Pros and Cons of Limited Liability Companies
Pros
•Cheap to form and maintain.
•Relatively few governance formalities.
•Limited liability for owner.
Cons
•State tax treatment may be unfavorable.
•Liability protections might be easier to breach than a corporation’s.
•More expensive to form and manage than a sole proprietorship.
The limited liability company, or LLC, has become a popular legal entity choice for small businesses in many fields. The reason for the LLC’s popularity is simple: it offers business owners limited liability at low cost. It is also easy to operate, with very few mandatory requirements. Wyoming adopted the first LLC statute in 1977, but it was not until the late 1990s that the IRS clarified that it would allow LLCs to elect for themselves whether or not to be treated as separate taxpayers from their owners. As a result of the clarified tax rules, the number of LLCs in the United States exploded.1
Figure 3.1 Limited liability company structure diagram
Figure 3.1 shows an example organization structure for an LLC. In Figure 3.1 the LLC is following default tax treatment and is not subject to separate income tax. Note that revenue and expenses flow through the company and end up as components of the freelancer’s personal income tax calculations. The company itself doesn’t have a relationship with the IRS as an income taxpayer, though its owner submits an extra form with the owner’s personal tax returns. Meanwhile, contracts and other obligations remain with the company.
Limited Liability
The owner of an LLC is referred to as the company’s member. Single-member LLCs are common. Members own membership interests in the company. Unlike the stock of corporations, an LLC’s membership interests usually do not need to be paid for in cash to be legally valid. Instead, in the company’s organizing documents the member can specify how membership interests are issued and held.
The member’s personal liability for obligations of the LLC is limited to the amount the member has contributed to the company. Essentially, this means that all other formalities being met, the member’s investment in the company is the only thing at stake should the company be sued or is otherwise unable to pay its debts.
Paul Loses His Shirt, but Keeps His House
Paul is a semiretired freelance website designer who owns Nice Site Designs LLC. When he formed his company, he specified in its organizing documents that he would become the sole member of the company in exchange for $10 in cash. Any other contributions he made to the company would be recorded as surplus capital contributions. Paul wrote a personal check for $10 and deposited it into the company’s new bank account. He also used his own money to buy a new computer and software, spending a total of $5,000, which he claimed as deductible expenses of the business at tax time. Paul is assiduous about keeping up with all the formalities of his company.
A client sues Nice Site Designs LLC for damages arising from mistakes Paul made in a website’s security. Fortunately for Paul, the court doesn’t let the client come after Paul’s substantial personal assets (his retirement accounts and home) even though he made mistakes. Unfortunately, the damages are much more than Paul bargained or prepared for, totaling over $500,000.
When the client goes to collect on its judgment against Nice Site Designs LLC it discovers that the only assets the company has are what Paul has put into it. Paul stands to lose his $10 initial contribution as well as whatever value remains in the computer and software, which are subject to being taken by the client. Ultimately, the judgment probably means that Paul’s business will have to shut down, potentially through a bankruptcy process to formally wipe out the debt owed to the client. (In most states, an LLC that is insolvent—that is to say, it has debts greater than its assets—cannot be legally dissolved other than by a court.)
In this admittedly unrealistic scenario, the real loser is the client, who has suffered serious harm as a consequence of Paul’s mistakes. In real life, a client that stands to lose this much value in a transaction with a freelancer will require the freelancer to carry professional liability insurance to protect it against such an event.
Formation
Forming an LLC is usually a simple process, started by filing a certificate of organization (alternatively called a certificate of formation or articles of organization) with the state’s business registrar, together with a fee. The certificate of organization is a public record. The filing is usually completed in person or by mail, but many states offer online filing as well. The fee is usually between $100 and $300. Once filed, the state stamps the document or issues a separate certificate with the filing’s effective date and the company’s unique file number, which you’ll use for all your future correspondence with the state regarding the company. Typically, the date the certificate of organization is received by the state becomes the date of formation of the company, though without paying a fee to expedite the filing’s return it can take anywhere from 1 week to a couple of months to receive formal confirmation, depending on how quickly the office processes them. Some states are notoriously slow about processing filings that aren’t submitted on an expedited basis.
