This page is one of seven chapters:
Main Page: How to create an LLC
Chapter 1: LLC Answers to Frequently Asked Questions
Chapter 2: LLC Compared to Other Business Structures
Chapter 3: Forming and Managing an LLC, A Comprehensive Guide
Chapter 4: Optimizing Tax Strategies for LLC Pass-Through vs. Corporate Taxation
Chapter 5: How to name your LLC Name Your LLC
Chapter 6: How to write and file an LLC Article of Organization
Chapter 7: How to write an LLC Operating Agreement with Template
How Many Member Can A LLC Have?
An LLC can include any number of members, but managing more than 35 may become cumbersome. It’s also possible to establish an LLC with just a single member. The percentage of ownership held by each member should be clearly specified in the operating agreement.
What Paperwork Is Needed to Start an LLC?
Exploring the essential legal documents and steps needed to form an LLC reveals that the process is straightforward and quick. This means you can transform your concept of creating an LLC into a recognized legal entity in relatively short order.
What Are the Key Steps to Form an LLC?
To establish an LLC, the primary legal requirement is to draft and file the Articles of Organization with your state’s LLC filing office. Some states also mandate a preliminary step of publishing a notice in a local newspaper indicating the intent to form an LLC before the Articles are submitted. For specific state requirements, refer to Appendix A. This filing office is typically part of the Department or Secretary of State’s office, located in the state capital, with larger states often having additional offices in other major cities.
The Articles of Organization for an LLC need not be extensive or complicated. You can generally complete your own in just a few minutes using a straightforward form provided by your state’s LLC filing office. This form usually requires filling in some basic information about your LLC, such as:
- The name of the LLC
- The principal office address
- The agent and office address for service of legal documents
- The names of the initial members or managers, if a specific management team is designated to operate the LLC.
What Should Be Included in an LLC Operating Agreement?
It is crucial for an LLC to have a written operating agreement to specify the fundamental rights and responsibilities of its members (and managers, if opting for a manager-managed LLC). Without such an agreement, resolving critical questions during times of crisis can become challenging. Issues that the operating agreement should cover include:
- How are important management decisions made: does each member get one vote, or are votes based on their percentage interests in the LLC?
- Are members required to make additional capital contributions if the LLC requires more operating funds?
- Are members entitled to periodic distributions of the LLC’s profits?
- Will interest be paid on the members’ initial capital contributions?
- Can members exit the LLC at any time, and are they entitled to an immediate return of their capital contributions?
- What compensation should a member receive upon leaving the LLC?
- Is a departing member allowed to sell their interest to an outsider?
Addressing these questions in a written operating agreement is essential. Such proactive measures can prevent many common issues that often haunt small businesses, ensuring smoother operations and clearer expectations.
Who Is Responsible for Managing an LLC?
In any business, including an LLC, someone must oversee its overall management. Under the default legal rules of most states, all members (owners) of an LLC are automatically tasked with managing the business. This setup is known as “member-management.” However, the members have the option to designate one or more individuals, who can be members or non-members, to handle the LLC’s management responsibilities. This alternative is referred to as “manager-management.” This choice should be clearly stipulated to ensure clarity in governance and operations.
Should Your LLC Be Member-Managed or Manager-Managed?
For most LLC owners, the preferred management structure is member-managed rather than manager-managed. This preference is typically due to the desire to avoid additional bureaucracy in smaller LLCs, allowing the members who own the business to also run it directly. Unless there are plans to involve outside investors who wish to play a managerial role in the business, it is likely more natural for an LLC to opt for member-management. This approach simplifies decision-making and operations, particularly in smaller or closely-held businesses.
What Are Your Options for Selecting Managers in a Manager-Managed LLC?
When establishing a manager-managed LLC, you have several options for appointing your management team:
- Select members as managers: Some larger LLCs, particularly those with passive investors who aren’t involved in the day-to-day operations, may choose to appoint only active members as managers.
- Select only nonmembers: Other LLCs might opt for management teams composed exclusively of nonmembers who bring specific expertise relevant to the business. This could involve hiring an external consultant or appointing an LLC officer who is not a member as the manager.
