As new startups decide upon a structure for their business, many are tempted to opt for a limited liability company (LLC), but without fully researching their options. Unfortunately, a hasty decision can lead to a number of unintended, future negative consequences. Therefore, we advise caution before leaping to any quick decisions about your business structure.
Aside from an LLC, other options include an S corporation or a C corporation. Each carries its own benefits and drawbacks, which may or may not be well suited to your situation.
As for an LLC, the benefits include
- Flexibility
- A simple, basic structure
- Ease of formation
- Ease of management
- Simplified tax situation in many cases; they can possibly be disregarded entities or taxed as partnerships with pass-through treatment of profits and losses
On the other hand, tax issues with an LLC are not always so simple. A number of different complications can occur, depending upon each situation. That’s why it’s important to consult a CPA before deciding upon an LLC.
An LLC often, but not always, requires an operating agreement as an ultimate arbiter of all facts regarding the LLC, members, and taxation. However, even though it is possible to form an LLC without an operating agreement, it is strongly recommended that you do so. When drafting the agreement, pay special attention to the following:.
- Length of the agreement – this can vary, ranging from about 10 to 60 pages. But those on the shorter end of that range probably lack clarity.
- Domicile: taxation, annual reporting requirements, and interpretation of the law by courts can vary from state to state.
- Membership: while all members hold common interests, some might be considered as “special rights members.”
- Options: employee stock option pools can’t be worked into an LLC, but workarounds offering similar benefits do exist.
- Control: carefully describe control, management, and voting rights.
- Management: whether the LLC is member managed or manager managed, and appropriate definitions of terms like CEO, COO, President, and Chief Marketing Officer.
- Investment: an LLC is not always the ideal vehicle for a startup’s investment plan. These issues must be carefully considered and described should you opt for an LLC.
- Contributions: type, nature, and value of member contributions to the LLC must be carefully considered, along with statements of valuation that will impact each member’s capital account
- Nature of interests: members will have capital accounts, subject to basis limitations which affect their tax treatment, but might also hold profits interests due to sweat equity or other intangible contributions.
- Obligations: the specific obligations of management, such as loyalty, due care, and the subsidiary fiduciary duty of good faith, must be considered and described.
- Indemnification and Advancement: provide for indemnification of manager and members other than for acts that are intentional, negligent, or taken in bad faith, but with extremely careful attention to definitions thereof.
When deciding to form an LLC, the process of drafting an operating agreement can help owners investigate and assess their true needs and expectations. While doing so, it is important to retain the guidance of an experienced business planning attorney who can help you to fully understand the benefits and potential drawbacks of each consideration. We can help you address potential pitfalls or even change direction in order that you end up with the structure that is best suited for your business.
