Ten Steps to Organizing an LLC
Jump right in as we take you step by step through the process of forming your own limited liability company (LLC).
Excerpted From Forming an LLC (Entrepreneur Press)
Organizing an LLC yourself can seem daunting upon first glance, but it's actually a series of small, simple tasks.
Step 1: Where Should You Organize?Your LLC's life begins when you file articles of organization with the secretary of state or an equivalent department of state government. (The federal government does not charter LLCs or corporations.) Several factors should guide your decision on which state is the best for your LLC. Those factors include the following:
- The state or states in which your business operates (the most important consideration for most companies)
- Initial LLC filing fees
- Annual filing fees and annual reporting requirements
- State-specific advantages such as privacy rights
As a general rule, if your business is small and operates in and sells products or services in only one state or even just mostly in one state, you should organize your LLC in the state where you conduct business.
But what if your LLC operates or does business in several states? You may be required to register in all the states where you do business-regardless of the state you choose for your organization. States generally require out-of-state LLCs (called foreign LLCs) to register and pay fees in the state in which they are operating as a guest. For example, a Delaware LLC that transacts business in California must register in California as a foreign LLC [and] pay a filing fee in California.
Step 2: Select Your LLC's NameAt this stage in the organization process, you must choose a name for your LLC. Understand, of course, that you may use a trade name in the public marketplace other than your LLC's name. This is called doing business as (DBA) a fictitious name. For example, a company could operate a store under the trade name Evolution, but the LLC's name could be Evolution Trade Group LLC, or any other name. The single greatest consideration when choosing a name is ensuring that no other person or entity is currently using the name. This consideration is guided by two factors. First, your use of a company name may infringe on the trademark or service mark rights of others. Infringing on the trademark rights of others may result in legal complications. Second, the secretary of state's office will not register a new LLC with the same name as an existing LLC. Keep in mind, however, that a secretary of state's office will have existing records only for company names in that state-the office will have no records for company names in the other 49 states. Thus, you may wish to search for existing trademarks and LLC names to ensure that your desired name is available.
Searching the Secretary of State's Records for Existing Company Names
Assuming that your name does not trigger a conflict with a registered or unregistered trademark, you should then search an online database of existing company names with the secretary of state in the state in which you intend to organize. Keep in mind that your LLC name must be distinguishable not only from other LLCs, but from corporations and partnerships as well. Nearly all secretary of state web sites offer free searching of existing company names.
A Note on LLC Names
Your LLC's name should reflect LLC status. Most states require an LLC identifier. Perhaps more importantly, you should always hold yourself out to the public as an LLC to ensure maximum liability protection. Therefore, your LLC's name must include either Limited Liability Company, Limited Liability Co. or LLC. (Some states allow Limited or Ltd., but this designation may imply a limited partnership.)
Step 3: Select the Registered AgentA registered agent is a person or entity authorized and obligated to receive legal papers on behalf of an LLC. Because an LLC is not a physical person, service of legal papers on an LLC without such a designated representative would be impossible. The registered agent is identified in the articles of organization, but can typically be changed upon the filing of a notice with the secretary of state. (Your state of organization may use a different term than registered agent. Typical equivalents include agent for service of process, local agent, and resident agent.)
The agent can be you, a family member, a corporate officer, an attorney, or a company that specializes in corporation and business services. The registered agent's name is a public record; if you desire anonymity, hire a professional to perform this service. The agent must have a physical address in the state of organization. Thus, if your business does not operate in the state of organization, you will need to hire a registered agent in that state. You must consider this additional expense when organizing out of state. Such services typically range from $50 to $150 per year. If you wish to hire a local agent and don't know where to turn, visit www.bizfilings.com . Business Filings, Inc. offers resident agent services in all 50 states at reasonable prices.
Having an attorney or a professional firm to serve as agent has advantages. Because the primary role of an agent is to receive service of legal papers, an attorney or a professional firm is likely to maintain a consistent address and to understand the nature of any legal papers served upon them. The agent will also receive important state and federal mail, such as tax forms, annual LLC report forms, legal notices, and the like.
Note that most secretary of state's offices where you file your LLC papers will not check to see if you have properly secured the services of a registered agent. If you do not select a registered agent properly, the secretary of state will mail you documents at the registered agent's address and you will not receive them. Thus, you should hire your registered agent either before or while filing your articles of organization.
Step 4: Should You Organize Your LLC Yourself or Hire an Attorney?At this stage in your organization, you must decide whether you will file and organize your LLC on your own, hire a discount LLC service or hire an attorney. Each approach has its advantages and disadvantages.