Many states provide preprinted forms for the certificate of organization on their website. Each state has its own requirements for what information is required. Figure 3.2 shows what a completed certificate of organization might look like for a California LLC. The following items are typical:
•The name of the business
There are relatively few restrictions on how an LLC is named. States usually require companies’ names to include an appropriate suffix (LLC, Limited Liability Company, Ltd.) and have a few minimal restrictions. We’ll cover naming in Chapter 6.
•The company’s business purpose
Many states require new LLCs to include a statement about what the new business will do. Some states allow an open-ended statement such as “any business permitted under the laws of this state.” Others expect a more specific description, such as “photography services.” The company’s stated purpose sometimes comes into play when dealing with banks, which will follow the letter of the certificate of organization. Most businesses that put limits on their scope of business in their formation document are doing so to satisfy investor requirements. Typically, freelancers will want to use the most open-ended description of their business to maximize their flexibility.
Figure 3.2 Example certificate of organization
Most single-member LLCs, like those freelancers are likely to use, are member managed, meaning the member has direct control over the affairs of the company. The alternative is manager managed LLCs, in which the company’s members have appointed a specific person to operate the business. A manager is typically one of several members of the company, or an outside professional hired to do the job. These are unlikely situations for solo freelancers.
•The name and address of an agent for service of process
The agent for service of process is the person who the business designates to receive formal notices from the state and service of lawsuits. The freelancer can serve as the agent for service of process, or can pay a fee to a service provider to fill this role. Because filings usually require both the name and street address of the agent for service of process, freelancers who work from home might want to hire a service to handle this requirement to keep their home address private. Some states, like New York,2 facilitate lawsuits by requiring entities to designate the Secretary of State as the agent for service of process; in such cases, the Secretary of State forwards copies of documents served against the company to the address specified in the company’s organizing document.
•The mailing address of the company, its member, and its manager
Unlike the agent for service of process, the mailing address of the company usually can be a P.O. box. If you decide to use an address other than your home, be sure it is a place where you are sure to receive what is delivered. Not all states require LLCs to publicly disclose the name and mailing address of their owners, but many do.
•The effective date of the filing
Some states allow filers to specify a date after the date the document is physically submitted for filing to serve as the effective date of filing. This is a good option if you have a compelling reason, such as taxes or insurance, for delaying the company’s formation. Usually it makes sense to let the filing date also serve as the effective date.
Some states have additional requirements for completing the formation of an LLC. New York, for example, requires publication of a notice of the LLC’s formation in local newspapers and a further filing to confirm that those publications have been completed.3 In California, new LLCs must file a Statement of Information (Form LLC-12), together with a $20 fee, setting out detailed information that isn’t included in the formation filing itself.4 Instructions regarding these requirements can be found with other forms on state websites.
A certificate of organization can always be amended by filing the appropriate form and paying a fee. A common reason for amending the original certificate is to change the company’s name. If you haven’t chosen a name but need to form a company right away, for example to sign a risky contract, you can always form a company with a “generic” name and update it later. Once the company’s name is changed you’ll need to let your clients and other contractual counterparties know about the change.
Management
The Operating Agreement
LLCs have very few legally required ongoing management formalities. Some states require an LLC member to enter into a governing document, called an operating agreement (also sometimes called an LLC agreement). Even in states that allow LLCs to operate without operating agreements, it is usually a good idea to adopt one. Otherwise the state’s default rules will apply. Depending on your situation, the default rules might not be the best fit for your business. By adopting a personalized operating agreement, you can decide for yourself how much formality you want to take on. Most freelancers will want to opt out of all but the minimal requirements that are necessary to maintain the LLC as a going concern.
The contents of a company’s operating agreement are largely up to the member, provided that the state’s statutory requirements are met. Every state requires different things to be included in an operating agreement, so it is important to use a form that is consistent with current state requirements. That said, these are fairly boilerplate documents. Simple forms of operating agreement tailored to every state’s laws can be found online, for free or for a fee. An experienced business lawyer should be able to provide a document tailored to your business and personal needs at nominal cost.
The operating agreement is a private document, meaning it isn’t filed with the state. Some service providers, especially those entering into a financial relationship with the company (banks, insurance companies), will need to see a copy of the operating agreement as part of their new client screening process or to confirm your authority to sign documents on behalf of the company.
