Are you in the process of forming an LLC? What is the right structure for you, and what are the legal steps involved? LLCs are one of the most versatile business entity types, meaning that there are many ways to set up the internal governance structure. This article will cover the basics of LLC formation.
What Are LLCs?
Limited liability companies, or LLCs, are a hybrid between corporations and partnerships. They can be taxed as a partnership while being operated as a corporation. What does that mean?
1. Partnerships are flowthrough entities, meaning that profits are passed directly to equity holders as personal income. Corporations have double taxation, meaning that after the entity is taxed, distributed profits are subject to a second round of taxation.
2. However, corporations benefit from a defined management structure, with shareholders at the top, directors in the middle, and officers at the bottom, unlike the loose governance arrangements of many partnership.
LLCs can enjoy the best of both worlds.
How Should You Structure Your LLC?
LLCs can be structured in numerous ways. They can either be member-managed or manager-managed, with managers either appointed by the members or set out directly in the constitution of an LLC. Managers can either be controlled by the members or provided with full management authority. There can be different layers or groups of managers, or members appointed to different committees. Members and managers can also appoint officers, such as a president or treasurer, to take over some or all of their responsibilities.
On top of all of this, LLCs can be structured like both partnerships and corporations. There may be an entity that functions in a similar way as the general partner of a limited partnership. There could also be a board of managers appointed by the members that elects officers typically seen in a corporation, such as a Chief Executive Officer or Chief Marketing Officer.
You can organize your team in any arrangement you want, really. There are no rules governing how LLCs must be managed, unlike business entities such as limited partnerships and corporations. But no rush if you don’t have an answer right away. You can amend your governance structure at any time, so long as your operating agreement allows amendments.
Operating Agreement
Operating agreements set out the operating rules of LLCs. Important clauses include, but aren’t limited to, guidelines on how the business will be managed, how profits will be distributed, and how disputes will be settled. They also contain a list of the members and the interests that each of them holds. In a nutshell, operating agreements function as the backbone that all other LLC documents must rely on for drafting rules.
You will need to draft your operating agreement carefully to avoid legal troubles down the road. What happens when you want to amend your operating agreement? What type of vote would be required? What happens when a member wants to sell their interest? Are there any restrictions on transfers, such as rights of first refusal or drag along rights? How will managers be appointed and removed? And how will major decisions, such as mergers and sales, be approved?
Your attorney will go over a list of questions covering these points and more. Think carefully about your business and your plans for the management team in the years ahead. At the same time, keep everything open enough so that you can quickly make the changes you need in case something goes wrong. The operating agreement should contain enough pages to provide lengthy operating rules, but shouldn’t be too detailed that the management structure would be too rigid.
To sum up
Starting a business is a big step, and you want to make sure that you have all your documents covered. Once you brainstorm the best management structure for your LLC, the next step would be to incorporate it into your operating agreement. Don’t just speak with an attorney, however. Ask an accountant about the best tax structure for your business model. As for the business model itself, speak to industry veterans, investors (if you plan on raising money), and anyone else you might find relevant. Good luck on setting up an LLC!