Self-Organization . Obviously, the greatest benefit of organizing your LLC yourself is initial savings. Self-organizing an LLC carries the lowest initial cost. Of course, as with any legal matter, cutting costs can often cost more later. For example, if your LLC is not properly organized, ambitious creditors may later reach your personal assets by piercing the corporate veil. (The doctrine applies equally to corporations and LLCs.) See Chapters 6 and 7 for more information on preserving your LLC's full liability protection.
Discount LLC Organization Services. A slightly more expensive alternative is to hire a discount LLC organization service. The prices range from $200 to $300 per company, and the companies offer a streamlined but competent service. Such companies are essentially filing services and include only the following activities:
- They file articles of organization with the appropriate state office.
- They prepare a boilerplate operating agreement.
- They record the minutes of the initial meeting of LLC members.
Nevertheless, discount LLC organization services do offer value. They can often navigate the bureaucratic complexities of various states and provide prompt service and tested documents. However, the boilerplate operating agreement and proposed minutes of the organizational meeting that discount organization services provide often contain fill-in-the-blank and optional provisions that can baffle an inexperienced organizer.
Hiring an Experienced Business Attorney. Finally, you may wish to hire a business attorney to organize your LLC for you. A qualified business attorney can do the following:
- Suggest alternatives and solutions that wouldn't occur to even the most diligent layperson.
- Assist with more complex features of LLCs, such as operating agreements and manager-managed LLCs.
- Anticipate problems before they arise.
- Prepare an operating agreement and minutes of the organizational meeting of members according to your specific needs.
- Ensure that no federal or state securities laws are violated when interests in the entity are sold to raise capital for the business.
What you can expect to pay varies. The hourly rate for business attorneys ranges from $100 to $350 per hour. The lower end of the scale will apply outside of major metropolitan areas and for less experienced attorneys. For services such as forming LLCs and corporations, business attorneys often charge a flat fee. You can expect to pay between $500 and $2,000 for complete organization services.
Step 5: Determine the LLC OwnershipYour LLC will issue ownership shares, called units, to its members as part of the organization process. A member's units in an LLC are referred to in the aggregate as [their] percentage interest. So if an LLC issues 100 units to its members and one member receives 60 units, that member's ownership percentage is 60 percent. You should choose your ownership structure early in the organization process, before filing your articles of organization.
The owners of an LLC will have the right to vote their units in proportion to their ownership interest. Thus, majority voting power ultimately exercises control over LLCs. Even if the LLC members choose to delegate management and operating authority to appointed managers, the members ultimately enjoy the right to elect managers and, if necessary, remove managers. In short, LLC members never delegate all their voting power and they have ultimate authority and control over the LLC.
How Many Members?
In the early years of the development of the American LLC, many states required LLCs to have two or more members-single-member LLCs were prohibited. Today, all states allow single-member LLCs. There are no legal prohibitions on the maximum number of LLC owners, but you should try to keep the number of members small.
Each member admitted to the LLC should execute an investment representation letter. The investment representation letter offers some measure of protection to the entity because the member being admitted to the LLC makes certain representations regarding his or her qualifications and fitness to serve as a member of the LLC. Also, in the investment representation letter, the member makes certain representations regarding his or her investment objectives, which are necessary representations in order to comply with state and federal securities laws.
Business owners contribute to a business a capital contribution of property in exchange for an interest in the business. A capital contribution is the total amount of cash, other property, services rendered, promissory notes, and/or other obligations contributed to a company for such owners' interest in a company. As a general rule, the amounts of capital contributions made to an LLC determine the ownership percentages in that LLC.
Members' capital contributions should be determined at the planning stage. Each member's capital contributions should be committed to writing in the LLC's operating agreement.
Step 6: File the Articles of OrganizationThe life of an LLC begins with the preparation and filing of articles of organization. Typically a one-page document, the articles of organization set out the following basic information:
- The name of the LLC
- The name and address of the agent for service of process, the person or entity authorized to receive legal papers on behalf of an LLC
- A statement of the LLC's purpose
- Optionally, the names of initial members or managers
- Other optional matters, such as whether the LLC will have an infinite life or be dissolved on some date
To begin the life of an LLC, you file articles of organization with the secretary of state (or other appropriate department) in the state of organization. You must file articles of organization along with a filing fee, which differs in each state.
As a general rule, don't appoint initial members or managers in your articles of organization unless it is required. The states differ on whether appointment of initial members or managers is required in articles of organization. In California, listing the names of initial managers/members is optional. In Nevada, it's required. Members and managers can easily be appointed soon after filing. Articles of organization are public documents and thus could reveal the names of an LLC's members to any member of the public.
