Tag Archives: small business

Forming Limited Liability Companies (LLC’s)

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The Limited Liability Company or LLC as it is better known has been one of the most popular business entity structures during the past 50 years. The LLC is the convenient hybrid of a partnership and a corporation and benefits form some of the most favorable aspects of both. LLCs limit the liability of their owners while giving them flexible management power and the ability to choose the business’s tax treatment. 

Unlike a general partnership, and more closely related to a corporation, the LLC must follow a series of rules for an effective formation, the failure to correctly follow these rules may prevent the attempted LLC from conducting business or protecting its owners from liability. 

An LLC is formed when articles of organization are filed with the Secretary of State (or if the articles so provide, the LLC will be formed on a later date no more than 90 days from the date of filing.) Articles of organization are functionally similar to a partnership’s articles of organization or a corporation’s articles of incorporation. An LLC has very limited power to conduct business before filing its articles of organization, except it may perform some limited prefiling organizational activities which might include some real estate transactions that will be assigned to the soon to be valid LLC. Despite the very limited exception, a soon-to-be-formed LLC generally may not incur debt prior to formation. However, the organizers of the LLC may incur debt on behalf of the soon-to-be-formed LLC and engage in other business, though they will be liable for any debts and liabilities incurred. After formation the LLC may through express agreement, assumption, or novation accept the liability of its organizers for the contracts and other liabilities incurred during its formation. 

Articles of Organization-

The LLC’s articles of organization must include fundamental information concerning the LLC, including the name of the LLC, the Purpose of the LLC, the name and address of the LLC’s registered agent and registered office, if it will be manager-managed then it must include a statement specifying such, the events or conditions that will result in the termination of the LLC, and the name and address of each organizer. The articles must be signed and filed by only one person, though that person does not need to be a member or manager of the LLC and may be an unnatural person like a partnership or LLC. In addition to the article of organization, the filer must submit a filing fee which differs from state to state. 

After filing but before actually conducting business, the LLC must have an operating agreement. An operating agreement is an agreement, written or oral, between all the members, or a written declaration by the sole member, that addresses the conduct of the business and affairs of the LLC and the rights, duties, and obligations of the members or managers. I have said it before but it bears repeating, an oral agreement may suffice but a written agreement may be wiser and can be required in some circumstances. Because operating agreements may be oral they seldom must be submitted along with or after filing paperwork, which means some states may not have a deadline for the adoption of an operating agreement or provide consequences for the failure to adopt an operating agreement. Practically speaking adoption of an operating agreement should happen simultaneously with filing.

Broad discretion is given as to what provisions will be included in an operating agreement. However, in the absence of an on-point clause or provision, state law acts as a gap filler and supplies default rules that apply to the LLC. These default rules are seldom advantageous to the members and may inhibit the intended business, so members should carefully review and address the issues covered by state default rules. 

Operating agreements often address many of the same issues that are covered in corporate bylaws. shareholder agreements, or partnership agreements. Because of the hybrid nature of LLCs and their flexibility, the form and contents of operating agreements may vary greatly depending on the specific facts and circumstances involved in the particular business venture. Despite the wide variation, an LLC’s operating agreement should address information or provisions relating to the members of the LLC including initial and additional capital contributions or loans; percentage/units/other measures of ownership interests; allocations of income and loss; tax treatment; distributions of cash at intervals or liquidation; business purpose; management rights and powers (including election or selection of managers, authority or restrictions of authority, meeting and related procedural requirements, indemnification; and transactions involving conflicts of interest); rights or restrictions on competing activities; accounting; rights or restrictions on new membership or transfers of interests; events of withdrawal of a member; dissolution and liquidation; amendment of the operating agreement; and other relevant organizational and operational issues. 

