Checking Out Flock

I am checking out flock for the first time.  It is pretty cool.  Lets see what happens with images.

Why form an LLC? An LLC introduction.

STARTright is the web’s easiest and most efficient way to form an LLC.  Some of our new members have asked me to write an LLC introduction or an overview of why someone would want to form an LLC.  I spent about an hour on the phone with one of our member’s the other day (she is from Arizona, and I only practice and am barred in Arizona, so I cannot advise at length to people outside of Arizona).   I realized that some basic LLC fundamentals concerning how one forms an LLC, how an LLC is taxed, the liability protections of an LLC and general use of an LLC in one’s business where not well understood.  So in order, lets talk about the why’s and how’s of forming an LLC.

 

Why form an LLC?

Forming an LLC is the right decision for almost any small business owner or partnership.  Most business owner’s are worried about three issues when starting their business.  Those issues are 1) start up costs, 2) lowering tax liability, and 3) liability protection.  I will discuss how forming an LLC is the best solution for each of these.

 

1. Forming an llc minimizes start up costs.

There is no question that hanging your sign and opening your doors for business will have the lowest start up costs.  This may not be the most prudent approach, however.  It also may not end up saving that much over forming an LLC.  When you start a business without forming a legal structure from which to operate that business, you still need to get a business license in order to open a business account at a bank.  In most counties, a business license can run upwards of $100.  If you form an LLC, you can usually get the Articles of Organization filed with the state for under $100 (states vary, but the vast majority do not charge over $100).   Almost any financial institution will open an account for your LLC based upon a filed copy of the Articles of Organization.   With that said, the savings you gain by not forming an LLC which is recognized and given state LLC law protections may be minimal and probably not worth it.

 

If the question is whether to form an LLC or another entity, the choice to form an LLC to save on startup costs is even clearer.  For a single business owner, the only other legal entity available is a state corporation.  Both the LLC and corporations offer legal protections which we will address shortly.  Fees to form an LLC as opposed to the fees to form a corporation are cheaper in most state.   LLCs are generally less complex and require fewer formalities.  This enables business owners to properly manage much of the LLC themselves cutting down on legal bills.  Many business owners that have corporations may choose to manage their corporation themselves, but few do it right.  Corporations have strict formality and structural rules.  As we will discuss later, the protections for those corporations are dependent upon those formalities being executed properly.   

 

2. LLCs have the most tax flexibility.

Many people complain about the complexity of the federal tax code, but it was designed to deal with the fact that no two businesses are completely alike.  For some businesses the ease and convenience of flow through taxation (that of a sole proprietorship) where the business is listed as an extension of the business owner’s person assets fits.  For others, the “self-employment tax” minimization of an S-Corporation fits, and for others, the large benefit write-offs of a C-corporation fits.  Before business owners could form and operate from an LLC, federal tax choices did not line up well with state structure and liability choices.   A business owner seeking corporate veil protections could not also get sole-proprietor type tax flexibility and vice versa.   By forming an LLC, you can keep the structure and formalities of your business simple and minimal, the protections at the highest levels allowed in any state, and choose the tax structure that works for you.

 

3. Forming an LLC gives you premier legal protections.

An LLC carries the greatest level of protections from legal liability available today.   Most people do not realize that the liability pendulum can swing from two directions.  The LLC offers both 1) corporate veil protections as well as 2) statutory business asset protection (the charging order).   

The LLC’s corporate veil protection is superior for one main reason.  The corporate veil is only as good as a judge says it is, and whether or not a judge will acknowledge or pierce the corporate veil depends upon the state law requirements for maintaining the businesses’ veil protection.  Corporations have lists of formalities and structural requirements such as shareholders, directors and officers that require lots of documentation to ensure corporate veil protection.  An LLC usually requires the owner to keep his business and personal finances separate and that will generally ensure legal protections.  Much easier.

