Monthly Archives: July 2014

LLC Operation and Other Post-Formation Matters

The purpose of this article is to provide information regarding the basic elements of operating a California limited liability company (“LLC”) and the roles of the following:

(a) the owners of the LLC, called “members”;

(b) the “managers” of the LLC which may be elected by the members to operate the LLC business; and

(c) the governing agreement for the LLC, called the “operating agreement”.

Failure to observe some of the requirements may harm the LLC or result in personal liability to managers and members.

This article is intended to outline certain of the basic legal requirements to which an LLC is subject. It is a summary of certain provisions of the California Limited Liability Company Act (the “Act”), which is a very lengthy and detailed statute, and accordingly this article cannot be considered a comprehensive description of the Act and its requirements.

I. Basic Structure of an LLC

An LLC is formed when its Articles of Organization have been executed and filed with the California Secretary of State’s office. The Articles of Organization are a Secretary of State one page form. An LLC may have one or more members at the time of formation and its members are required, either before or after filing the Articles of Organization, to enter into an operating agreement, which may be written or oral and may be as simple as an agreement among the members to form the LLC. This is the instrument which governs the LLC and it will typically contain provisions specifying capital contributions, profit sharing percentages, management and control, admission of new members and restrictions on transfer of memberships and perhaps special tax provisions specifically allocating gains and losses and perhaps specific items of each.

LLCs are but one of a number of forms of organization in which people can conduct a business. The LLC is owned by the members who can either (i) manage the business of the LLC themselves, in which case the LLC would be a “member-managed LLC”, or (ii) elect a manager or managers to manage the business of the LLC, in which case the LLC would be a “manager-managed LLC.” One of most important differences between a member-managed LLC and a manager-managed LLC concerns the authority of the members to bind the LLC to LLC obligations:

(a) In a member-managed LLC, each member has the power to bind the member-managed LLC (like general partners in a partnership).

(b) In a manager-managed LLC, no member has the power to bind the LLC (just as no shareholder of a corporation can bind the corporation); only a manager or authorized officer of the LLC can bind the manager-managed LLC.

Management duties include decisions about key policies and LLC transactions and establishment of guidelines within which the business of the LLC will be conducted. The managers can hire officers and employees to perform the LLC’s day-to-day business.

The principal distinguishing feature of an LLC is the limitation of liability which the members of the LLC enjoy (like a corporation), as well as the pass-through income tax treatment enjoyed by the LLC and members (like a partnership). So long as the LLC is properly formed and in existence, and is properly operated, the members will not be personally liable for the LLC’s debts, obligations, and liabilities. In other words, if the LLC’s debts exceed the value of the LLC’s assets, the LLC’s creditors should not be entitled to seek repayment from the members’ personal assets.

Of course, a personal guarantee by an LLC member of an LLC obligation would give rise to personal liability of that member to the extent specified in the guarantee (as it would for a shareholder in a corporation). Failure by a member to remit employee withholding taxes can provide another basis for personal liability of a member (as it would for a shareholder in a corporation). Liability based on the personal tortious behavior of a member would of course provide the basis for personal tort liability of that member (as it would for a shareholder in a corporation). But generally the LLC liability shield, like the corporation’s liability shield, should protect individual members from LLC debts, obligations, and liabilities.

The following is a brief description of the roles of the major parties in an LLC — the members and the managers. Although the following is written as if members and managers are separate persons, the same individuals could serve as members and managers.

A. Members

The members own the LLC and provide the capital with which the LLC commences its business. In a member-managed LLC, members by definition manage the business of the LLC. In a manager-managed LLC, members as a group often do not take an active role in running the business. Normally one or two members will be intimately involved in day-to-day operations of the LLC, and other members will be passive, non-active investors. Beyond electing the managers and voting on certain key events in the LLC’s life, the members of a manager-managed LLC entrust management of the LLC to the managers (much like the shareholders of a corporation entrust management of the corporation to the directors and officers of the corporation). Matters requiring member votes are discussed in “Member Votes” below.

B. Managers

Managers are elected by the members. At the outset managers can simply be specified in the operating agreement, which is of course approved and signed by all members. Thereafter, if the operating agreement so permits, members can hold annual or other regularly scheduled meetings and elect the general manager and any other managers of the LLC. Managers manage the business and affairs of the LLC and exercise the LLC’s powers. Managers may either perform these responsibilities themselves or these responsibilities can be performed by officers and employees under the direction of the managers.