Operating agreements may be modified at any time by following the provisions provided in the original operating agreement or if none exist then by following the requirements of state law. Operating agreements are typically modified when there has been a substantial change in circumstances or business that was not anticipated by the original operating agreement so that the original operating agreement does not address the changed responsibilities, business operations, or property contributions. Generally, all the members should sign an amended operating agreement and the amendment should include language that indicates that it amends or modifies the original agreement. In the alternative, aka the less messy and prone to error solutions, the partners can execute a new operating agreement that includes language indicating it replaces the previous operating agreements and is the final and complete iteration of the operating agreement. 

Amending the Articles of Organization

Once filed the articles of organization must be amended in certain circumstances and may be amended in others. Amended articles are required within 60 days of a change from a member-managed to a manager-managed LLC (or vice-versa), after a change in the LLC’s name, or after a change in the dissolution date of the LLC. Articles of organization may otherwise be amended at any time and in any respect so long as they only reflect provisions that are contained in the LLC’s operating agreement. In the alternative, articles of organization may be amended by restating the original articles of the organization, without any additional amendments.

 As a final lingering piece of history, an LLC may be organized to conduct or promote any lawful business purpose (Some states require a statement of specific purpose or some iteration stating that the LLC is organized to conduct any lawful business.) When LLCs were first formed, and corporations for that matter, they could only receive the legal protections and benefits of their formation if they were formed to accomplish a specific purpose. 

Partnership Formation: Basics

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As I mentioned in a previous article, a partnership is the presumed business entity when two or more people operate a business together for a profit. In its simplest form, this means that two people selling fruit on the side of the road and splitting the profits operate a partnership. This presumed partnership structure is governed by state statutes and may provide some unfavorable terms, for example even though one partner contributed 99% of the capital, the profits must be split equally. To remedy this issue states, permit parties to a business to create partnership agreements that control how the partnership will operate rather than the gap filler provisions of state law. 

An oral agreement to conduct a partnership may be valid but will be subject to the Statute of Frauds and so should generally be avoided. If the business of the partnership involves those subjects addressed by the Statute of Frauds, then the partnership agreement and contracts derived from that agreement must comply with the statute. Due to concerns about enforceability and fraud, contracts and agreements regarding the sale of goods, transactions in lands, creation or modification of debt, or work that cannot be completed within a year should be in writing. That is not to say partnerships and contracts created by oral agreement are ineffective, rather they will be harder to enforce if an issue arises. 

Some partnerships like the limited partnership or limited cannot be formed without the use of a written agreement. Those partnerships must comply with statutory requirements which often involve submitting the partnership agreement to the Secretary of State to obtain limited liability status.   

Partnership formation is fairly simple, as it can be created with very little formality, however, there are a few things to consider before forming a partnership or before entering a business arrangement that could be classified as a partnership. 

This is a checklist listing some information to consider and address before forming a general partnership.