- Select a mix of members and nonmembers as managers: There are also LLCs that prefer a hybrid approach, incorporating both members and nonmembers into the management team. This option allows for a blend of internal knowledge from members and external expertise from nonmember managers.
What Are the Tax Consequences for Non-Managing Members of a Manager-Managed LLC?
In a manager-managed LLC, non-managing members may have the potential advantage of avoiding self-employment taxes on their share of the LLC’s profits. This distinction in tax treatment can provide significant savings, as self-employment taxes are not levied on the passive income received by these members, distinguishing their earnings from those of active members who directly manage the business.
How Are Members and Managers Selected and Removed in an LLC?
In an LLC, the process for selecting and removing members and managers is typically outlined in the Articles of Organization initially filed with the state LLC filing office. Under the default rule in most states—unless specified differently in the operating agreement—new members can only be admitted with the unanimous consent of all existing members. If the LLC operates under a manager-management structure, replacing an initial manager requires a majority vote by the members. However, this rule can be modified in the operating agreement to allow managers (by a majority or greater vote) to fill a managerial vacancy instead of the members.
State laws generally do not provide specific guidelines on the removal of members or managers. According to common provisions in LLC operating agreements:
- Members: Removal from the LLC typically occurs only for specific reasons, such as bankruptcy or incapacity, and must be approved by a unanimous vote of the other members.
- Managers: Removal can often be more straightforward; most operating agreements allow for the removal of managers “without cause” by a vote of the members. Additionally, managers are usually appointed for specified terms, meaning they can be replaced at the end of their term if the members decide to elect someone else.
These mechanisms ensure that the governance of an LLC can adapt to changing circumstances while maintaining the integrity and intent of its founding principles.
What Legal Authority Do LLC Members and Managers Have?
In an LLC, the legal authority to bind the company to contracts, business transactions, or actions generally rests with the members in a member-managed setup, or with the managers in a manager-managed arrangement. This authority also extends to other duly appointed representatives, such as officers, provided the actions fall within the normal scope of the LLC’s business. A notable legal caveat is that any contract involving an outsider who is aware, or should be aware, that the LLC representative does not have the authority for a specific transaction, will not be binding on the LLC. Proving such knowledge, however, can be challenging.
Example
Martin, a Vice President at Delightful Dough Bakery, LLC (“Delightful Dough”), which operates as a member-managed bakery, places an order for $500 worth of ingredients from Sweet Paper Supplies Company. The order consists of $400 worth of ingredients intended for Delightful Dough and $100 of personal items for Martin. During the transaction, Martin charges the entire order to Delightful Dough’s account. Later, Sweet Paper Supplies receives a payment of $400 from Delightful Dough, accompanied by a note from the bakery’s accounts payable officer instructing them to seek the remaining $100 from Martin personally, as the bakery did not authorize the purchase of personal items. In this situation, a small claims court would likely require Martin to pay the $100 balance. This is based on the premise that Sweet Paper Supplies could reasonably believe that Martin, as an officer of the bakery, had authority to place the full order on the bakery’s account unless otherwise specified by Martin at the time of the order.
It’s advisable to operate under the assumption that any contract or transaction authorized by someone in management is legally binding. Choosing the right individuals to serve as members or managers is critical to avoid potential legal issues.
What Are the Voting Rules for LLC Members and Managers?
The default laws in many states dictate the allocation of voting rights in an LLC based on the capital contributions of each member. For example, a member who contributes 50% of the capital typically receives 50% of the voting power. However, there are variations in these default rules depending on the state:
- Some states allocate voting rights on a per capita basis (one vote per member) unless the LLC operating agreement specifies otherwise.
- Other states determine voting rights based on members’ interests in LLC profits, which may differ from their capital interests.
Under these state default rules, most matters requiring a vote among the members must be approved by a majority, meaning more than 50% of the total voting interests of the members.
Example
Sweet Sensations Bakery, LLC, a bakery business with three partners, has allocated ownership percentages among its members as follows: Rachel owns 30%, Jason has 25%, and Melissa holds 45%. For any resolution or decision to be approved, it requires the affirmative support of at least two out of the three partners to form a majority.
In scenarios where the LLC is manager-managed, the typical state rule grants each manager one vote, and a majority of these votes is required to approve decisions. This system emphasizes the importance of clearly defining voting rights and structures in the operating agreement to ensure smooth governance and decision-making processes within the LLC.