Once adopted, an operating agreement can always be amended, either by a signed document that describes the amendment, or by adopting a whole new agreement. The member of the LLC needs to sign the amendment for it to be effective. Assuming that the original operating agreement is properly drafted, amendments are pretty unlikely to be necessary for a freelance business.
Operating agreements typically cover the following matters:
•The powers of the member
Even though an LLC has only one member, the member’s authority to act on behalf of the company (sign contracts, open bank accounts, appoint officers) might need to be spelled out in the operating agreement. Many states allow open-ended language granting members essentially unlimited authority to act on behalf of their LLCs. Other states may require a more detailed list of specific authorities, which might include the power to transact business on the company’s behalf, bind the company by signing contracts, borrow money and open bank accounts, and buy or sell company assets.
•The powers of officers
If signing contracts with the title of “member” isn’t appealing to you, you can give yourself a different title (president, for example) for purposes of day-to-day work. Be sure to document your extra titles and their authorities. Almost all the powers held by the member as member manager can be duplicated in an officer position. Your authority as member will still be necessary for formal actions like winding up the company, making amendments to the operating agreement, or complying with requirements of banks or government authorities, but the officers of an LLC can do almost everything else, like signing contracts.
•How ownership of the company works
The operating agreement determines what members can do with their membership interests, as well as how new membership interests get issued. These provisions needn’t be complicated in a single-member LLC. If you later decide to bring in another member, you will probably amend your operating agreement to restrict the ability of you and your partner to sell or give away ownership interests in the company.
•What happens to the company if the member dies, is incapacitated, or declares bankruptcy
Disaster planning is part of managing business risk. Unlike a corporation, an LLC can be organized to automatically dissolve at the death of its sole member. Alternatively, the company can continue to exist, with the membership interests simply becoming another asset of the former member’s estate. Similar provisions addressing member bankruptcy usually only appear in LLCs with more than one member, but watch out for such terms if you’re relying on a form agreement found on the Internet. Before adopting any provision that gets triggered by a disaster event, it is worth understanding if there are significant downsides. For example, how your state treats business assets in an estate, and how a dissolved business’s liabilities might pass on to your heirs. If the company dissolves upon your death, its limited liability protection may go with it, leaving your heirs exposed to your outstanding business debts. On the other hand, leaving an unwanted business entity in place can add an extra layer of complexity to estate management. These are probably more important considerations for freelancers with especially valuable business assets and debts.
Ownership and Member Contributions
The rules governing LLC ownership are fairly permissive with respect to the way ownership is issued. When an LLC is organized, the operating agreement can simply state who the member is without requiring the member to pay anything for owning the company. Although paying for ownership isn’t always required, it’s still necessary for the LLC to be adequately capitalized, a topic we touched on in the last chapter. Be sure to keep track of the money you put into the company on your capital account.
If the operating agreement includes any formalities governing the issuance of membership interests, they should be closely followed. For example, the operating agreement may require the member to sign a resolution approving the issuance. If the operating agreement requires the company to issue a paper certificate of the membership interests, then that certificate needs to be prepared, signed, and kept in a safe place. A membership interest certificate can be an ordinary piece of paper with standard language on it, so this needn’t be a complicated step provided you have a template that meets your state’s requirements. If allowed by state law it’s a good idea to make such certificates optional, so you needn’t create one unless the need arises.
Statutory Filings and Other Maintenance Formalities
Aside from any governance requirements included in the operating agreement, the following items are often needed to keep an LLC in good standing with state and local authorities:
•Periodic reporting
Most states require LLCs to file periodic reports with the Secretary of State, typically annually and usually with a small fee in the range of $25, though they can be substantially more. Illinois, for example, collects a $250 fee for annual reports filed by mail (more for electronic filings).5 Annual reports typically call for updated information about the company, such as any change of address, change of member, or other details. They can be filed by mail and sometimes can be filed electronically. In a few states, like New York and Texas, the Secretary of State doesn’t collect annual reports from LLCs. Instead, those states gather information through the state tax authority.
