OVERVIEW
Starting a limited liability company (“LLC”) in California is a popular choice for entrepreneurs who want the liability protection of a corporation combined with the tax efficiencies and operational flexibility of a partnership. In California, LLCs come in two forms: (i) manager-managed LLCs, where one or more designated members (or outside managers) are charged with the day-to-day operations of the LLC; and (ii) member-managed LLCs, where all of the members of the LLC are involved in the day-to-day operations of the business. This article relates to the latter—member-managed LLCs.
As I discussed in one of my prior articles, doing business as an LLC not only provides limited liability to all of the company’s owners (i.e., “members”), but also allows the LLC to be taxed as a partnership for federal income-tax purposes (where income is taxed only once, or “passed through,” at the owner level).
While forming an LLC in California is relatively straightforward, successfully operating one involves ongoing compliance and a solid understanding of business, legal, and financial responsibilities. In this article, I delve into some of the key tips to remember to best position your business for success and help you navigate certain legal complexities inherent in doing business as an LLC.
MAKE GOOD DECISIONS ABOUT HOW YOUR LLC WILL BE GOVERNED
Unless You’re a Single-Member LLC, You Need an Operating Agreement
An LLC Operating Agreement is an agreement entered into by the LLC’s members that governs not only the company’s ownership structure, member responsibilities, decision-making processes, profit distribution, incurring debt, and procedures for handling disputes, but also addresses the transfer of the members’ ownership interests (i.e., adding or removing members), limitations of powers/authority, ownership of intellectual property, and dissolution of the LLC. Well-defined procedures prevent misunderstandings and ensure smooth operations.
If you’re the only member of your LLC, then you won’t need an Operating Agreement unless your bank requires one, and even then, a generic one will suffice. After all, it’s just you. But if there are two or more members, an Operating Agreement is critical.
But not just any Operating Agreement. A document that important should never be a generic, one-size-fits-all, online document that somebody threw together for you with no prior thought (or even worse, a form document downloaded from a paid legal service used by a lazy or unqualified attorney). Rather, your LLC’s Operating Agreement should be a fully customized document, created specifically for your LLC, following a detailed conversation with you and the other members regarding how you want your company to operate. Such a conversation should involve, for example, all of the following topics:
- how the company will be managed on a day-to-day basis;
- what individual(s) have the power and authority to bind the business (i.e., enter into agreements in the company’s name);
- what individual(s) have the power and authority to spend the company’s money, write checks, open bank accounts, etc.;
- whether the company will be limited to operating a certain type of business;
- whether decisions should be made on a majority basis, or something more, such as unanimity or via a super-majority vote;
- how to value an owner’s share if the owner leaves the business (either voluntarily or following an owner’s incapacity or death);
- whether distributions of net profits should be mandatory or not (to avoid the problems associated with phantom income); or
- what, if any, voting rights current and future owners should have.
Remember, although not mandated by California law, in the absence of a signed Operating Agreement, your LLC will be subject to the default rules set forth in the Revised Uniform Limited Liability Company Act. Many of those default rules (which kick in only in the absence of an applicable provision in an Operating Agreement) may not suit your LLC’s unique needs or the members’ desires.
Comply with Required Formalities and Regulations
One of the benefits of operating your business as an LLC rather than, say, as a corporation, is the fewer number of corporate formalities that must be followed. That doesn’t, however, mean that there are no formalities to follow. LLCs in California need to comply with state-specific registration, reporting, and filing requirements. One primary requirement is the filing of an initial, and then biennial, Statement of Information with the California Secretary of State. The Statement of Information provides detailed information about your LLC, including the identities of its members/managers.
Whether to Require Certain Member Meetings Depends on Several Factors
One of the formalities required of corporations in California, but not of LLCs, is the requirement to hold annual meetings (and keep minutes for those meetings). While members of manager-managed LLCs should insist on requiring the managers to hold certain mandated meetings with the members, that is not necessarily as important for member-managed LLCs. Deciding whether to include such a requirement in the Operating Agreement depends on a variety of factors, including whether the members’ membership interests in the LLC (i.e., their ownership percentages) are relatively similar, or the degree of each member’s involvement in the day-to-day operations of the company.
ABIDE BY NECESSARY FINANCIAL REQUIREMENTS
Keeping Personal and Business Finances Separate is Critically Important
One of the most common ways for the members of an LLC to lose the limited liability protection offered under the law is to fail to recognize (and treat) the LLC as a separate person from its members. A member’s personal funds, assets, or accounts must never be mixed with LLC’s funds, assets, or accounts. Always maintain a crystal clear separation between members’ personal finances and the LLC’s finances. Open a business bank account exclusively for your LLC’s business transactions and consistently use that account for all business expenses and income. This not only simplifies accounting, but also helps maintain the legal protection of the members’ personal assets.
Also, the LLCs revenues should only be distributed to members in the form of paid compensation (i.e., wages), distributions to pay income tax (see below), or other distributions authorized by the members or required by an Operating Agreement.