Example
Sweet Delights Bakery, LLC, is a bakery venture operated by four entrepreneurs, with management handled by a five-person team. This team consists of the four member-owners along with an additional non-member, Luca, a master baker celebrated for his skill in crafting a signature brioche twist—a standout product of the bakery—and his superb culinary prowess. In this manager-managed framework, each manager, whether a member or not, holds one vote on critical management issues. For any resolution or major decision to be approved, a majority vote is required, necessitating at least three out of the five managers to be in agreement.
Luca’s role is central; he is more than just a member of the team but acts as an essential tie-breaker. Whenever the member-owners find themselves split evenly in their decisions, leading to a two-to-two deadlock, Luca’s vote becomes the deciding factor, effectively breaking ties and facilitating smooth decision-making. This organizational structure emphasizes the vital role each manager plays in reaching consensus and driving the bakery’s progress forward.
How Should Membership and Management Meetings Be Conducted for an LLC?
State regulations typically do not mandate specific requirements for the frequency, notification procedures, or conduct of LLC membership meetings. It is generally up to the LLC members to establish their own rules for these meetings. The operating agreements provided in this guide do not require regular LLC meetings, allowing for flexibility in decision-making processes. Formal meetings are often unnecessary for many critical business decisions, which can be made more efficiently without them.
However, there are certain situations where holding formal LLC meetings, with decisions recorded in written minutes, becomes essential:
- Legal or Tax Formalities: If the LLC needs to approve and record significant legal or tax actions, such as making a legal or tax election or approving the buy-back of a departing member’s interest, a formal meeting is required to ensure these actions are properly documented in the LLC records.
- Significant Business Decisions: When facing major or contested business decisions that impact the LLC significantly, such as selling key assets or dissolving the LLC contrary to the wishes of some members, it’s crucial to have a formal meeting with all members present to discuss and approve these actions.
- Management Elections: In the case of a manager-managed LLC, formal meetings may be necessary to elect or re-elect the management team for subsequent terms.
While requiring regular meetings can be time-consuming and may not always be necessary, establishing guidelines for when these meetings should occur ensures that important decisions are handled appropriately and are legally compliant. This practice not only aids in the smooth operation of the business but also protects the interests of all members involved.
What Are the Limits of Liability for LLC Members and Managers?
One of the primary advantages of forming an LLC is the protection it offers in terms of limited personal liability for its members and managers. This protection generally shields them from personal financial responsibility for debts and legal actions against the LLC. However, it’s crucial to understand that this immunity is not absolute and there are several scenarios where members and managers could still face liability:
- Breach of Fiduciary Duties: Members and managers have fiduciary duties to the LLC and to each other. If they act in ways that breach these duties—such as engaging in fraud, misuse of company assets, or gross negligence—they can be held personally liable.
- Personal Guarantees: If a member or manager personally guarantees a loan or another type of financial obligation for the LLC, they can be held liable if the LLC fails to meet its obligations.
- Illegal Actions: Members and managers are not protected from liability for committing illegal acts, whether these acts are directly related to the business operations or not.
- Direct Actions Against Individuals: If a member or manager personally injures someone or personally engages in a wrongful act, they can be held individually liable.
- Impact of Outside Liabilities on the LLC: An LLC member’s personal liabilities, like personal bankruptcy or legal judgments against them, could potentially affect the LLC. For example, a creditor of a member might attempt to seize the member’s interest in the LLC, affecting the operations and potentially the stability of the LLC itself.
Understanding these limitations is essential for members and managers of an LLC. It ensures they operate within the bounds of the law and the organizational structure, maintaining the integrity and financial health of the business while protecting themselves and the entity from undue risks.
What Is the Duty of Good Faith Required of LLC Members and Managers?
Members of a member-managed LLC and managers of a manager-managed LLC are legally obligated to manage the LLC in good faith and in the best interests of the LLC and its members. This requirement is known as the “duty of care,” akin to the obligation that corporate directors owe to a corporation. In corporate law, this duty is further clarified by the “business judgment rule,” which protects managers and members from personal liability for honest business errors as long as their decisions are based on a rational assessment of the facts available to them, even if those decisions later result in financial loss.
