The limited liability company (LLC) offers flexibility and liability protection. Since its inception, the LLC has become the most widely used business entity in the country. Let’s look into why so many business owners and entrepreneurs prefer using an LLC, and whether a domestic limited liability company is right for you.
Is a Domestic Limited Liability Company Right for You?
Probably. Let’s take a look.
The most important reason business owners use the LLC is for liability protection. LLCs shield business owners from owing personally when the LLC is sued.
If a cake maker accidentally makes an entire wedding party sick, the company is culpable, not the cake maker’s home. Likewise, if the cake maker defaults on a financial obligation, the business is at risk, not her children’s college savings plan.
Having a layer of protection only works, however, if the owner keeps his or her personal assets separate from the company. Commingling funds can erode the protection and allow a plaintiff to “pierce the corporate veil.” As long as a business owner maintains different accounts and maintains a professional relationship with the company, then he or she likely has protection. For more information on liability protection and why it’s important, take a look at…
Domestic Limited Liability Company vs Foreign Limited Liability Company
A domestic limited liability company is one that is filed in the state where you are working. For example, my law firm, Henderson & Henderson, LLC, was created in 2014 in South Carolina. Our practice is in Charleston, SC, so it is a domestic LLC. If we add another office in Charlotte, North Carlina then we could file a certificate of authority to use my existing LLC in North Carolina. This would make my LLC a domestic LLC in South Carolina and a foreign one in North Carolina. It still gets the same liability protection. It’s just a matter of what state it was formed in.
The real question here is whether you should consider using a state like Delaware instead of your home state. Let’s stick with my example. If I filed in Delaware, the LLC would be domestic for the state of Delaware but foreign for South Carolina. The process is that you file in Delaware and then obtain a certificate of authority to use that same LLC in another state.
You could read for days about the pros and cons of using Delaware, but I’m going to make it simple: use your home state unless you are seeking investors.
If you use an outside state, you will have to file and pay filing fees and potentially annual fees in that state as well as your own. The upside to Delaware is that they do have business-friendly laws (albeit many states have caught up) but also it’s largely a comfort that investors have with the laws and processes in that state. They are already familiar with Delaware and there is a well-developed case law that gives investors more predictability. If you are a single member or you and a few friends are just starting out, keep it simple and file in your own state. At a minimum, consult with an attorney before you file in Delaware because it can add to the hassle of starting a business by adding to the paperwork and fees so make sure you and your business will get a benefit from doing so before you jump in.
For starters, the LLC offers flexibility with regard to business structure. LLCs offer outstanding flexibility and various operating structures, which is why so many different types of companies use an LLC. All types of businesses can use them – consultants, coaches, restaurants, contractors, boutique clothing or fishing stores, online stores and services, and even mega-companies.
LLCs can be set up as “member-managed” or “manager-managed.” Personally operated businesses might opt for member-managed if the owners are heavily involved in the daily operations. A more robust company with many members and many locations or high volume will often use the “manager-managed” option so the owners can hire an expert to run the daily operations of the business.
Additionally, most LLCs have operating agreements, which detail the understandings between owners. Operating agreements can be 10 pages or 110 pages depending on the level of sophistication needed. Typical topics covered in an operating agreement include: member ownership percentage, decision making, investment structure, member responsibilities, dissolution, management strategies, how members exit the company, and numerous other guidelines for the healthy practice of a business.
When setting up an LLC, most states require you to decide if you are “at-will” or “term.” This is something worth taking the time to thoughtfully consider. The “at-will” designation, also known as a perpetual LLC, is not always advisable because it could force the LLC to end when one member exists – of course, this depends on the jurisdiction. This is just one of the seemingly trivial details that can create problems down the road. If you have an LLC but no operating agreement, it is imperative that you get one to hold the liability protection. [Get one here!]
Taxation in an LLC is flexible in most states. In most cases, the business owners check a box indicating how the company should be taxed. The owners can be taxed directly, called pass-through taxation. Alternatively, the company can be taxed at the corporate level like a corporation. An S-Corp designation is also available.
It’s important to understand the basics of tax. It’s hard to operate a business without a basic understanding. Check out this article for more information. “Startup Business deductions.”
Lastly, many tax issues require an accountant or other tax professional. Entity formation is usually not a complicated tax issue, but there are some pitfalls after your company is up and running so watch out and ask if you don’t know. It’s generally a good idea to develop relationships with professionals to assist your business, especially a tax professional.
Three LLC Examples, and One Not
Below are three examples of the types of companies that would benefit from using an LLC. The fourth is an instance that should look to a corporate structure instead.
Three recent college graduates decide to try their luck in the virtual reality world. They decide to set up a gaming studio where customers can pay to use virtual reality games. Each of the graduates borrow money from their parents for startup costs.
- An LLC is an excellent choice of business entity.
Wesley and John are brothers. They are also both lawyers. After years of working for other people, they decide to partner up and begin their own law firm.
- An LLC is great for this type of situation.
Two longtime friends decide to open a catering business. One will put in the sweat equity and the other will fund the venture.
- LLCs work wonderfully for these kinds of partnerships. Just make sure the operating agreement reflects the understanding between the partners.
Jack and Jill decide to open an online children’s clothing market. They both have vast experience in the clothing industry and have lots of contacts. They have discovered a new fabric but it will cost millions to build machines and bring it to market. They are going to need lots of money from investors but they believe this will be the new cotton. So while they think this will cost millions, it will make many millions more.
- This is a closer call and one Jack and Jill should discuss with an attorney. An LLC may be ok early but they could also consider using a corporation due to the ability to assist in raising money and ease of transferring ownership.
When Not to Use an LLC
As example 4 above demonstrates there are instances where a company should consider organizing as a corporation. Companies seeking to raise funds from many investors would benefit from corporate formalities and the tried and true rules that have benefited corporations for many years.
LLCs work well for most types of businesses, but if there are many moving parts and people, it is best to consult a lawyer who can guide the organization process.
Thoughts for the Road
The LLC is a favored business entity for good reason. LLCs offer corporate flexibility, a liability shield, and multiple tax options, among other things. There are limitations, but not for most companies. If you are just starting out, an LLC might be the perfect fit for your company.
To better understand these and many other business issues, we invite you to visit www.draftedlegal.com where you can find information and products to serve your company. The creators of Drafted Legal are lawyers and business owners who have helped hundreds of businesses navigate the startup process.