Nearly every secretary of state's web site offers sample articles of organization in either word processor or portable document format (PDF). You should always use the form recommended by the secretary of state, if one is available.
Step 7: Order Your LLC Kit and Seal (Optional)An LLC kit is little more than an attractive three-ring binder where you maintain LLC records such as articles of organization, operating agreement, minutes of meetings, tax filings, business licenses, membership ledger, etc. LLC kits range in price from $50 to $100. LLC kits usually include the following:
- Model operating agreement and minutes of the organizational meeting, with optional provisions
- Blank stock certificates
- An LLC embossing seal
- A blank member ledger and transfer ledger
- LLC forms on CD
LLC kits aren't required by law in any state; they are completely optional. Whether you elect to purchase a kit or not, you should always maintain the following core LLC documents in a three-ring binder: articles of organization, operating agreement, membership ledger, and business licenses.
The LLC Seal
An LLC seal is a hand-operated embossing seal that contains the name of your LLC, state of organization, and date of organization. Seals are used to impress the official company endorsement on important documents, such as recorded minutes of company meetings. LLC seals have a historical ancestor: the corporate seal. Corporate seals, once universally required, are no longer mandated in every state. LLC seals are standard features in almost any LLC kit but are typically not required by law.
A stock certificate is a printed document that evidences ownership of shares in an LLC. LLC kits will include blank stock certificates. You can print the certificates by running them through a printer, typing them, or filling them out by hand.
Stock certificates are historically associated with corporations. However, LLCs operate with less formality than corporations; stock certificates aren't as commonly used by LLCs. Still, the function of stock certificates is important: it gives the stockholder written evidence of his or her ownership of the company. I recommend the use of stock certificates because they minimize disputes over ownership.
A membership ledger is a written table showing the owners of an LLC. The ledger must also indicate the percentage held by each owner. As new members are added to the LLC through the sale of membership interests, their ownership is recorded on the ledger. The membership ledger should also show transfers of members' ownership interest, as when a member dies and his or her interest is transferred through his or her will.
The importance of the membership ledger cannot be overstated. It should be maintained diligently. The membership ledger is akin to the deed on a piece of real estate. It is the primary evidence of ownership in an LLC and carries a great degree of weight when presented in court. LLC owners should insist upon receiving updated copies of the membership ledger periodically. See Appendix A for a sample membership ledger.
Step 8: Define the Management Structure and Choose ManagersThe next step is to decide what type of LLC your company will be: a member-managed LLC or a manager-managed LLC. Your choice is not carved in stone. A member-managed LLC can switch to a manager-managed LLC with a mere vote of its members and a new or revised operating agreement.
Member-managed LLCs are operated by the LLC's owners, much in the manner of a general partnership. Smaller LLCs tend to be member-managed. Member management is simpler because it doesn't require any voting or appointment of managers-the owners themselves simply go right to work on the LLC's business. Single-member LLCs, in almost all cases, will be member-managed.
Manager-managed LLCs are operated by appointed managers, who may or may not be members. Manager-managed LLCs appear and operate much like limited partnerships or corporations. They are more complex because the appointment of managers requires voting rules to govern the process of appointment. Larger LLCs tend to be managed by appointed managers.
If you select a manager-managed format for your LLC, the members will need to agree on a few points at the beginning. First, how many managers will run the LLC? One manager works fine for a small company. Larger companies with more complex challenges benefit from the informed consensus that builds through a multimanager team. Put simply, three people are less likely to make a bad decision collectively than one person acting alone.
Finally, odd-numbered manager teams are always preferable to even-numbered manager teams. Even-numbered teams can sometimes encounter deadlock on decisions, when managers split 50-50 on an issue. Extreme cases of deadlock can trigger resignation or removal fights, owner votes, and sometimes even court intervention if the deadlock can't be resolved according to the LLC's operating rules.
Once you determine your LLC's management structure and the number of managers, you simply select appropriate provisions for your operating agreement. If your LLC is to be manager-managed, you will select initial managers and name them in the LLC's operating agreement. LLC managers can, but need not, be LLC members.
Ultimately, LLC managers serve on behalf of an LLC's members. Keep in mind that a proper operating agreement should always give the members the right to oust a manager who is not serving to the satisfaction of members. It is also wise to require that managers be appointed every year or every few years. Managers should not be appointed for indefinite terms.