Example
Tom and Linda, two of the three partners of Sweet Treats Bakery LLC, a member-managed bakery, decide to allocate a quarter of the bakery’s saved profits to promote Tom’s new creation, the GlowCake—a cake with an illuminated decorative element. Despite the profitability of this innovation being uncertain and actively debated, they move forward with the investment, outvoting the third partner, Carl, who disagrees with the plan. The product fails to capture market interest, resulting in substantial financial losses.
Can Carl sue Tom and Linda for their decision?
Under the business judgment rule, as long as their decision was made without deceit, concealment, or misrepresentation, and was a legitimate business decision, they should not be personally liable for the financial fallout. However, if Tom and Linda had omitted critical information about the product’s viability that might have impacted the decision-making process, Carl might have a case to reclaim the lost investment directly from them for failing to disclose all essential facts during the decision-making process.
This situation underscores the importance of transparency and good faith in managing an LLC, ensuring that all members or managers act with honesty and integrity in their business dealings.
What Are the Legal Consequences for LLC Members and Managers Causing Unjustifiable Loss?
In many states, LLC laws permit members to initiate “derivative actions”—lawsuits filed on behalf of the LLC against other members or managers who are believed to have caused financial harm to the LLC. These actions provide a mechanism for holding members or managers accountable for actions that detrimentally affect the company’s financial health.
Example
Consider the situation at Sweet Treats Bakery LLC. In this case, Tom and Linda redirect funds for their personal use rather than allocating them to the development and promotion of Tom’s GlowCake. Such actions are not only unethical but also legally actionable. Tom and Linda can be sued by Carl, representing the bakery, and they may be held personally liable for the amount of the misappropriated funds.
Additionally, many states include “indemnification” provisions in their LLC laws. These provisions mean that the LLC itself may cover legal expenses, settlements, court judgments, fines, and other liabilities that arise from management decisions, provided that the person benefiting from indemnification acted in good faith and in the best interests of the LLC. However, these protections do not extend to intentional misconduct, fraud, or illegal actions.
It’s important for LLC members and managers to understand these legal aspects thoroughly. Members or managers considering actions that could potentially harm the LLC should consult with legal experts familiar with LLC laws in their state to understand the implications fully and ensure compliance with the law. These provisions highlight the importance of acting responsibly and ethically in the management of an LLC to avoid personal liability and potential legal consequences.
How Does Liability to Outsiders Affect LLC Members and Managers?
LLC members and managers generally benefit from limited liability protection, meaning they are not normally held personally responsible for management errors. This foundational aspect of LLC structure shields personal assets from claims against the business under most circumstances.
Example of Limited Liablity
In the case of Cakes & Crusts Bakery LLC, when a customer sues the bakery and its owners personally for a poorly executed custom cake order that led to a significant event disruption, the owners would not be personally liable. The limited liability structure of an LLC should protect their personal assets from claims arising from this business issue.
However, limited liability does not extend to personal actions that cause harm, such as torts—legal wrongs like negligence that result in injury or property damage to others. Members and managers can be held personally liable if their negligent actions cause harm.
Example of Tort Liability
Oscar, an employee/member of Oscar’s Oven Fresh Bakery LLC, while on a delivery for the bakery, negligently collides with another vehicle, causing significant damage and personal injury to the other driver. Despite his LLC membership, Oscar can be held personally responsible for both the repair costs and medical expenses resulting from the accident.
It’s crucial for LLC members and managers to verify their insurance coverage to handle such liabilities. Insurance policies such as commercial, automotive, workers’ compensation, or even a member’s homeowner policy might cover damages arising from torts committed by LLC managers or employees. Checking both LLC and personal insurance coverage can provide important protections in the event of an accident, potentially covering some or all of the damages incurred.
Understanding these aspects of liability helps LLC members and managers prepare and protect themselves adequately against possible legal challenges and financial risks.
What Happens When a Creditor Targets an LLC Member’s Interest?
While the LLC structure generally protects members from being personally liable for business debts, the reverse situation—personal creditors targeting an LLC member’s interest—does present a vulnerability.