•Franchise and income taxes
Many states impose a flat tax on every legal entity registered in the state, independent from income taxes. The amount of the tax varies widely. Some states charge a flat fee across the board, while others base the fee on the company’s revenue from the prior year. A single-member LLC does not file separate income tax returns. Instead, its owner reports business income and losses on IRS Schedule C, the same form used by sole proprietors. Chapter 7 goes into more detail about tax matters.
•Local business licensing and registrations
Formal Business Records
The simplicity of managing an LLC extends to the way the company’s actions are documented. In a member managed LLC with a sufficiently permissive operating agreement, the member can mostly manage the affairs of the company without constantly documenting the member’s approval in written consents or in meeting minutes. There are a few exceptions that may arise where the member’s approval of the company’s actions needs to be formally recorded. Even for a single-member LLC, it is important that such approvals be documented and filed with the company’s records. This can feel unintuitive at times, because the sole member is often authorizing herself to act. But the absence of such formalities can be a bad fact in litigation or in an IRS audit, so it’s important to follow them.
State laws rarely require LLCs to pass member resolutions as part of their routine governance process. There are certain events that do require member consents, but these are rare: selling off all the company’s assets or sales of membership interests are two examples. Instead, most demands for special resolutions will come from sophisticated counterparties you will do business with, especially banks. You should expect to receive a template resolution from these sorts of businesses, so you won’t have to figure out the magic phrases they’re looking for. Just be sure to carefully review any form documents to ensure that they accurately reflect the deal and your company’s details, such as its name and mailing address.
After a few years operating her academic editing business as a sole proprietorship, Kara’s circumstances have changed. She has found a permanent professorship that has allowed her to settle down and buy a home. Her editing business has also expanded. She still edits papers for academics, but now her main client is a large consulting firm that produces environmental impact reports for large-scale infrastructure projects. Her client hires her on a project-by-project basis, using a contract drafted by the client’s legal team. The contract gives Kara a lot of obligations she’s never faced in the academic world, like confidentiality, arbitrary mechanisms that can reduce her fees if she fails to meet certain obligations, and an ambiguous clause that might require her to carry expensive professional liability insurance. Kara is willing to take on these burdensome requirements because the client pays top dollar.
One afternoon she gets a call from her client asking her to take on a new project. During the conversation, her contact tells her that the company is in the middle of a big lawsuit over omissions in the last report Kara worked on. Although the mistakes weren’t Kara’s fault, the news gives her pause. She decides that it’s time to think about getting insurance and forming a limited liability entity for her business.
After looking at the costs and requirements for LLCs and corporations in her state, Kara decides that an LLC is the best fit for her business needs. She likes the simplicity of the LLC’s corporate governance rules, and is satisfied that the LLC will provide her with a reliable degree of liability protection if she gets caught in a lawsuit. She concludes that the extra paperwork she’ll need to complete, the franchise taxes she’ll have to pay, and the annual reporting she’ll have to do are all small costs compared to the risks the entity will help her manage. Kara doesn’t stop there, though. She also starts hunting around for professional liability insurance to see whether she can find something that will protect her at a justifiable cost, and better comply with her client’s expectations.
Once Kara gets her new LLC up and running, she lets her client know that her company will own the relationship going forward. The client tells her that they can’t agree to transfer her old contracts to the new company, but that in the future they’ll happily prepare new contracts using her company’s name.
___________
1 As with all legal entities, the laws governing limited liability companies vary widely from state to state. The Revised Uniform Limited Liability Company Act of 2006 has been adopted in several states (California, District of Columbia, Florida, Idaho, Iowa, Nebraska, New Jersey, Utah, and Wyoming) and is the basis for the information in this chapter. National Conference of Commissioners on Uniform State Laws. 2006. Revised Uniform Limited Liability Company Act. www.uniformlaws.org.
2 N.Y. LTD. LIAB. Co. LAw § 203(e)(4).
3 N.Y. LTD. LIAB. CO. LAW § 206(a).
4 CAL. CORP. CODE § 17702.09.
5 Office of the Illinois Secretary of State. 2017. “LLC Annual Report.” http://www.cyberdriveillinois.com/departments/business_services/annual_reports/llc_instructions.html.