Now we will look at the other way the liability pendulum will swing. Most business owners realize that they want to protect their personal lives from their business, but what they often fail to do is to protect their business from their personal life.  By forming an LLC, a business owner ensures that anyone who sues him personally will not get instant and unlimited access to the business and its assets.  Instead, the LLC is protected by state statutes that require a judge to limit the plaintiffs access to the business.  This is called a charging order.  Unlike a state corporation where a plaintiff could take all the shares and control the corporation including forcing it into liquidation, by forming an LLC, you ensure that you as the business owner retain control of the LLC management even if you are sued personally.  I will write more on charging orders later, and this is supposed to just be a quick overview.  It is important to understand the limitations involved with a single member LLC when it comes to statutory business asset protections also.  Please read “The Single Member Hitch” for more on Single Member LLC Protections.

Follow Up To LLC Part 1: Getting that other LLC Member

Last week one of the readers left me a comment asking me whether or not he could use his spouse as the minority partner.  Here was my comment:

Generally the best way to avoid losing charging order protection is to get another member.  Because you do not want to lose control, it is best that you give that member a very small portion of the LLC.   I will write a post on this later, but most states give the LLC members a great deal of flexibility.  The California LLC Act allows members to break free from the California LLC Act’s standards by writing into an operating agreement the way the members want the LLC to operate.  This means you can make the call.  You get to write this operating agreement in a way that benefits you as the primary member.   If the other member has 5% or less, and decisions are made by a 65% member or manager vote, (corporate super majority) then you really can run the LLC on your own terms. You need to make sure you address two things however.  

1. Either you need to also write into the operating agreement that the members holding 65% or more do not need to notify the other members to make these decisions, or you need to always call some sort of phone or other meeting when you are making decisions that would generally require a meeting of the members or managers.  It is always good to show that you are following what is in the operating agreement.
2. Second, if you have another member, the money has to be split their way also.  Make sure you assess the tax consequences and necessity of giving that member his portion of distributions if you distribute money out.

A spouse is not a good option for a junior member. The point is to distribute the injury of having an unwanted member in a bankruptcy suit. You and your wife are considered one.

Definition of an LLC: Part-1 The Single Member Hitch

Especially useful for small business owners, the LLC can mold to almost any business model.  Most of the concepts explained below are better explained in the STARTright videos available in your member account.  Limited Liability Companies mesh the best parts of the corporation and partnership.     

Like anything, an LLC is weak when used in ways it was not intended.  I am writing a series of blog entries addressing best practices when using an LLC.  As always, I will follow the STARTright philosophy and try and convey basic concepts using visual diagrams.  This allows you the business owner to make the right decisions.  

Today, lets talk about single member LLCs. Unlike partnerships or corporations, the limited liability company provides two directions of protection.  

• The corporate veil protection: The veil protects the members personal life if the LLC is sued.

LLC has Corporate Veil Protection

• The partnership / charging order protection: The charging order protects the company and the member’s investment if one of the members is sued in his or her personal life.

 

LLCs receive Partnership Charging Order Protection

Single member LLCs are potentially weak if the owner is hoping to protect the LLC if he gets sued himself.  I say potentially, because in law everything is a matter of a two step analysis:

1. Initial Philosophy: laws are usually created to meet a societal need.   
2. Evolving Trends: After a law is introduced, the courts assess whether to change the original interpretation of the law to meet evolving societal needs. 

The original charging order philosophy protected guys A, B from having to accept D as an unwanted partner if C, the person they originally went into business with gets sued.  They don’t want to have to deal with D.  

 

LLC charging order protection intended to stop unwanted partner.

To prevent this unwanted member scenario as shown in figure 3, the charging order is all D can get out of C’s membership as shown in figure 2 above.  The charging order limits D.  He must wait for A and B to decide to distribute money.  No distributions = no money. 

The Single Member Hitch: When a the member of a single member LLC is sued, there is no other members to protect from D.

 

LLC has no one else to protect.

Two bankruptcy courts have used this flaw in the LLC protection to allow creditors of a business owner to completely take over his LLC and liquidate it for cash.  The first case was in Colorado and the nation held its breath to see what would happen next.  The next case was in Idaho and actually used the Colorado case to base its decision on.  This means the trend is starting to move in the direction of denying charging order protection to single member LLCs.  The two cases are linked in pdf format below.  Next I will talk about how a single member LLC owner can remedy this problem.

Albriet: Colorado Bankruptcy Case

A-Z Electronics: Idaho Bankruptcy Case