Tag: operating agreement

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At some point, just about every lawyer is asked this question by a client or friend. Why do I need to pay lawyers’ fees to create my LLC, file my trademark, draft my will, etc.? I like to keep things simple. Why can’t I just use LegalZoom or another self-service documentation provider?

[Note: This post was written while I was a practicing attorney running a solo law practice. When published, it was one of my most popular posts. Since April 2015, I have been working with attorney, executive and entrepreneur clients as a career coach and writer, and I am not currently available for legal engagements.]

Well, the short answer is – you can. You can get a short, generic form agreement or filing from a service provider (with or without minimal “attorney review”), which may look and feel like a helpful, valid and comprehensive document until some dispute arises. You can also put your own roof on your house with the advice of a book or YouTube video, or from a kit, which may look and feel just fine until water starts to leak in….

silver-keyboard

Take a multi-member LLC agreement, for example. What are some of the things that can go wrong with a sparsely-drafted, generic agreement? I recently checked out the standard form of operating agreement from one of these services (not LegalZoom in this case, but a competitor with similar services). It allowed me to create a PDF copy (not Word, so I could not make additional changes) of a multi-member LLC agreement, with the help of prompts included as part of the program. Here are only some of the problems I observed in the program and language of the document, aside from what else could be added or improved:

1) Initial capital contributions are included but there is no language about what happens if (a) a member fails to contribute or (b) additional contributions are required or desired over time. These contributions may be needed to keep the company solvent, pay debts or ensure adequate capitalization (so limited liability is respected by the courts), or desired to expand the business, but under the agreement there is no mechanism to encourage or require them.

2) The agreement provides for profit allocations four times a year, with no discretion by the manager or a vote of the members. What if the proposed distribution would render the company insolvent? Should the members ignore or amend the LLC agreement at that point or call their lawyers to sort it out?

3) The agreement also provides that the members will receive enough funds to cover their income taxes when profits are allocated. Like the above, it sounds good, but what if there is not enough cash to do it (e.g., in the case of a large property distribution)? Should there be, for example, an exception in some cases? The program not only does not allow the option, it fails to clarify or even present the issues.

4) The agreement provides that “members … keep accurate books and records”. Have you ever heard of proper accounting by multiple individuals, none of whom has ultimate responsibility for it? Same for the tax filings. Have fun with that one.

5) The program automatically grants all members authority to sign checks from the LLC’s account. Does that sound like a good idea? Well, it depends, but in many cases it is better to have only one or two people handling the company purse.

6) Any member can withdraw at any time. The program did not offer an option that would require the member to provide any notice of withdrawal (so that, for example, the others could get funds together to buy him/her out).

7) The program also plugged in (without verification or options) that the members agree to hire an outside firm to assess the value of a withdrawing member’s shares. How would you, if you were trying to administer this agreement, find the right person to do that? How much would it cost? Is one opinion enough and what qualifications must the firm have? Again, if you are not working with a lawyer, you may not know if there are other valuation options and/or how to craft careful language to avoid disputes.

8) The agreement also provides that if the withdrawing member is not bought out by the others (collectively or individually) within 60 days, the LLC will be dissolved. A smart and devious LLC member could use this provision to force the hand of the other members, especially if the others are cash-poor, with threat of dissolution simply by threatening to withdraw.

9) There are no options – only standard language – regarding what happens a member dies or becomes incompetent. In that case, the interest goes to the heir who would have “all of the rights of an assignee of the member’s interest”. (It did not state “and all of the obligations”, which is a critical flaw.) This means that if a child, spouse, parent or other individual is an heir, the other members are stuck with him or her. Even if the new member has no idea how to run the business, is a pain in the neck, etc. Of course, the members could dissolve the LLC by majority vote and create a new one (with additional cost, heartburn, potential tax consequences, loss of goodwill in the name, potential breach of leases and other long-term contracts, etc.) Or they could kick out or buy out the new assignee/heir if the agreement included provisions to do so, which this one did not.

10) Under the standard language – which could not be changed in this program – all amendments to the agreement require unanimous written consent of the members. Depending on the number of members and their commonality or diversity of interests, this may or may not be recommended. Also, if unanimous consent is needed for every single change, one member can always stalemate or simply not participate in the amendment, holding the others hostage.

11) The so-called “required mediation” language is very poorly drafted and will likely be misunderstood or the source of bitter disagreements, if ever invoked. For example, the agreement says that “all members agree to enter into mediation before filing suit” yet also provides that “if any member doesn’t attend the mediation, the members are free to file suit”. Changing the language to read “the members (other than the member who did not attend the mediation) are free to file suit” would be just a start at improving the provision.

12) Did I fail to mention that, upon initially selecting an LLC agreement, you are not given a warning or alert from the program that you should check with your accountant or otherwise to determine whether an LLC is even appropriate and most efficient in the first place? If it is not, how much money and time have you saved?