In performing these responsibilities, the Act imposes on managers the same fiduciary duty with respect to the LLC and its members that a general partner owes to a general partnership and the other partners of that partnership (the Act does not specify a fiduciary duty for members). It is permissible to modify and otherwise refine the fiduciary duty of the manager in the operating agreement. Indeed it is advisable to do so. Typically the operating agreement will specify fiduciary duties such as the “duty of loyalty” and the “duty of care” for LLC managers.

The duty of loyalty dictates that a manager must act in good faith and must not allow personal interests to prevail over interests of the LLC and the LLC’s members. A standard example that raises these issues is a proposal that the LLC enter into a transaction which benefits a manager, or involves the manager in a conflict of interest between the manager and the LLC or its members. Such transactions are often called “self-dealing” transactions. They are not prohibited, but such transactions must be predicated upon (i) full disclosure, (ii) proper approval from disinterested managers and members, and (iii) fairness to the LLC and its members.

The duty of care requires a manager to be diligent and prudent in managing the LLC’s affairs. This is sometimes referred to in corporate law as the “business judgment” rule. If a manager makes a decision, conscientiously and without fraud or conflict of interest, such manager will not be second-guessed by courts based on how that decision happens to work out for the LLC. A manager is not held liable merely because a carefully made decision turns out badly.

C. Officers

Like a corporation, the LLC members and managers can appoint officers for the LLC who serve at the pleasure of the managers, subject to contracts of employment (if any) such officers may have with the LLC. The officers perform the bulk of the day-to-day operation of the LLC’s business. Normally an LLC will want at least a general manager (or president), a chief financial officer, and a secretary. More than one of these offices can be held by the same individual. An LLC may have additional officers. These additional officers are either appointed by the general manager or another officer if such officer has been delegated authority to make such appointments.

The following is a brief summary of the standard duties of the following officers. All of these could be modified by the managers.

  1.  General Manager or President. The general manager is the chief executive officer and general manager of the LLC unless the LLC has a chairman of the board and has designated the chairman as chief executive officer. The general manager has general supervision, direction, and control over the LLC’s business and its officers. The general manager can also be called the president of the LLC.
  2. Chief Financial Officer. The chief financial officer keeps the books and records of account of the properties and business transactions of the LLC. These duties include depositing corporate funds and other valuables in the name of the LLC and disbursing funds as directed by the managers.
  3. Secretary. The secretary of an LLC keeps the LLC’s articles of organization, operating agreement, record of members’ addresses and holdings in the LLC, and written minutes (if any) of the proceedings of the LLC’s members and managers. The secretary usually has the duty of giving notices to members and managers of members’ and managers’ meetings.

II. Member Votes; Manager Actions

A. Member Votes.

Certain fundamental changes in the life of an LLC, such as a merger or liquidation of the LLC, require a vote by the members. These fundamental changes include the following:

  1. Amendment of the articles of organization (requires at least a majority vote of the members; this requirement can be modified upward by the operating agreement).
  2. Amendment of the operating agreement (requires unanimous vote of the members; this requirement can be modified downward by the operating agreement).
  3. Merger or consolidation of the LLC with or into any other LLC (requires at least a majority vote of the members; this requirement can be modified upward by the operating agreement)
  4. Winding up and dissolution of the LLC (requires at least a majority vote of the members; this requirement can be modified upward by the operating agreement).

B. Manager Action.

Matters of general operating policy should be considered and authorized by the general manager or managers of the LLC. Although there is no statutory requirement with respect to how frequently the managers should act, it is advisable that the managers meet at least quarterly. In addition, a specially convened meeting of the managers may be called if action is required before the next regular meeting of the managers. Action by the managers may also be taken by the unanimous written consent of the managers. Although case it is likely that most manager actions will be taken by unanimous written consent without a meeting, it may prove useful to schedule a regular managers’ meeting to address significant matters which have arisen on a quarterly or, at least, annual basis. Manager meetings can be held either in person or by conference telephone so long as all managers in attendance can hear each other simultaneously.