  1. Who are the Partners?
    1. What is the full name, legal and how are they known in the community
    2. What are the financial resources and/ or liabilities that they currently have or will contribute to the partnership?
    3. What is their family circumstance? (Are they married, divorces, estranged, expecting children, etc. Each can substantially impact the business. If a partner is getting divorced they may be forced to liquidate their interest in the partnership.)
    4. What are the relevant skills or experiences of each partner?
  2. What is the business?
    1. What business activities are anticipated now and in the future?
    2. What is the name of the partnership? Is that name available?
    3. What is the primary location of the business? Are there other locations where the business will operate?
    4. What will the business need to start?
    5. What will the business need to operate? What buildings, equipment, inventory will be necessary to maintain the business?
    6. How will business assets be acquired? Will partners contribute cash, property, or services and how will those be used to acquire assets? Will the partnership buy equipment, lease it, or will it be part of a capital contribution?
    7. How much cash will the business need to start up? How much will it need during the first month, six months, and year? What reserves will it need if there is a delay in cash flow?
    8. If the business expands in the future, how will that be accomplished? Will that funding come from profits, borrowing, or contributions by partners?
  3. What are the important dates for the partnership?
    1. When will the business begin?
    2. How long will the business operate? 
    3. Are there specific dates or events that will cause the business to terminate?
  4. What about Capital?
    1. What property, cash or otherwise, will each partner contribute, and when? If partners contribute services, what is the value of those services and what are the tax implications?
    2. How will value be determined by contributed property or services? How will liabilities associated with that property be apportioned between partners?
    3. How will additional contributions or withdrawals from the partnership operate? If partners are withdrawing some or all of their contributions, can that happen before the business is dissolved and wound up?
    4. How and who will determine whether additional contributions will be required?
    5. If partners are unable to make the required contribution, will collateral security be an alternative?
    6. What are the rights of partners and the partnership if a partner defaults on the contribution?
    7. Should partners receive interest on their contributions? (Unless provided in a partnership agreement most state laws do not require this treatment.)
    8. Can partners lend money to the partnership? What are the terms and conditions for such lending?
  5. How will distributions be handled?
    1. How often will distributions occur? How much or what percentage of available cash will be distributed? How will those amounts and dates be determined and by who?
    2. Can property be distributed rather than cash? If so how will liabilities be handled?
    3. How will refinancing, sale, or other capital proceeds be distributed if different than cash?
    4. Are there minimum guaranteed returns or preferred returns for partner contributions?
    5. Will partners receive a salary or its equivalent? Can partners draw against future distributions?
    6. Are partners entitled to reimbursement for ordinary business expenses?
  6. How will profits, losses, and taxes be treated?
    1. How will profits be divided among partners, and will those allocations remain constant or will they change during the life of the partnership? If they change, what is the triggering event?
    2. How will losses be allocated? Will losses be allocated based on the partner’s share of profits, initial contributions, equally, or some other formula? Will loss allocations change during the life of the partnership? If so, what will trigger that change?
    3. Will partners have special tax allocations or treatments? (This tends to cause a lot of taxing problems after the first couple of years. If it may be an issue, talk to a qualified accountant and or tax attorney for advice.)
    4. Will any tax items be specially allocated to one or more partners? (See above)
    5. How will profits, losses, and tax items be allocated between assignors or assignees of partnership interests?
  7. How will the accounting and banking be handled?
    1. What will be the fiscal and tax years of the partnership?
    2. How will partnership books be maintained? Will the partnership use an accrual or cash basis? Who will be the primary bookkeeper?
    3. What financial statements will be provided to the partners and how frequently? (In addition to the requirements of State and Federal laws.)
    4. Will the partnership have periodic audits, reviews, or investigations by accounting firms? If so, when, how will they be accomplished, and how will they be financed?
    5. What are the rights of partners to access or copy the books and records of the partnership?
    6. Where will deposit accounts be maintained and who will have signature authority? Will the partnership have investment accounts, if so with whom and who will have control?
  8. How will the partnership be controlled or managed?
    1. What are the rights of partners to management? Will partners have an equal voice, will all decisions or certain decisions require unanimous consent, will decisions be made by managing partner(s) or by a majority/ supermajority in number or interest of partners?
    2. What authority will partners have? Will all or only some partners have the authority to bind the partnership?
    3. What will be the process to select or remove managing partners?
    4. What bond or other security will be required to be a partner?
    5. How will partner meetings be held, when, where, and who can call a meeting? (Additional notice and quorum requirements should be considered.)
    6. What rights do partners or the partnership have to indemnification by the other? What requirements or procedures should operate as a prerequisite to indemnification?
    7. What additional agreements or other actions will be permitted or forbidden by the partnership agreement?
    8. How much time must partners dedicate to the business and what other activities may partners engage in, including competing activities?
    9. How will disputes be resolved and is there a preferred method, such as litigation, mediation, arbitration, etc?
  9. How will new partners be admitted or partner interests be transferred?
    1. What are the conditions for a new or additional partner to be admitted?
    2. What are the restrictions on the sale, transfer, encumbrance of partnership interests?
    3. What are the rights of assignors or assignees of a partnership interest, and under what conditions will an assignee become a substitute partner?
    4. Will partners or the partnership be given a right of first refusal before assignments or transfers of partner’s interests occur?
  10. How will partners withdraw or be expelled from the partnership?
    1. What provisions are needed to expel a partner, on what grounds, and by what method?
    2. Can partners withdraw from the partnership? If so what notice is required?
    3. What activities may a withdrawing or expelled partner engage or be prohibited from engaging in, eg starting a competing business?
    4. What will happen to the business in the event a partner dies, becomes disabled, is expelled, files for bankruptcy, withdraws or otherwise disassociates with the partnership? What options are available to the remaining partners? May they continue the partnership or liquidate it? If the partnership continues, how long may the disassociated partner or estate participate in the management and business of the partnership, and may their interest be purchased?
    5. What right will partner’s have to purchase the interest of a deceased, disabled, expelled, bankrupt, or withdrawing partner, and whether the partnership may be a purchaser?
    6. How will the purchase price of a partnership interest be determined? 
    7. How will payment of the purchase price be made and whether security for future payments will be required?
    8. What rights do former partners have for indemnity against future liabilities or will they remain liable for their share of all or some liability? Will funds be withheld from the purchase price of a partnership interest to address contingent claims?
  11. What are the requirements for Life insurance?
    1. Are partners required to purchase life insurance and name the partnership as beneficiary? May the partnership purchase life insurance for its partners?
    2. How will uninsured partners be treated?
  12. What happens when the partnership winds up and liquidates?
    1. What acts other than the expiration of the term of the partnership will result in liquidation and winding up of the partnership? Examples include an agreement by a certain number or percentage of partners, sale of all or substantially all the partnership assets, the death, disability, bankruptcy, withdrawal, or expulsion of a partners. What will happen while winding up and what rights do partners have to continue the business or purchase the interest of an affected partner?
    2. What are partners entitled to on liquidation of partnership assets? Do liquidators receive special compensations?
    3. What are the rights of partners to specific property on liquidation?
    4. What property may be distributed in kind and whether property may be distributed disproportionally or subject to liabilities?
    5. What priority will partners have to distribute property on winding up and liquidation?