If you are starting a multi-member LLC in any jurisdiction, I strongly urge you to consult with a business attorney and have a properly drafted LLC operating agreement to clearly spell out the rights and obligations of the parties. (I would offer a similar recommendation for other important legal documents.) Any money and time you spend on the “front end” getting it right will likely be money and time you save on the “back end” if the relationship between you and your fellow LLC members sours or if there are disagreements about what a poorly-worded contract actually means. (Oh, and at that point, can you imagine who will want to pay the legal fees to resolve your differences?) As is often said colloquially, marriage and business relationships are often much easier to get into than to live with or get out of. Don’t be the one caught holding the bag.

None of the information posted on this site constitutes legal advice or forms an attorney-client relationship, and there may be facts not discussed here that are relevant to your situation. 

LegalZoom is a registered trademark of LegalZoom.com, Inc. 

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If you plan to start or have recently started your own business and are considering a single-member LLC (i.e., a limited liability company of which you are the sole owner), it is tempting to cut corners on the formalities, cost and time investment that may be associated with administering a “real business”. After all, no one can dispute profits, control or any aspect of the company with you, so why do you need the hassle? Successful or not – including the scary and exhilarating bits – it’s all yours.

The main problem if you fail to treat your LLC as a real business is that, when you actually need the limited liability protection that the LLC is meant to afford, the courts may not treat it as one either.

[Note: This post was written while I was a practicing attorney running a solo law practice. Since April 2015, I have been working with attorney, executive and entrepreneur clients as a career coach and writer, and I am not currently available for legal engagements.]

The Concept of Limited Liability

If you are going into business for yourself, there is no requirement to form an LLC or any other legal entity. There are quite a number of small businesses that operate as sole proprietorships, especially in the early days of the business when there is little or no revenue generation. The reasons to form an LLC or other entity vary, from simply appearing “more professional” to raising capital or engaging in tax planning, but obtaining limited liability status is certainly a key motivator.

In contrast to the single-member LLC, a sole proprietor simply operates a business in his or her own name. Let’s say Katie Lynn designs handbags, for example, and sells them from her home. Her business transactions are all done through her own name. Katie has personal liability for her own conduct as well as any debts of her business. If she purchases fabric, rents display space or incurs other liabilities that she later cannot afford to pay, Katie’s creditors can come after her home or other personal assets.

If Katie forms a limited liability company – let’s call it KL Designs LLC – she can now take a step back from the business if – and this is the important point to note – she takes appropriate care in the operation of her LLC. Simply forming an LLC one day and making no other changes to her business operations will not afford Katie the protection she expects. She needs to run KL Designs LLC not as an extension of Katie Lynn but as a separate entity or “legal person”.

Veil Piercing

The risk that Katie now runs, as the sole owner of an LLC, is that she has spent time and money to create KD Designs LLC but will be liable for its debts nonetheless. To be clear, there are instances where an LLC owner can be personally liable despite any entity status, including:

– personally and directly injuring someone,

– personally guaranteeing a business loan or other liability, or

– intentionally or recklessly committing fraud or illegal acts.

An LLC owner can also be personally liable if he or she does not treat the entity as a separate legal entity. In that instance, a court can hold that Katie or another business owner is essentially operating as a sole proprietorship and disregard the LLC status. Below are some ways sole member LLCs can protect themselves against “veil piercing”, which is the legal term used to analogize that the entity is simply a facade or “veil” covering the owner rather than shield against liability.

Operating Agreement

The central document for an LLC is the operating agreement. An operating agreement sets forth the obligations of the member(s) with respect to ownership percentages, capital contributions, profits and losses and other rights and responsibilities. It also overrides any default rules on the governance of LLCs in the relevant jurisdiction, which may or may not be what the owner(s) intended. As a sole owner of an LLC, having an operating agreement and following what it requires to authorize or take action by the entity are the first steps to demonstrating that the business is separate from one’s individual affairs.

Funding the LLC and Insurance

Undercapitalization – i.e., lack of sufficient funds to operate the business – is another reason a court may pierce the veil of an LLC and hold the owner(s) personally liable for the company’s debts. LLC owners need to invest sufficient cash in the business to fund its expenses and should hold sufficient liability insurance to cover lawsuits and claims (which will also be available to cover instances where the limited liability status is not respected).

Separation of Business and Personal Assets

An LLC owner should obtain a federal employer identification number (EIN) and keep bank accounts and financial accounting separate for the LLC and his or her personal assets. The absence of corporate records and commingling (mixing) of business and personal assets are two factors that courts consider in determining whether the piercing-the-corporate-veil test is met.

Transacting Through the LLC

All agreements and business transactions should be conducted through the name of the LLC. If we consider our example above, all contracts, invoices and other documents that Katie enters into on behalf of her handbag business should be in the full name of KL Designs LLC (including the “LLC” designation) and signed by Katie in her capacity as president (or another title) of the company.

The above considerations are crucial for any owner of an LLC, including a single-member LLC, who wants to preserve the limited liability status that an LLC is intended to afford.

None of the information posted on this site constitutes legal advice or forms an attorney-client relationship. This is a public forum. Please do not post confidential or fact-specific information regarding your legal questions on this site.