Matters appropriate for manager action, which can be immediately approved by written consent or which might arise and be accumulated, pending approval by the managers, include the following:

  1. Appointment of officers, setting of salaries, and declaration of bonuses (at least annually, typically at a meeting of the managers immediately following the annual meeting of members).
  2. Appointment of manager committees, if any.
  3. Opening of LLC bank accounts and the designation and change of LLC managers and officers authorized as signatories. Any bank’s LLC account form will usually include a resolution which the party executing the form represents to have been adopted by the managers of the LLC.
  4. LLC borrowing and delivery of collateral in connection with such borrowing.
  5. Consummation of material contracts for the purchase or lease of significant assets or services or the disposition of LLC assets or for the rendition of services outside the ordinary course of the business of the LLC.
  6. Policy decisions with respect to the construction of material assets or the investment of material amounts in research and development projects.
  7. The adoption of pension, profit-sharing, bonus and other employee benefit plans.
  8. The repurchase of LLC interests.
  9. Amendment of LLC bylaws (if any).
  10. Review of financial statements of the LLC.
  11. Appointment of auditors, if any.
  12. Any action which requires a member vote.
  13. The issuance and sale by the LLC of additional interests in the LLC.

In the case of any such actions, the secretary of the LLC should prepare minutes of the meeting at which such actions were approved or prepare the form of written consent evidencing any such manager or member actions.

III. Observance of “Corporate Formalities” Not Required

Unlike a corporation, the observance of “corporate formalities” is not an important part of maintaining the shield from liability and other protections and advantages offered by the LLC form of doing business. The term “corporate formalities” normally means holding annual (or other regularly scheduled) meetings of the owners and managers, providing written notice in advance of such meetings, preparing detailed minutes of matters decided upon at such meetings, and so forth. The Act specifically states that the failure to observe such corporate formalities “shall not be considered a factor tending to establish that the members have personal liability for any debt, obligation, or liability of the” LLC where the articles of organization or operating agreement of the LLC do not specifically require such formalities to be observed.

This does not mean that LLC members are completely free to ignore the separate legal identity of the LLC. For example, members must always keep in mind that the LLC assets and funds are in the name of and owned by the LLC, not by the LLC’s members. Separation of LLC assets from personal assets of the members is very important. See “Separation of LLC and Personal Assets” below.

IV. Separation of LLC and Personal Assets

It is important for any company to respect the difference between the company’s bank accounts, property, equipment, and other assets and personal assets owned by the company’s owners. An LLC, like a corporation or other legal “person”, is a separate legal entity with assets that are owned by the LLC. Any attempt by an LLC member to dispose of or use LLC property would be no more proper than an attempt by that member to dispose of or use another member’s personal property. Members must respect the fact that the LLC’s assets are the property of the LLC, not the members. Similarly, an LLC member should not intermingle such member’s personal assets with the company assets of the LLC.

The Company’s books, records, and financial statements should be maintained clearly to reflect the separation of the Company’s assets from the personal assets of the members. The Company must conduct business in its own name (not in the individual name of any manager or member). All letterhead, business card, bills, checks, invoices, and other Company forms should show the Company’s full legal name (and fictitious business name, if any), and the Company’s current address, telephone number, and fax number.

As a statement of sound business practice the observations made about separation of personal assets from company assets are fairly obvious. There is an additional, less obvious reason to follow those rules.

Creation of an LLC shield from liability for LLC owners inevitably gives rise to attempts to pierce that shield by creditors of the LLC. This has long been the case for the liability shield of corporations. As long as there have been corporations, there have been attempts to “pierce the corporate veil”. Published cases in which such attempts have been successful usually involve a recitation by the court of a dozen or so factors in support of the court’s ruling that the shareholders of the corporation should be held personally liable for the debts, obligations, or other liabilities of the corporation. At the top of this list of factors are (i) failure by the shareholders to respect the corporation’s separate identity (by intermingling corporate and personal assets) and (ii) some other form of misconduct by the shareholders with respect to the corporation.

The LLC entity is sufficiently new in the United States so that there is virtually no case law specifically addressing the relevant issues in this area. Nonetheless, it should be pointed out that at least two specific statutory factors favor LLCs over corporations in this area.

First, the Act expressly states that LLC members are not liable for LLC debts, obligations, and liabilities merely by virtue of being a member in the LLC. There is no such explicit statutory enunciation of the shield from liability for shareholders in corporations (instead, the corporate shield is based on many years of case law and common law corporate principles). Second, one of the many factors often listed in piercing-the-veil cases for corporations is that the shareholders did not respect corporate formalities specified in the relevant corporation’s statute, bylaws and other charter documents. With regard to LLCs the Act makes it clear that the LLC need not respect corporate formalities. Failure of an LLC to respect corporate formalities cannot be considered a factor “tending to establish that the members have personal liability” for any LLC debt, obligation, or liability. See “Observance of Corporate Formalities — Not Required” above.

