Happy New Year everyone!
Welcome to a new year of growing your business and engaging in new ventures.
I wanted to start this year with a topic that applies to any industry or field because every business and project needs to be properly structured for legal and tax reasons. To keep it simple, this post focuses on a structure that has been widely publicized lately because of the recent tax bill passed to overhaul the U.S. tax code, Limited Liability Companies, or LLCs. It is reported that the new bill will lower the tax burden on LLC owners significantly. I’m not an accountant so I can’t verify whether this is true, but I am happy to see that LLCs are starting to enter the mainstream when discussing business structures!
Over the past 16 years plus, I have set up hundreds of LLCs for client ventures in real estate, music, television, film, technology, brand management, media collaborations, and as a structure to protect client’s intellectual property and other assets. I’ve always been a fan of LLCs from a legal perspective because, if formed and managed properly, this entity offers the best of both worlds…limited legal liability (which you don’t get with partnerships) and less formalities to deal with in comparison with running a corporation. For example, if you are a partner in a partnership and it gets sued, then your personal assets (i.e., house, cars) are vulnerable if the plaintiff wins. On the other end of the spectrum, if you are a shareholder in a small corporation and it fails to comply with certain legal and tax formalities, then your personal assets may also be at risk (i.e. the plaintiff may be able to “pierce” your corporate protection).
An LLC is an entity that falls somewhere in the middle of partnerships and corporations. Check out this short (45 second) video (and the associated blog post) if you want a quick explanation on this subject or more about LLCs.
The popularity of LLCs has increased significantly over the past decade. In California, the number of formations has increased by almost 70% (in 2006 there were about 62,000 LLCs formed; in 2016 there were about 104,000 formed). I predict that the number of newly formed LLCs will skyrocket in 2018 if the alleged tax advantages hold true, so I thought a great topic to kick off the new year would be to list 4 Common Mistakes that I see people make when forming or operating an LLC.
- LLC Members Do Not Have A “Deadlock Provision” In the Company Operating Agreement
A deadlock provision (or more formally called Impasse Resolution) is a method specified in the Operating Agreement that governs what happens when members with equal ownership disagree on a decision. A common scenario is when an LLC with only 2 equal members are at odds on a decision which results in a 50/50 deadlock (i.e., one member votes to get a bank loan; the second member votes not to get a bank loan). If the Operating Agreement states that all decisions must be made by majority vote, then what happens? Exactly! Without language in the Operating Agreement indicating how a deadlock is resolved, the company business could be adversely affected. I’ve seen unresolved deadlocks result in very bad outcomes, including members suing other members, businesses failing due to lack of management unity, and Courts ordering lucrative businesses to dissolve!
Be aware that many form Operating Agreements found on the Internet, or provided by LLC formation companies, do not include a deadlock provision. Make sure your Operating Agreement has a deadlock provision!
- The Company Operating Agreement Is Outdated
As you may be aware, California completely re-wrote its LLC law in 2014 and made some additional revisions in 2015. The new law is called the California Revised Uniform Limited Liability Company Act. If your company is older than 4 years, or happened to use an old Operating Agreement template, you need to update it immediately.
In general, the previous LLC law provided members with flexibility when drafting the company’s Operating Agreement. This allowed the Operating Agreement to govern operations and the old law supplemented what may not have been covered in the agreement. The new law takes the opposite approach. It defines specific default laws that automatically apply if the company’s Operating Agreement does not address a certain issue.
For example, the new law states that an LLC is member-managed (it takes a vote of the members to approve something) unless the LLC (1) has filed articles of organization stating that the LLC is manager-managed (approval is allowed by one or more managers); and (2) has a written operating agreement expressly establishing management by a manager. Many existing manager-managed LLCs formed under the previous law may not comply with both of these provisions since it was not a requirement, so the new law may have automatically converted these LLCs to member-managed entities, which means the current manager no longer has authority to make decisions. Imagine what would happen if a dispute occurs based on one of those unauthorized decisions! I recently saw this issue result in a company losing a lawsuit.
Make sure your company is operating under an updated Operating Agreement.
3. The Members Do Not Properly Document LLC Activity
This is a common scenario. You form an LLC through one of those cookie cutter companies and eagerly start to hold yourself out as a formal business. A few years later, you engage an attorney for some reason (to discuss a lawsuit against the company, the company wants to apply for a bank loan, someone wants to buy the company, etc.) and you give the attorney your nice-looking LLC record book. When the attorney opens the book, the only things in it are the filed Articles of Organization and a bunch of unsigned template documents!
This scenario happens frequently so don’t feel embarrassed. Many people are in love with the concept of owning a company but ignore the work that is required to properly form it and maintain records. Don’t be that person.
There are many reasons why you need to keep your records up to date. The following are a few examples:
- To Prevent “piercing” of your legal protection. If you are in a lawsuit, the first thing an opposing party will do is try to discredit the existence of your LLC and get to your personal assets. If your paperwork is not in order you are helping the other side.
- To Memorialize membership percentages. It is critical that each member’s ownership interested is documented in a signed Operating Agreement! I once had a client who believed that he was a 50% owner based on an unsigned Operating Agreement. After he was sued by the other members, the Court ruled that he only owned 1/3 of the company. He lost a lot of money because of this ruling.
- To define the scope and limits of management. Whether your LLC is member-managed or manager-managed, everyone needs to be clear on how decisions are made. Usually there are some decisions that can be done without everyone’s participation, but major decisions, like whether the company will be sold, should require unanimous approval. Any limits should be spelled out in the Operating Agreement.
- To Document Member Contributions and Member Loans. Almost every company deals with funding issues at some time. Usually members will transfer money and property to and from the LLC, which is normal, but these transfers need to be properly categorized and documented! It is different if you contribute money to the LLC in exchange for membership interest vs. you loaning the LLC money that you expect to be repaid. If you don’t document your transfers, the IRS or a Court may do so however they see fit. I don’t suggest you let this happen.
- To Properly Purchase or Transfer Assets Into The LLC’s Name. Members who purchase assets or register IP with the intent that the LLC be the owner need to properly assign and transfer the transfer in writing. Failing to do so can result in a rude awakening during a significant Company event, such as a lawsuit, bankruptcy, or company dissolution.
- LLC Members Commingle Company Funds With Personal Funds
This is another very common mistake. The most important rule when operating an LLC is to not commingle funds! This includes things like a member cannot pay personal bills with LLC money and vice versa. All LLC income must go into the LLC bank account and all expenses must come out of that account. Even small things like your monthly web domain charges. If the LLC is short of cash, the members should deposit money into the LLC account, pay the expense, and properly document the transfer of funds as either a capital contribution or a loan.
If a member needs money and the LLC has excess funds, the LLC should pay the member and the LLC will reflect on its books that the payment is either a return of capital, a distribution of profits, or a repayment of a loan.
I see many more mistakes but these are probably some of the most costly.
Until next time!