Under the laws of most states, the personal property of an LLC member, including their interest in the LLC, can be reached by personal creditors through what is called a charging order. This legal mechanism does not transfer ownership of the interest itself but acts as a lien on distributions from the LLC to the debtor member. Essentially, it allows the creditor to intercept profits that would otherwise go to the member.
Example
Alex has a personal loan from a car dealer that he fails to repay. In response, the car dealer obtains a charging order against his interest in the LLC. This order does not transfer ownership of Alex’s LLC interest to the car dealer but allows it to receive any profit distributions that would normally be paid to Alex, as outlined in the LLC’s operating agreement.
This form of creditor action reflects the unique intersection of personal liability and business operations in the context of an LLC. Members must be aware that while their personal assets are generally protected from business liabilities, their business assets (in the form of profit distributions from an LLC) can be vulnerable to personal creditors. This understanding is crucial for financial planning and for protecting the stability of both personal and business financial affairs.
How Does a Creditor’s Foreclosure on an LLC Member’s Interest Affect the LLC?
A charging order against an LLC member’s interest might not be very beneficial to a creditor if the LLC does not distribute profits regularly. In such cases, a creditor may seek to escalate the situation by asking a state court to foreclose on the member’s interest. If state law permits, and if the court approves, this allows the personal creditor to become a new legal owner of the LLC interest, but with specific limitations.
- Understanding Foreclosure and Transferee Status: When a creditor forecloses on an LLC interest, most state laws stipulate that the creditor becomes a “transferee” or “assignee.” This status entitles the creditor to all economic rights associated with the member’s interest, such as receiving distributions and benefiting from the value of the interest upon the business’s sale or liquidation. However, transferees typically do not receive the right to participate in the management or voting of the LLC nor other full membership rights.
- Impact on LLC Operations: This limited involvement means that if an LLC does not frequently distribute profits or is unlikely to be sold, the economic benefits to the creditor can be minimal. However, should a creditor become a full voting member (which is less common but possible under some states’ laws), it could disrupt the LLC’s operations significantly. A creditor’s primary goal is often to liquidate the interest to settle the debt, not to contribute to the LLC’s ongoing success.
- Potential for Forced Dissolution: Additionally, in some jurisdictions, assignees or transferees might have the legal right to petition for the dissolution of the LLC. This is considered an extreme measure but can be invoked by creditors seeking to recover debts through the liquidation of the LLC’s assets.
- Legal Consultation Is Key: Given the complexities and variances in state laws regarding LLCs and creditor actions, it is essential for LLC members to consult with an experienced attorney. This step is crucial to understand the potential implications of personal financial issues on their business interests, including the possibilities of charging orders, foreclosure, and forced dissolution. This legal advice can help protect both the individual’s and the LLC’s interests, ensuring that all parties are aware of their rights and obligations under the law.
Are LLC Membership Interests Considered Securities Under the Law?
When someone purchases or invests in an LLC, determining whether their membership interest constitutes a “security” as defined by state or federal laws is crucial. This classification affects whether the interest needs to be registered with the Securities and Exchange Commission (SEC) at the federal level and with state securities offices, or if it qualifies for an exemption from these registration requirements.
Understanding the Definition of a Security: The definition of what constitutes a security isn’t straightforward but generally hinges on the investor’s involvement and expectation in the business. A key criterion often used to determine if an LLC membership is a security comes from a common legal interpretation known as the “Howey Test,” derived from SEC v. W.J. Howey Co. This test considers an investment contract as a security if it involves an investment of money in a common enterprise with an expectation of profits to be derived from the efforts of others.
- Active vs. Passive Investors: If the owner of an LLC interest actively manages or operates the business, typically, this interest is not considered a security. For example, if a person buys into an LLC and intends to work actively in managing the business, their membership interest is usually not a security.
- Reliance on the Efforts of Others: Conversely, if an investor purchases an interest in an LLC with the expectation that they will profit from the efforts of others (e.g., a professionally managed LLC where the investor has no role in daily operations), then the interest is more likely to be classified as a security under both federal and state laws.
Legal Implications: If an LLC interest is classified as a security, it must adhere to specific regulatory requirements, including registration or qualification for an exemption. These laws are designed to protect investors from fraudulent schemes and ensure transparency in the investment’s management and financial condition.
