Forming an LLC:  Beyond the Basics

LLC stands for Limited Liability Company and it is a powerful tool for business owners or those holding real estate. Most of us are familiar with the LLC as a means of mitigating personal liability. This article will begin by exploring that advantage along with some others, while also examining some of the drawbacks of using an LLC. Armed with that knowledge, the reader will then be invited to engage in an analysis of when an LLC is necessary and when it is useful, along with the advantages of forming an LLC in certain states outside of your home state.

What are the advantages and disadvantages of forming an LLC?

To answer this question, it is helpful to take a brief look at the different type of business structures. Broadly, there are three categories: A sole proprietorship, a corporation, and an LLC (there are more, but those are beyond the scope of this article).

A sole proprietorship is essentially doing business as yourself. Aside from getting licenses and permits if those are required and an Employer Identification Number if you have employees, you do not need to do anything to form one. A sole proprietorship is easy to set up and to run. It is also easy to pay taxes as a sole proprietor, as you need only file your regular tax return and report the business income as your own. The potential problem, however, is one of “personal liability.” If you are sued, found responsible for a wrongful act, and the court orders you to pay money (this is called a “judgement”), that money can be taken from your personal bank account, brokerage accounts, retirement accounts, and even your house up to a certain amount of its value.

A corporation is less likely to cause you that problem. A corporation—of which there are a few types—will limit personal liability and make it so that if someone sues you and gets a judgment against you, they can only seek satisfaction from your business assets. But where a corporation may reduce your fear of a lawsuit wiping out your life savings, it can create headaches when it comes to how you must run your business. A corporation is required to hold annual meetings and keep minutes. Further, a corporation incurs double taxation, first at the corporate level and then as personal income.

An LLC may be a happy medium. An LLC can limit your personal liability like the way a corporation can while at the same time provide you some of the ease of operation that a sole proprietorship can. An LLC does not require annual meetings or corporate minutes, and its members can opt for “pass-through” taxation, whereby you report income from the business on a regular tax return. 

Note that while an LLC may limit personal liability, it does not eliminate it. You can be held personally liable for a personal wrong (the legal term is “tort”) that you yourself commit during the course of business by your own lack of care. Fraud and certain other specific acts will also subject you to personal liability. Another potential disadvantage of an LLC is that while it is much easier to run than a corporation, it does still have more requirements than a sole proprietorship, namely that you cannot co-mingle personal funds and business income. Another possible drawback of an LLC is that it will require a greater initial start-up cost than a sole proprietorship.

When is an LLC necessary and when is it not?

Let us assume that you make money by buying clothes and selling them online for a mark-up. You do business as yourself under your own name and you have no employees. What are the potential reasons you might be sued? The likelihood that your business causes injury to someone is fairly low. Maybe you prefer to use the same debit card you use to make everyday purchases to make purchase for your clothing-sale business. That would be a prohibited co-mingling of funds with an LLC. Further, you don’t want to spend the money to hire an attorney to form an LLC for you. Litigation is always a possibility, but with your business, there is a low likelihood of being sued. It may not be worth it to form a Limited Liability Company.

Now assume that you sell auto parts and provide services where you install them for a fee. You have a shop, equipment, and five employees. Your business has multiple opportunities to be sued, from a customer slipping and falling at your storefront to an improperly installed part, to a worker damaging a customer’s vehicle. An LLC is necessary in this scenario to help limit your personal liability and the relatively small cost to form one pales in comparison to the devastating cost of a lawsuit that can seek payment from your personal assets. At this point, you might be thinking, “Isn’t that what insurance is for?” It is sound practice to get insurance in case you are sued. But that insurance will only cover your business assets. Your personal assets would still be at stake.

When is an LLC useful?

An LLC is useful, but not necessary, when you hold real estate. Of course, depending on the intended use of the real estate an LLC could move from useful to necessary. Obviously, commercial real estate that is frequented by many people produces more points of vulnerability against a lawsuit. Now, you are in a similar situation to the business owners discussed previously, and you have a need to limit personal liability. Your property insurance policy would provide coverage up to a particular monetary limit, but if the judgment from a lawsuit were greater than the policy limit, your personal assets could be exposed.

But an LLC has a useful advantage beyond just limiting liability, namely ease of transfer. An LLC can be sold by a fairly simple process in which membership interests are transferred. The real estate is still owned by the LLC, with only the members being changed. This is an effective tool not only for those who are seeking to some day sell their real estate, but also for those who are planning their estate. If you intend to leave your loved ones your real estate after you pass, a transfer of membership interests is a seamless way to do so.