Buy/Sell Agreements

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The buy/sell agreement may not be familiar to individuals who have just started their business or are working on their own however, these agreements are an important way of controlling the outcome of the business. The basics of the agreement are straightforward, the agreement sets out how an owners share of the business may be assigned or transferred if the owner dies or wants to leave the business. The agreement serves to smooth the changes that might occur if one of the four D’s happen. In the case of death, divorce, dissolution, or disaster, the agreement lays out how the business ownership will work moving forward.

There are a few different ways that these agreements may be setup. First, the agreement may require that the remaining owners purchase the shares of the departing owner. Second, the business may purchase the ownership interest of the departing owners, this happens more often with closely held corporations than partnerships or LLC’s. Depending on what the owners of the business want, they may opt for a mix of the two options.

It is important to know that there are several reasons that a business may need a buy/sell agreement even if things are going well and there doesn’t seem to be any reason to use one. One of the big reasons is that it allows the owners to restrict who may become an owner. It is very common that small business owners are concerned about the possibility that a new owner will push the original owner out of control. When an owner dies, a restriction on who becomes the new owner can prevent the deceased owner’s estate from selling, transferring or otherwise controlling the business when the estate does not have the same focus on the success of the business that an original owner may have had. Additionally, the agreement creates an impartial method of determining the value of the departing owners share of the business. Instead of allowing the remaining owners and departing owner from arguing and possibly destroying the business, a valuation method creates the separation necessary to conduct an impartial sale of the departing owners share or another transfer free of the concerns that might hinder or destroy a sale.

It is important to remember that along with many other business transactions, a buy/sell agreement must be funded by the owners or the business. Problems frequently pop up where an agreement states that the business or an owner will buy the shares of a departing owner yet the buyer does not have the money available to make the purpose. This may result in the becoming stale and eventually unenforceable. Or the buyer may be saddled with debt that makes them insolvent, which in turn kills the business and forces the individual owner or business into bankruptcy. To avoid this problem companies often rely on insurance policies in the case of the death or disability of an owner, or they use cash proceeds and or borrowed money to buy the departing owner’s share.