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2019 Edition
Recognizing and Avoiding Common LLC Pitfalls
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SPOTTING AND AVOIDING COMMON LLC
PITFALLS
Key Topics:
■ The different types of LLCs
■ Common mistakes when setting up an LLC
■ Taxation and using an LLC to buy real-estate
■ The importance of an operating agreement
■ How to handle disputes
I. INTRODUCTION
What is an LLC?
■ An LLC is a limited liability entity
■ An LLC can be used to protect the personal assets of
the owner(s) from the business’s liability
Advantages of an LLC:
■ Adaptable
■ Flexibility
■ Easy to change and customize
■ User-friendly
■ Tax-advantageous
II. SELECTION
Issues That Arise Early On:
■ Due to the variety of customizable options, its
common to see issues arise early in the creation
process
■ Its pertinent that the client, attorney, and
accountant know all of their options and the
differences between these options before making
any selections
1. CHOICE OF ENTITY
Misconceptions:
■ People often believe LLC’s are:
– Not as “sophisticated” or “formal” as corporations
– Less attractive than a corporation to future investors
and customers, or potential partners
Reality:
■ An LLC is the most attractive option for most business owners
■ Less rigid, only as complex as the owner wants to make it
■ Less information to disclose, only requires an operating agreement for governing
■ Able to limit fiduciary duties
2. MEMBERS
Multi-Member LLC Warnings:
■ The more members you have, decision-making and
overall management can become slower, more
tedious, and more complicated.
■ This process is made even more complicated when
member(s) are not business-savvy or have issues
staying in contact/communicating
Rewarding Employees
■ Often, founders wish to ‘reward’ membership units to
a deserving employee.
– Usually, there is also a motive to make the
employee feel more invested in the company too
■ Unless the employee is being targeted to take over the
company, this can be accomplished by issuing
phantom units, bonuses, or other non-equity
incentives
Non-Employees
■ Sometimes LLC owners wish to give units to non-employees (like a spouse, passive investor, or former employee).
■ In this situation, a non-equity incentive (or even a paid or unpaid position) can be used instead
■ By choosing a non-equity incentive, the LLC is ensuring the individual is not directly participating in the management of the company
Tax Perspective:
■ Single-member LLC’s can be beneficial from a tax perspective
– IRS considers them “disregarded entities” (the owner and the LCC are combined for taxes)
– Adds an extra layer of protection (like an S-Corp)
■ LLC’s are also very flexible in terms of tax elections (more on this later)
3. MANAGEMENT
Management Decisions
■ Management of an LLC mainly depends on who is
best equipped to oversee and manage the day-to-
day operations
■ In some states, LLC management may be
outsourced to a different entity
Member-Managed■ Member-Managed (default model)
– Often used when members of an LLC want to be
actively involved in the daily operations
■ Manager-Managed
– Often used when an LLC had too many members or
there are multiple members with different interests
– An individual or a group of people (may or may not be
members of the LLC) are appointed as the
manager(s)
III. SERIES LLC’S
What is a Series LLC?
■ A Series LLC is a single entity that contains multiple,
separate series
■ These series are treated as separate subsidiaries
– Each has its own assets, engages is separate
business transactions, and is protected from other’s
debt
Advantages & Disadvantages
■ Advantages
– They are easier and less expensive to set up. Also, you only have to pay one registration fee, and have one set of governing policies.
■ Disadvantages
– Only 14 states, DC , and Puerto Rico have the applicable statutes in place. There are also many disparities in the laws that govern series LLC’s in those areas.
IV. SINGLE-MEMBER
Improper Set-up:
■ Single-Member LLC’s are easy to set up and govern,
and add another layer of protection between owners
and clients.
■ However, if incorrectly set up, an owner will not
benefit from a Single-Member LLC. Instead, they will
be subject to many of the liabilities they were
originally seeking protection from.
Common Mistakes:
■ In single-member LLC’s, individuals tend to ‘ignore’
many of the corporate structures and formalities
that multi-member LLC’s adhere to.
■ In order to fully benefit from the protection an LLC
provides, business owners must keep their business
separate from their selves/personal benefits.
Cont. ■ The following three topics are often the root of many single-
member LLC issues.
■ Bank Accounts:
– Its imperative that personal and business bank accounts are kept separate
■ Recording Keeping:
– A hard copy of complete notes and records (rather than a mental copy) ensures easy accessibility and review when necessary
■ Succession:
– A business can fail or head in the wrong direction if the proper/desired successor is not determined ahead of time
V. TAXATION
Legal Status vs. Tax Treatment
■ Legal view - types of business entities:
– Sole proprietorship, partnership, corporation, and LLC.
■ Taxation view - types of tax treatment:
– Sole proprietorship, partnership, S corporation, C corporation, and tax-exempt entity
■ An LLC can theoretically elect any of the 5 different tax treatments
Tax Treatments and LLC’s
■ Partnership:
– An LLC “passes through” its profits/losses to its
members. The members then declare it on Form
1065 (instead of From W-2)
■ S-Corp:
– An LLC passes profits like in a partnership, but
members bear the profit/loss in proportion to their
ownership stakes
Cont. ■ Sole proprietorships
– Similar to partnerships, usually subject to self-employment tax
■ C Corporations
– Not considered a “pass-through” entities, instead they are taxed at the corporate letter. Other amounts distributed to members are taxed again at the individual level
■ Tax-exempt entities
– Pays not federal tax, usually engaged in political or educational activities
VI. REAL ESTATE
Purchasing Real Estate:
■ The flexible nature and easy creation of LLC’s make them prime option for reducing risk in real estate purchases
■ LLC’s can also be used to shield identities, as LLC’s do not typically disclose their owners
■ Risk can be spread across multiple LLC’s
– Be wary of using too many, or not enough, individual LLC’s.