Should I form a Single-Member or a Multi-Member LLC? And what about Member-Managed versus Manager-Managed?

An important point of terminology: an LLC is not “owned” and it does not have “owners.” Instead, an LLC is “managed” and has “members.” For the most part, a business with a single owner is suited to forming a single-member LLC and a business with many owners is better off forming a multi-member LLC. We say “for the most part” because there are always exceptions, and you should consult an attorney before deciding which to form. If you form a multi-member LLC, you must decide whether to form it as member-managed or manager-managed LLC. Here again is a decision that you should consult an attorney on before making. However, generally speaking, a manager-managed LLC is better In businesses with less stakeholders where you want decisions made quickly and with little input, and a multi-member LLC is one in which slower decision making is more ideal because there are more stakeholders and the impact of those decisions requires more deliberation and input.

What is an Operating Agreement?

An operating agreement is to an LLC what the constitution is to the United States of America; it is the rules by which the enterprise is governed. An operating agreement outlines the business' financial and functional decisions including rules, regulations and provisions. Once the document is signed by the members of the limited liability company, it acts as an official contract binding them to its terms. Operating agreements are critical to clarify the operational conditions and arrangements between members.

What goes in an operating agreement depends on the specific needs of the business and the preferences of its members. Mark these words: there is no one-size-fits-all operating agreement. What works for one business may be inefficient and a cause for headaches in another. Resist the urge to seek out a template for an operating agreement. Such templatized agreements can and do include unnecessary provisions that you are then bound by. A failure to adhere to these provisions can be cause for a lawsuit from a disgruntled member or from an outside party that will be able to “pierce” personal liability protection by showing that the failure to operate by the terms nullified the Limited Liability status of the company.

Wyoming LLC’s: An Added Layer of Asset Protection

Wyoming was the first state to create the Limited Liability Company in 1977. Ever since, it’s state legislature has worked diligently to make sure it is the leading state as to the supremacy of its liability protections. Forming an LLC in Wyoming means you are forming an LLC in a place where the law is constantly being updated to ensure the highest degree of liability protection. 

The first and most immediate benefit a Wyoming LLC will provide you is anonymity. If you form a Wyoming LLC and then make the Wyoming LLC the owner of the LLC in your home-state, anyone that is seeking to sue your LLC in your home state will have no clue as to the name, address, or location of the members of the home-state LLC. This is a powerful deterrent against lawyers seeking a deep pocket to pursue satisfaction of their client’s claim. When the allegedly injured party seeks a lawyer to pursue a lawsuit, one of the first things the lawyer does is look to see who the owner of the business that caused that injury is. When their search produces a nameless, faceless LLC in Wyoming, the lawyer is less enticed to pursue that claim.

The second benefit that a Wyoming LLC will provide is added liability protection. Recall that while an LLC can limit your personal liability, it will not eliminate it. Specifically there are four acts that, if taken by the members, will open their personal assets up to a judgment in a lawsuit. Those acts are as follows:

• Fraud. This is hard for the suing party to prove because they have to prove that there was an intent to deceive.

• Inadequate Capitalization. This means that the LLC does not have enough capital to meet the LLC’s future financial needs and give the LLC the ability to pay its debts as they come due. This is easy to prove and even easier for LLC members to commit. A business running on a shoe-string budget from time to time may fit this definition.

• Failure to Observe Company Formalities. Recall the above warning against using templatized operating agreements. If that operating agreement sets forth formalities that the company does not follow, it can expose the members to personal liability. Even a well drafted agreement can set forth requirements that members fail to adhere to after years of running the business.

• Comingling of Company and Personal Assets. If a member even pays their mortgage out of the company account, the LLC will no longer offer protection.

Here is where the beauty of the Wyoming LLC comes into play. In most states, proving only of the above acts to peel back the personal liability protection and attack a member’s personal assets. But in Wyoming, except for fraud—which as discussed is very hard to prove—the suing party must prove more than one of those actions. For example, a Wyoming LLC that has inadequate capitalization by itself will not, if sued, fail to protect the personal assets of the member. Instead, that LLC must have inadequate capitalization and must be comingling company and personal assets. Any two of the three will expose the members, but it the fact that both must be shown makes personal liability much less likely.

Conclusion

Hopefully, this article has you thinking beyond the basics of “liability protection” and looking instead at when that protection is necessary and if so, how much protection you should seek. You should also be informed about the importance of a well-drafted operating agreement, as well as the advantages and disadvantages of single-member and multi-member LLC’s. A good attorney will listen to your circumstances and your needs and know your points of liability. That will allow him or her to form an LLC that is customized to your needs and that can provide you the highest amount of protection possible.