Comply with Required Tax Obligations
As a pass-through entity, LLCs don’t typically pay income taxes themselves. Instead, the LLC’s financial activity is reflected on the members’ personal tax returns. California, however, imposes an annual $800 franchise tax on LLCs, along with an additional fee based on gross income. Understanding these obligations, and consulting with a tax professional, is crucial to avoiding penalties and maximizing tax benefits offered to LLC members.
Many LLC members don’t realize that because of the pass-through nature of an LLC, they are each responsible for paying taxes on their pro-rata share of the LLC’s net revenues—regardless of whether or not the LLC actually distributes those revenues to them. This phenomenon, known as phantom income, can be used as a weapon against members who own relatively small membership interests in their LLCs. You can review my prior article on phantom income for more information, including ways for members to prevent the problem.
LEGAL AND FINANCIAL PROTECTION
Having an Attorney on Retainer (i.e., as general counsel) is Worth the Expense
For obvious reasons, business owners—especially new business owners—are concerned about wasting limited start-up capital. One thing your LLC should never skimp on, however, is having a competent corporate attorney on retainer.
If you were to look at what all successful and nimble businesses have in common, you’d find that those companies enjoy a strong and regular working relationship with top-notch corporate and business attorneys. Whether it’s to ask a simple question, advise you in a business dispute, or draft a complicated business contract, immediate access to experienced, sophisticated, and qualified legal advice is key to a business’s growth and success.
Your LLC should also consult with its corporate attorney if it’s considering any of the following:
- doing business in another state;
- amending the Operating Agreement;
- having a member (or the LLC itself) buy out an existing member’s membership interest;
- admitting one or more new members;
- amending the articles (to, for example, switch to a manager-managed LLC);
- merging with another company (or having another company merge into your LLC);
- selling or otherwise transferring all, or substantially all, of the LLC’s assets; or
- dissolving the LLC.
Get Insurance
Even with limited liability, it’s a good idea for your LLC to obtain insurance coverage appropriate for your industry and scale of operations. General liability insurance, professional liability insurance, and commercial property insurance are common types that member-managed LLCs should consider.
ADAPTABILITY ANDE FUTURE PLANNING
LLCs Can be Flexible in How Profits are Distributed
Unlike corporations, LLCs in California can distribute profits to members in any way they see fit, not necessarily based on the percentage of ownership. For example, let’s say your LLC has four members, each of whom owns an equal percentage in the LLC (i.e., 25%). If one of the members fronted a certain amount of start-up capital that he or she wanted repaid (first money in/first money out), the members could agree that a certain percentage of the LLCs net revenues (e.g., 60%) be distributed to that member until the sum has been repaid, after which each would be entitled to their 25% interest in such revenues. Or, they could split revenues in any other way that they choose to. Corporations cannot operate that way (a “25% shareholder” must receive 25% of the net revenues, and so forth).
This is the type of thing that the members would want to have fleshed out in the Operating Agreement discussed above.
Prepare for Changes in Membership
LLCs that plan ahead for what to do if a founding member wants to leave the LLC, becomes incapacitated, or dies will be glad they did. This too is something that an Operating Agreement should address in detail.
COMPLY WITH CALIFORNIA’S COMPLEX WEB OF EMPLOYMENT LAWS
If your LLC intends to hire (or already has) employees, you must comply with both federal and state employment laws. These cover various areas such as the improper use of independent contractors, wage laws, anti-discrimination policies, workers’ compensation, and unemployment insurance. Failure to adhere to these laws can result in severe financial and legal penalties and harm your business reputation.
One of the best ways to ensure that your company is compliant with California’s labyrinth of labor/employment laws is to obtain, use, and maintain a strong set of customized employment related documents, including:
- employee handbooks;
- at-will employment agreements;
- vehicle use policies;
- drug testing consent agreements;
- independent contractor agreements; and
- performance reviews.
When customized for your company, such documents can help you both avoid crippling penalties, as well as ensure that you consistently comply with the plethora of requirements relating to mandatory written notices/handouts regarding:
- proper classification of employees (e.g., exempt v. non-exempt or employee v. independent contractor);
- overtime;
- mandatory breaks;
- health and safety;
- job requirements/expectations;
- harassment; and
- compensation (including payment of commission-based compensation).
CONCLUDING THOUGHT
Operating a member-managed LLC in California involves continuous effort, beginning with a comprehensive understanding of the legal framework, a commitment to financial diligence, and strategic operational management. By paying careful attention to the legal protections that an LLC provides and planning for the future, you can focus on growing a successful business while minimizing potential risks.
Remember, the key to smooth operations lies in clear communication among members, adherence to a well crafted and customized Operating Agreement, and compliance with state regulations. While the journey may seem complex, the flexibility and protection offered by operating your business as an LLC can make it a rewarding choice for your business.