This is not to say that LLC members can ignore the many years of corporations law developments in this area. It is a safe bet that courts will apply some principles from this area to LLC piercing-the-corporate-veil actions. Until more clearcut guidance is provided by courts, LLC members and managers would be well advised to bear in mind the foregoing observations about piercing-the-corporate-veil case law applicable to corporations.

V. Adequate Capitalization

The Company should be adequately capitalized to carry on the Company’s business activities. This is of course an obvious statement of sound business practice. A less obvious reason to assure that the Company is and remains adequately capitalized concerns the piercing-the-corporate-veil case law discussed above. One of the factors enunciated by some of the courts that have ruled that creditors of a corporation should be allowed to hold the shareholders personally liable for debts and obligations of the corporation is that the corporation was not adequately capitalized. Hence, adequate capitalization is an additional, very important factor relating to the shield from personal liability provided by the Company for its members.

VI. Other Post-formation Matters

Although it is not intended to be exhaustive, the following checklist summarizes legal requirements applicable to a new LLC. Some of the requirements arise as a consequence of formation of the LLC; others apply to all new businesses regardless of the form of organization. Certain requirements are highly formal and technical; many must be satisfied within a specified time period. Care must be taken to comply with these matters as they arise because in many cases there are serious penalties which can be assessed for failure to comply.

A. Local Business License. The LLC may be required to obtain a business license from the city in which it intends to operate.

B. Employer Identification Number. Every employer must obtain an employer identification number which will be used on federal tax returns and certain other documents.

C. Annual LLC Statement of Information. Each year, the LLC must submit a Form LLC-12, providing a current list of names and addresses of the LLC managers (and if there are no managers, of the members), the LLC chief executive officer, and the LLC agent for service of process.

D. Estimated Federal Income Tax. The LLC members will be required to pay estimated federal income tax in installments (like a general partner in a partnership). Your accountant should keep you current with this requirement.

E. State Minimum Annual Franchise Tax. Every LLC organized, registered or doing business in the state of California is subject to an annual minimum franchise tax of $800 (payable by the 15th day after the 4th month following formation of the LLC).

F. State Graduated Gross Receipts Fee. In addition to the annual $800 franchise tax, an LLC in California is subject to a graduated fee determined as follows:

For tax years beginning on or after December 31, 1999:

  1.  $865 if the LLC’s total income from all sources is $250,000 or more, but less than $500,000;
  2. $2,595 if total income is $500,000 or more, but less than $1,000,000;
  3.  $5,190 if total income is $1,000,000 or more, but less than $5,000,000;
  4.  $7,785 if total income is $5,000,000 or more.

For purposes of the fee calculation, total income is defined as gross income plus the cost of goods sold. The fee is based on the LLC’s income from all sources, including income from sources within and without California. In certain cases, the fee is calculated by taking into account the income of “commonly controlled limited liability companies”. The fee is payable with the LLC’s California tax return. Your accountant should keep you current with the tax requirements in California.

G. Tax Returns. Both federal and state income tax returns must be filed on or before the fifteenth (15th) day of the third month following the close of the taxable year, unless a timely extension to file is obtained.

H. Personal Property Taxes. If the LLC owns significant personal property it may be required to file a property statement with the County Assessor and may be subject to a personal property tax. Forms may be obtained from the County Assessor.

I. Sales and Use Taxes. If the nature of the LLC’s business includes the sale at retail of tangible personal property (goods), then the LLC may be subject to sales and use taxes and would need to obtain a seller’s permit from the California State Board of Equalization. This may be applicable in your LLC’s circumstances.

J. Payroll Withholding.

  1. Federal. The LLC will be required to withhold income tax and social security tax from taxable wages paid to its employees. Funds withheld must be deposited in certain depositories accompanied by a Federal Tax Deposit Form 8109. An “Employer’s Quarterly Federal Tax Return” (IRS Form 941) must then be filed before the end of the month following each calendar quarter. Any manager, officer, or other person obliged to withhold taxes may become personally liable for a 100% penalty if he fails to pay the withheld funds to the Internal Revenue Service.
  2. California. The LLC will also be required to withhold California income tax from its employees’ taxable wages. Within fifteen (15) days after becoming subject to the personal income tax withholding requirements, the employer must register with the Department of Employment Development. A booklet entitled “Employer’s Tax Guide for the Withholding, Payment and Reporting of California Income Tax” may be obtained from this Department.

K. Federal Unemployment Tax. The “Unemployment Tax Return” (IRS Form 940) must be filed and any balance due paid on or before January 31 of each year. Details may be found in IRS Circular E, the “Employer’s Tax Guide.”

