when using an LLC for asset protection include:
- Appropriate restrictions on voting, control, and distribution rights
- Tax liability provisions
- Insurance requirements
Key Clauses for Business Succession Planning
Succession planning is a critical component of drafting a comprehensive LLC operating agreement, as well. While succession may be a long way off, addressing the issues up front can help you, your business partners, and your loved ones avoid unnecessary confusion and disagreements down the line. When considering business succession in connection with your LLC operating agreement, some of the key clauses include:
- Restrictions on transfer of membership interests
- Buy-sell provisions
- Anti-dilution provisions
- Veto rights
- Dispute resolution provisions
Note that other estate planning tools can often be used to address succession of ownership rights in an LLC, as well.
Contact Jiah Kim & Associates about Forming Your New LLC
Keep in mind, the lists above are not intended to be exhaustive, but rather are merely intended to show the types of issues that can come into play when drafting an operating agreement for an LLC. If you would like to speak with an attorney about preparing your LLC’s operating agreement, call Jiah Kim & Associates at (646) 389-5065 or contact us online today.
This blog post is written for educational and general information purposes only, and does not constitute specific legal advice. You understand that there is no attorney-client relationship between you and the blog publisher. This blog should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.
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This post is also available in: Spanish