Protection for Investors: Securities laws aim to shield investors from unethical practices and ensure they have adequate information about their investments. They are not designed to protect active business owners from the outcomes of their business decisions.
Conclusion: LLC members or potential investors should consider the nature of their investment and their role in the business when evaluating whether an LLC interest might be treated as a security. It is advisable for LLCs and investors to consult with legal experts specializing in securities law to ensure compliance with relevant regulations and to safeguard their investments appropriately. This legal consultation is crucial in navigating the complex landscape of securities law and its application to LLC membership interests.
Why Are Member-Managed LLC Interests Typically Not Considered Securities?
In a member-managed LLC, where each member is actively involved in the management and operation of the business, the membership interests are generally not classified as securities. This classification is based on the principle that the profits are earned through the members’ own efforts rather than from the efforts of others.
Understanding the Role of Active Participation: The primary distinction in securities law, particularly under the framework set by the Howey Test, hinges on the source of expected profits. The test determines that an investment is considered a security if the returns are expected to come primarily from the efforts of someone other than the investor.
- Member Contribution in Management: In a member-managed LLC, each member is directly involved in decision-making and day-to-day management. This active participation means that the members are not merely passive investors waiting for profits generated by the efforts of others, which is a key criterion for defining an investment as a security.
Implications of This Classification: By not being classified as securities, membership interests in a member-managed LLC bypass certain regulatory burdens, such as the need for registration with the SEC or state securities authorities. This simplification can lead to reduced legal and administrative costs and less complexity in how the business is run.
Legal Protections Still Apply: While these interests might not be securities, members still have legal protections under other areas of business and contract law. These laws help ensure that all members fulfill their duties and obligations towards the LLC and each other.
Conclusion: For entrepreneurs considering forming an LLC, understanding whether their membership interests might be considered securities is crucial. In member-managed LLCs, the active involvement of each member in the business typically means that these interests are not securities, providing a clearer and more direct path to managing their business without the additional regulatory oversight required for securities. This aspect should be considered when planning the structure and operational strategy of the LLC.
How Do Securities Laws Apply to Manager-Managed LLCs?
In the case of a manager-managed LLC, where members do not actively participate in the management of the company, the interests of non-managing members are more likely to be considered securities under state and federal law. This classification arises because these members typically expect to earn profits from the efforts of the managers rather than through their own active participation. This distinction may lead securities regulators to apply an “all or none” approach, where either all LLC memberships are considered securities, or none are, depending on the specifics of the LLC’s operations.
Navigating the Securities Landscape: Even if your LLC membership interests are classified as securities, there are several exemptions under federal securities law that can facilitate compliance and reduce regulatory burdens:
- Private Placements:
- Under Section 4(2) of the Securities Act of 1933, an LLC can sell securities privately to a limited number of investors without general advertising or promotion.
- This exemption is more likely if there are restrictions on the transfer of memberships (e.g., language on membership certificates and in LLC records that limit transfers).
- Typically suitable for smaller LLCs, where the memberships are a personal investment, and resale is restricted.
- Inside-the-State Sales:
- The intrastate offering exemption under Section 3(a)(11) of the Securities Act exempts from registration the offer and sale of securities conducted entirely within one state to residents of that state.
- This exemption can be useful for LLCs operating and offering memberships only within a single state.
- Regulation D:
- This is a more formal exemption process requiring adherence to specific Regulation D rules and filing Form D with the SEC.
- Regulation D is feasible if you offer and sell small membership interests to a limited number of people (typically up to 35), who might be personal friends, family members, or associates with sufficient financial acumen to understand and manage the risks.
- Restrictions on the transfer of memberships are also necessary under this exemption.
State Law Considerations: State securities exemptions often parallel federal rules. Many states offer exemptions for private sales of securities solely within the state or to a limited number of persons. Depending on the state, you may need to file an exemption form and possibly pay a filing fee.
Conclusion: Manager-managed LLCs should carefully assess whether their membership interests are classified as securities and consider available exemptions for compliance. Consulting with a legal expert in securities law is highly recommended to navigate these complex regulations effectively and ensure that the LLC operates within legal boundaries while minimizing potential legal and financial risks.