Step 9: Prepare and Approve Your LLC's Operating Agreement
The operating agreement governs an LLC's internal operations, [including] such as holding meetings, voting, quorums, elections, and the powers of members and managers. Operating agreements are usually set out in a five- to 20-page document. Your LLC kit, if you choose to purchase one, may contain a sample operating agreement for your particular state. Operating agreements are not filed with the state, like articles of organization. In fact, operating agreements should be kept confidential. Yours should remain with the LLC's core records.
The preparation of your operating agreement takes work. Don't simply sign any sample agreement. You must read through the entire document and make sure that you understand all of its provisions. You and your co-owners should execute the operating agreement only after you have all thoroughly digested its contents.
While many states don't legally require your LLC to have a written operating agreement, it is unwise to operate an LLC without one. The first reason is simple: Oral agreements lead to misunderstandings. You are overwhelmingly less likely to have a dispute among members if all parties commit their understandings to a mutual written document.
If your LLC members do not adopt an operating agreement, your LLC will be governed by the state default rules. The default rules are set out in each state's statutes. Naturally, these rules don't cover every possible circumstance; they cover just the basics. You should not rely on the default rules because they might not be right for your company.
Finally, adopting an operating agreement can protect the members from personal liability in connection with LLC business. Members should always endeavor to give the LLC separate existence, to hold the LLC out to the public. An LLC without a written operating agreement can appear much like a sole proprietorship or partnership. LLCs require fewer formalities than corporations, but that doesn't mean that they require no formalities at all.
Percentage of Ownership
How the ownership percentages of an LLC are divided among its members is one of the most important decisions a company's organizers will face. Choose wisely-in most cases, more than 50.01 percent of the vote of an LLC's members can dictate significant decisions regarding the LLC. This is why many company founders so often jockey for 51 percent ownership-to maintain company control. Furthermore, if an LLC is ever sold, the money received for the LLC will probably be divided among the owners in proportion to their ownership.
The owners' percentage ownership should be set forth in writing as part of the operating agreement. This written record will eliminate any later misunderstandings or disputes with respect to share ownership.
A distributive share is each owner's percentage share of the LLC profits and losses. Most often, a member's distributive share is equal to that member's percentage ownership share. This is how most people set up their LLC. For example, Nancy is a 55 percent owner and Sheila a 45 percent owner of an LLC. At the end of the year, they have profits of $10,000 to divide between them as owners. They will divide these profits according to their ownership share. Nancy would receive 55 percent of the profits as her distributive share, or $5,500. Sheila would receive 45 percent of the profits as her distributive share, or $4,500.
Your operating agreement will cover the following matters:
- The powers and duties of members and managers
- The date and time of annual meetings of members and managers
- Procedures for removing managers, if you choose to operate a manager-managed LLC
- Procedures for electing managers
- Quorum requirements for member votes
- Quorum requirements for manager votes, if you choose to operate a manager-managed LLC
- Procedures for voting by written consent without appearing at a formal meeting
- Procedures for giving proxy to other members
- How profits and losses will be allocated among members
- Buy-sell rules, which set forth procedures for transfer when a member wants to sell his interest or dies
The owners of an LLC formally adopt the operating agreement by all signing the agreement and agreeing that it shall govern the operations of the LLC. An operating agreement is a contract among the members of an LLC; once it is executed, the LLC's members are bound by its terms.
Step 10: Obtain a Federal Tax Identification Number for Your LLC
Because your LLC is a legal entity, federal law requires that you obtain a Federal Employer Identification Number (EIN or FEIN). In addition, most banks require you to give an EIN before opening a bank account. You obtain your EIN by filling out Form SS-4, Application for Employer Identification Number, or by applying online. If you mail the form, expect to wait up to six weeks to receive your EIN. If you fax your form to a service center, you'll receive your EIN in about five days. You can also obtain an EIN immediately by telephoning an IRS service center during business hours.
To make an online application of an SS-4, [go] to https://sa2.www4.irs.gov/sa_vign/newFormSS4.do . Simply follow the instructions for filling out the form, and you'll receive your EIN in a few minutes. Print and save a copy of the form, and keep it with your entity's records. You don't need to mail a copy of the form to the IRS.
Your LLC's Fiscal Year
LLCs must have the same fiscal year-end as their members. While LLCs can have corporations as owners, it's more common for LLCs to be owned by natural persons. Natural persons, like you and me, have fiscal years that end on December 31-our fiscal year is a calendar year. LLCs that are owned by natural persons must select December 31 as their fiscal year. Thus, the LLC's tax returns will be due on April 15 in the year following each fiscal year.