The Limited Liability Company (LLC) is a popular form of business for good reason – it offers liability protection and flexibility. It has not always been available, but since Congress adjusted the tax code to allow it, the LLC has become the most favored business entity. Black’s Law Dictionary defines the LLC as “A company – statutorily authorized in certain states – that is characterized by limited liability, management by members or managers, and limitation on ownership transfer.” As we’ll see, there is more to it.
An LLC is not to be confused with a partnership. Sometimes, people loosely use the term “business partner” or “partnership.” But, it is, in fact, a term of art and an entity type similar to that of an LLC (just a lot more dangerous). One of the main features is how easy it is to establish a partnership. But, from a lawyer’s perspective, your goal is really trying to AVOID creating a partnership entity. The reason is that, in a legal “partnership,” each partner is jointly and severally liable, personally, for the debts and liabilities of the business.
In other words, being “partners” with someone inside of an LLC is a great idea. Being “partners” in a partnership entity is usually not a good idea. Instead, use an LLC to protect your personal assets and to protect yourself from the actions of your partner.
For the most part, people use the phrase partnership to describe two or more people working together as business owners. That’s how we are going to approach the rest of this article (but, do yourself a favor and don’t get in a legal partnership without consulting an attorney).
LLCs enjoy liability protection just like corporations, which means the owners have a statutory shield from liability. The owners are not personally liable for the debts and obligations of the LLC. In other words, if the company fails, the investors’ and owners’ personal assets are not at risk – provided you understand rules. In South Carolina, for instance, the code says “the debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company.” (Section 33-44-303(a). The rules are similar in most states.
Partnerships do not enjoy liability protection. Even worse, you are liable not only for yourself and the business but your partner too.
Flexibility in Management
Like partnerships, LLCs provide flexibility in governance and operation structure. The trick is creating an operating agreement (like a partnership agreement). Operating agreements are the governing agreements entered into by and among members. They spell out a wide range of rules and agreements. In an LLC, partners are called members. LLCs can be either member-managed or manager-managed, which is similar to partnerships in that actual partnerships provide great flexibility.
In different states, LLC default rules may be different so it’s important to have an operating agreement instruct members on LLC management. This way members can select what works best for the business. Here are some of the agreements contained in good operating agreements:
- The use of company capital and how it affects members
- Financial rights and obligations of members
- Operational rights and obligations of members
- How to add or remove members
- Valuation of member interest and how to redeem interest
Through the use of a properly drafted operating agreement, it’s easy to add members to an LLC. Moreover, it’s possible to make an agreement specifically for your company.
Another advantage of the LLC is the tax options. There is no Internal Revenue Service (IRS) LLC designation (like there is with a corporation or partnership). Instead, LLCs select how they want to be taxed – an LLC simply “checks the box.” Depending on various circumstances, LLC members can be tax like a corporation at the entity level or taxes can pass through the company to the individual owners. There is also an option for the S-Corporation designation. It’s advisable to familiarize yourself with your options or consult a tax advisor when making these decisions.
Examples of LLCs and Establishing a Working Partnership
Two friends, Natalie and Kathleen, want to start a bakery. They want to go in 50/50 on everything: time, money, marketing, and everything else.
They can decide to set up an LLC called “Pitt Street Bakery, LLC” and designate it as member-managed. They can then opt for S-Corporation or pass-through taxation. Both ways will establish the company as a total “partnership” (used in the casual sense) with everything going into the business and all earnings and all assets as 50/50. The main thing they want is to make the business owned jointly between both owners.
The best way to cement a fair “partnership” within an LLC is to create an Operating Agreement (many call it a partnership agreement). In it, Natalie and Kathleen can list the various understandings between the two of them. For example, they can agree on how much of the business each person owns, who is responsible for what, how they will make decisions, how one person would leave the business, how receivables and payables will be handled, and they can put in place a buy-out provision. They can also agree on various expectations and job performances, among many other issues.
We encourage all businesses with multiple owners to have an agreement between the owners (whether it’s a partnership agreement (used in partnerships), operating agreement (used in LLCs), or bylaws and shareholders agreement (used in corporations)). Just the fact or reaching agreement on certain things and reducing it to writing, greatly enhances the chances of future agreement. It also eliminates ambiguities. The idea is simple: people generally try to uphold the commitments they make, especially written agreements.
Other Options and When to Use Them
There are many different variations of partnerships, LLCs, and even corporations. And, each of them has benefits in some scenarios. But, for a new business with a handful of owners, it’s hard to imagine many scenarios where an LLC is not a great decision.
Companies raising capital for companies with many investors may select other forms of business…often opting for a Delaware corporation for its many benefits (one of which is simply the investors familiarity with the structure and laws). If the structure is complicated or involves many people, it would behoove owners and investors to use a lawyer when deciding how to move forward. A lawyer can help the company create a corporate structure and help them decide how best to abide by the formalities. Raising money and investing with many investors are two main reasons a company might need to use a lawyer to set up a corporation.
How to Form an LLC
The first thing you have to do is set up a business plan. If there is no plan, there is no success. Next, you need to decide what kind of business designation you need: LLC, partnership, or corporation. Once you’ve decided, set it up. For an LLC, for instance, you can use an attorney or a reputable online service like Drafted.
You also need to create an operating agreement that takes into account the various different agreements between how the members intend on operating the company. This part is vital as well. Use an attorney or a premium legal resource to guide you in the right direction.
There are scores of other necessary things to do before your business becomes a success, but these things will give you a headstart.
One Last Thing…
Piercing the corporate veil is a lawyerly term meaning your company could expose members to liability if certain corporate formalities are not followed. It’s imperative that members keep business affairs and personal affairs separate.
If you and your business partners need help setting up your LLC or learning more about entity formation, visit Drafted Legal for more information. We’ve made it easy to set up your business easily and quickly while equipping you with the tools you need for success. Don’t zoom through your legal, get Drafted.