Consistency:
■ Ensure you remain consistent in your set-up and
practices.
■ It is important to make sure that the correct policies,
documents, and responsibilities are aligned to each
individual LLC involved.
VII. INTERESTS
Membership Interests:
■ Membership interests are NOT corporate shares.
The number, nature, and power of these interests (or
units) are often determined by the LLC’s
members/operating agreement.
■ There are local and federal laws, as well as statutory
defaults that factor into these decisions as well.
Economic vs. Operational Benefits: ■ Some companies will create different processes for
how economic or operational benefits can be transferred.
■ In some states, this dichotomous approach can create more problems than benefits
■ Usually, it is best if a membership unit is treated as a single, complete unit and transferred in its entirety
Operating Agreement: ■ A company’s operating agreement should outline things
like:
– How many units the LLC will authorize
– Whether the LLC can authorize additional units
– What will happen to the original member’s dilution if
more units are distributed
– How members can transfer their units
– What will happen when a member dies or leaves
their position
Other Considerations: ■ Will the LLC “certificate” their units?
– They can easily be misplaced, damaged, etc.
– They also serve as evidence of ownership to other
parties without revealing other information
■ What happens in the event of an involuntary transfer?
– Usually in the case of bankruptcy, death, or divorce
– The LLC should decide if this type of transfer results in
a purchase option for the company, a loss of voting
rights, or both.
VIII. SHOPPING
Forum Shopping:
■ Typically, it makes the most economical and
practical sense to set-up your LLC in the state where
you reside or primarily conduct business.
■ Trying to set-up an LLC in another state to avoid
taxes or get a tax break usually results in paying
more fees and taxes.
IX. PROTECTION
Asset Protection Options:
■ While an LLC limits your liability to a certain extent,
there are additional options a company can use to
further protect them selves
■ Insurance plans, credit optimization, and consulting
with an estate planning attorney are all viable
options for companies.
Insurance:
■ An insurance broker can walk you through your
options, and help you decide what makes the most
sense
■ Types of insurance brokers: Commercial General
Liability, Directors and Officers Liability,
Cybersecurity, Buy-Sell, Key Person, and Professional
Liability.
X. GOVERNANCE
Operating Agreement:
■ Crucial to the successful operation and decision-making of an LLC
■ It should be customized to the unique needs of each LLC (NOT an online template)
■ The operating agreement should define: 1) how members are paid, 2) exit plans (if applicable), and 3) dispute resolutions
1. MONEY
Compensation:
■ The money paid to employees based on their work
for the company (salary, bonuses, etc.)
– Usually subject to tax withholdings and taxed at
the typical income rate
■ Compensation is rarely mentioned in an operating
agreement. However, a statement regarding who can
set compensation rates is often good to add.
Tax Distributions:
■ The money given to employees to cover taxes
■ This is NOT compensation or paid as a reflection of
work
■ These distributions can be mandatory, discretionary,
or not applicable, depending on the company’s
operating agreement
Profit Distributions
■ The earnings from a given year that have not been shared
with members
■ Companies can be penalized with taxes for retaining these
earnings
■ Usually, LLC’s will distribute these profits to their members
(the proportions should be outlined in the operating
agreement)
2. EXIT
Exit Provisions: ■ Important questions to discern:
– Can a member voluntarily “withdrawal” at will?
– If so, what are the terms?
– Does the LLC have an option to purchase the exiting member’s interest?
– How is fair market value calculated?
– How will the purchase be paid out?
– When is a payout option not applicable? (like in cases of fraud)
3. DISPUTE RESOLUTION
Dispute Resolution: ■ Traditional litigation v. alternative dispute resolution
(arbitration/mediation)?
– Traditional litigation in faster and less expensive
– Alternative dispute resolution is more private and easily accessible
■ Choice of law and choice of venue
– What type of court?
■ Attorney’s fees
– Can be a good leverage point, and help to settle disputes quicker
XI. DISPUTES
Before its too late:
■ Fairly early into the development phase, LLC’s should develop the following provision before issues arise:
– A dispute resolution policy
– A deadlock provision (for bigger issues like selling the business)
– A withdrawal option, so members can make a clean break and leave when needed
CONCLUSION
Review:■ When starting an LLC, make sure you:
– Know all of your options (and their differences) before making any big decisions
– Know all the applicable laws and tax rules
– Have well-versed advisors to help you
– Select strong co-partners or managers (if needed)
– Build a strong legal infrastructure
– Have the correct safeguards in place to help you when issues arise
Ryen Rasmus, Esq.Berenzweig Leonard, LLP
■ Ryen Rasmus is a Senior Associate Attorney at Berenzweig Leonard, LLP in McLean, VA. Ryen specializes in the drafting of contracts and operations documents; resolution of business and intellectual property-related disputes; and counseling in the fields of corporate, employment, and entertainment law.
■ Prior to his joining the firm, Ryen served as law clerk to Chief Judge Karen J. Burrell and the Hon. Louis A. Sherman of the Norfolk Circuit Court. While in law school, Ryen worked at a Top 200 law firm in Washington D.C., a Hampton Roads law firm specializing in entertainment law and small business-related issues, and the office of legal counsel at a major state educational institution. Outside of his work with the firm, Ryen volunteers time with several non-profit organizations that seek to promote education and positive youth development.