It can provide the limited liability and creditor protection features of a corporation, the pass-through tax attributes of a partnership, and the flexibility to customize management and internal control matters to meet the particular goals of business ownership.
Because of a ‘best of both worlds’ set of features, more businesses and ventures are organized as limited liability companies each year. In the last few years, more new LLCs have been formed than new corporations. (Of course, it’s not for every business, and the circumstances that might lead an owner toward a different corporate entity are outlined in the tips box with this article.)
There are three advantages to an LLC: limited liability of owners, ‘pass-through’ taxation and maximum flexibility. Like a corporation, an LLC is a separate legal entity, responsible for its own legal liabilities. Its owners, like the shareholders in a corporation, are not personally liable for the debts of the company.
While an LLC is a separate legal entity, it is not a separate taxpayer. The taxable income of the LLC’s business operations flows through to the owners. The owners report the income on their personal returns. The LLC files only an informational return and doesn’t pay income taxes.
Corporations are both separate legal entities and taxpayers, so business income can get taxed twice, once at the corporation level and again at the owner level because dividends are taxable income to the stockholders.
Finally, LLCs are flexible, both in terms of governance and management and the structuring of their internal affairs. LLCs can be managed by boards or members. They can even delegate almost all management powers to a single managing member. Member owners also have great freedom to customize their deal and don’t have to squeeze themselves into cookie-cutter forms and statute-mandated structures.
How to form an LLC
An LLC is formed by meeting the requirements of the Minnesota Limited Liability Company Act. The act requires the LLC organizer to file articles of organization and pay a filing fee to the Secretary of State.
The articles of organization must include basic information regarding the LLC: its name, office address, name and address of the organizer and a statement of how long the LLC is intended to exist (it can be perpetual).
Other provisions can be added, such as a statement of business purpose, a list of powers, restrictions on transfer of ownership, definition of voting rights, and other matters. A very basic form of articles of organization is available from the Minnesota Secretary of State’s Web site at www.sos.state.mn.us. This basic form is often modified to fit individual circumstances.
The articles of organization are intentionally short for LLCs. The goal is to meet the statutory requirements and to get the company legally formed.
The important document, which states the ‘rules of the road’ for the business entity, is the Member Control and Operating Agreement (MCOA). In essence, the MCOA is the contract between the owners of the LLC as to how they will govern the entity, share or delegate management power, share profits and losses, distribute cash, and eventually end their relationship and terminate the company.
The first step in putting together an effective MCOA is to decide on the basic management structure for the LLC. Will the owners (called ‘members’ in an LLC) directly manage the business like partners in a partnership? Or will they appoint a board to oversee the general management of the LLC, which in turn will elect officers to oversee day-to-day operations, like in a corporation.
There is even flexibility to somewhat blend the two structures by having the members appoint an executive committee or a single managing member to perform the general oversight and day-to-day management functions.
The MCOA should also define when members will meet, voting rights, what records will be kept and who will have access to them. The Minnesota statute provides minimum guidelines for each of these areas, but the members have great flexibility to customize the structure to meet ownership?s individual goals and needs.
Next, the MCOA should define the rules for the economic life of the LLC. How much money will each member contribute to start the business? When is the contribution due and in what form ? cash or other property? What are the limits for the LLC to borrow money? How will it raise new capital? How many owners must vote to approve borrowing or the addition of new members?
The agreement will also need to address how and when the LLC will distribute profits and cash flow to its members. It is common to provide that the LLC will distribute sufficient dollars to pay income taxes that the members must pay on the LLC’s profits. Beyond such ‘minimum distribution’ rules, the agreement should define who determines the amount and timing of cash distributions.
Choosing your partners
The MCOA should define the rights of the members to pick their partners into the future. What happens if one of the members dies or becomes disabled? What if a member becomes insolvent and its creditors try to attach the member’s interest in the LLC? What if one member wishes to sell their interest in the LLC to a third party? The MCOA, through member control features, can and should define the answers to these questions.
The owners will likely restrict the right of any one owner to sell their shares to an outside party that the other members do not know. The agreement will contain either option rights or rights of first refusal to restrict the free marketability of a member’s interest.
Besides defining the events which will trigger a member control right, the agreement should also define how the value of the LLC will be determined should a triggering event occur. The MCOA could provide that the members will annually agree on a valuation or that the interest will be valued by an accountant or appraiser on a regular basis. Finally, the MCOA should define the payment terms after the exercise of a right of first refusal, addressing down payment, interest rate and the like.
Because there is no standard form agreement, business owners should work closely with counsel to identify goals, elect options and craft an agreement that fully realizes the potential to make the LLC option work for them.