L. California Unemployment Compensation Insurance. Registration with the California Department of Employment Development can be accomplished at the same time that the LLC applies for a seller’s permit (if needed) from the Board of Equalization. Forms for returns are mailed automatically to all registered employers.

M. Workers’ Compensation. All employers must either be insured against workers’ compensation liability by an authorized insurer or obtain from the Manager of Industrial Relations a certificate of consent to Self-Insure. The required insurance may be obtained through the nearest local office of the State Compensation Insurance Fund, or it may be placed with a licensed workers’ compensation private carrier.

N. Trademarks; Trade Names; Trade Secrets. Company trademarks and trade names should be registered in the Company’s name with the U.S. Patent and Trademark Office. Trade secrets of the Company should be protected by obliging Company employees to sign confidentiality agreements.

O. Securities Law Matters. If all members of the Company are actively involved in the management of the Company, and have the experience and ability necessary to manage the Company, then the interests in the Company would not constitute “securities” under California or federal law. If any of the members are “passive” investors, then the offer and sale of an interest in the Company to such investor would constitute the offer and sale of a “security”. Normally such offers and sales can be structured to satisfy the requirements for exemption from registration under federal and state securities laws (this was the case for the Company). If no exemption is available, then the securities would require registration pursuant to federal and state securities laws. Even if an exemption from registration is available, the sale by the Company of additional interests to new investors (or additional contributions of capital by existing members) should be accompanied by the filing of a “25102(f) Statement” with the California Department of Corporations.

P. Fictitious Business Names. If the Company intends to transact business using a name other than that specified in the Company’s articles of organization, the Company must file a fictitious business name statement with the clerk of the county in which it has its principal place of business. The Company must also file a fictitious business name statement in any other county in which it intends to transact business. Once a fictitious business name statement is on file with the county clerk, the statement must be published in a newspaper of general circulation in the same county once a week for four consecutive weeks. Within thirty (30) days after publication, an affidavit of publication must be filed with the county clerk’s office.

Q. Qualification in Other States. States universally require a “foreign LLC” (one not incorporated in that state) to “qualify” before “doing business” in such state. Qualification usually consists of the filing of documents, payment of a fee, and appointment of a resident agent for service of process. “Doing business” is more often defined by the exceptions than by an enumeration of specific acts which are covered by that term. However, if the LLC elects to do business (e.g. open an office) in another state, it will be required to qualify in that state. Failure to qualify may result in financial penalties as well as the inability to bring suit in the courts of the state with respect to acts and transactions in the state during the period of the violation.

R. Real Estate. If the LLC owns real estate, recordation of the articles of Organization in the County Recorder’s real estate records is advisable.

VII. General

A. Signing on Behalf of the LLC

Whenever the LLC managers or officers are signing agreements, documents, or correspondence on behalf of the LLC, care should be taken to include the LLC’s name in the signature block and to indicate the title of the manager or officer signing. An example of an appropriate signature block is included below:

[LLC name]

By: _________________________

Name: [name of individual]

Title: [General Manager, etc.]

Failure to do so may lead, in the context of litigation involving a signed document, to including the person who signed the documents in the lawsuit in his or her individual capacity.

B. Bylaws

This article describes a number of the important legal aspects of running a business in LLC form. It is important to remember that the operating agreement and articles of organization of the LLC are the authoritative source of advice as to how to do certain things that will come up from time to time. For certain types of LLC (normally those with a larger number of members), a form of bylaws similar to the type of bylaws applicable to a corporation may be advisable or useful.

C. Official Documents

A number of small LLCs have found it useful to designate one of the officers, usually the secretary, to be the recipient of all “official” correspondence concerning the LLC and its relationships with the various government agencies with which it deals. This helps to avoid forgetting to submit certain of the regularly filed forms, such as the Annual Form LLC-12 (see item IV.C above), which though simple documents can lead to troublesome problems if they are not taken care of promptly.

D. Finances

An important feature of post-formation LLC operation is scrupulously to keep the LLC’s money separate from the personal funds of members, managers, or employees. Failure to keep these separate is a common problem with closely held or newly formed LLCs. Such a co-mingling of funds is often seized upon by LLC creditors and other persons suing an LLC as a reason to disregard the LLC entity and impose liability on the individual members for the LLC’s debts, obligations, and liabilities as discussed in “Separation of LLC and Personal Assets” above.

Obviously, many issues may arise which are either out of the ordinary or of special importance to the LLC.