2019 Edition

Recognizing and Avoiding Common LLC Pitfalls

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SPOTTING AND AVOIDING COMMON LLC

PITFALLS

Key Topics:

■ The different types of LLCs

■ Common mistakes when setting up an LLC

■ Taxation and using an LLC to buy real-estate

■ The importance of an operating agreement

■ How to handle disputes

I. INTRODUCTION

What is an LLC?

■ An LLC is a limited liability entity

■ An LLC can be used to protect the personal assets of

the owner(s) from the business’s liability

Advantages of an LLC:

■ Adaptable

■ Flexibility

■ Easy to change and customize

■ User-friendly

■ Tax-advantageous

II. SELECTION

Issues That Arise Early On:

■ Due to the variety of customizable options, its

common to see issues arise early in the creation

process

■ Its pertinent that the client, attorney, and

accountant know all of their options and the

differences between these options before making

any selections

1. CHOICE OF ENTITY

Misconceptions:

■ People often believe LLC’s are:

– Not as “sophisticated” or “formal” as corporations

– Less attractive than a corporation to future investors

and customers, or potential partners

Reality:

■ An LLC is the most attractive option for most business owners

■ Less rigid, only as complex as the owner wants to make it

■ Less information to disclose, only requires an operating agreement for governing

■ Able to limit fiduciary duties

2. MEMBERS

Multi-Member LLC Warnings:

■ The more members you have, decision-making and

overall management can become slower, more

tedious, and more complicated.

■ This process is made even more complicated when

member(s) are not business-savvy or have issues

staying in contact/communicating

Rewarding Employees

■ Often, founders wish to ‘reward’ membership units to

a deserving employee.

– Usually, there is also a motive to make the

employee feel more invested in the company too

■ Unless the employee is being targeted to take over the

company, this can be accomplished by issuing

phantom units, bonuses, or other non-equity

incentives

Non-Employees

■ Sometimes LLC owners wish to give units to non-employees (like a spouse, passive investor, or former employee).

■ In this situation, a non-equity incentive (or even a paid or unpaid position) can be used instead

■ By choosing a non-equity incentive, the LLC is ensuring the individual is not directly participating in the management of the company

Tax Perspective:

■ Single-member LLC’s can be beneficial from a tax perspective

– IRS considers them “disregarded entities” (the owner and the LCC are combined for taxes)

– Adds an extra layer of protection (like an S-Corp)

■ LLC’s are also very flexible in terms of tax elections (more on this later)

3. MANAGEMENT

Management Decisions

■ Management of an LLC mainly depends on who is

best equipped to oversee and manage the day-to-

day operations

■ In some states, LLC management may be

outsourced to a different entity

Member-Managed■ Member-Managed (default model)

– Often used when members of an LLC want to be

actively involved in the daily operations

■ Manager-Managed

– Often used when an LLC had too many members or

there are multiple members with different interests

– An individual or a group of people (may or may not be

members of the LLC) are appointed as the

manager(s)

III. SERIES LLC’S

What is a Series LLC?

■ A Series LLC is a single entity that contains multiple,

separate series

■ These series are treated as separate subsidiaries

– Each has its own assets, engages is separate

business transactions, and is protected from other’s

debt

Advantages & Disadvantages

■ Advantages

– They are easier and less expensive to set up. Also, you only have to pay one registration fee, and have one set of governing policies.

■ Disadvantages

– Only 14 states, DC , and Puerto Rico have the applicable statutes in place. There are also many disparities in the laws that govern series LLC’s in those areas.

IV. SINGLE-MEMBER

Improper Set-up:

■ Single-Member LLC’s are easy to set up and govern,

and add another layer of protection between owners

and clients.

■ However, if incorrectly set up, an owner will not

benefit from a Single-Member LLC. Instead, they will

be subject to many of the liabilities they were

originally seeking protection from.

Common Mistakes:

■ In single-member LLC’s, individuals tend to ‘ignore’

many of the corporate structures and formalities

that multi-member LLC’s adhere to.

■ In order to fully benefit from the protection an LLC

provides, business owners must keep their business

separate from their selves/personal benefits.

Cont. ■ The following three topics are often the root of many single-

member LLC issues.

■ Bank Accounts:

– Its imperative that personal and business bank accounts are kept separate

■ Recording Keeping:

– A hard copy of complete notes and records (rather than a mental copy) ensures easy accessibility and review when necessary

■ Succession:

– A business can fail or head in the wrong direction if the proper/desired successor is not determined ahead of time

V. TAXATION

Legal Status vs. Tax Treatment

■ Legal view - types of business entities:

– Sole proprietorship, partnership, corporation, and LLC.

■ Taxation view - types of tax treatment:

– Sole proprietorship, partnership, S corporation, C corporation, and tax-exempt entity

■ An LLC can theoretically elect any of the 5 different tax treatments

Tax Treatments and LLC’s

■ Partnership:

– An LLC “passes through” its profits/losses to its

members. The members then declare it on Form

1065 (instead of From W-2)

■ S-Corp:

– An LLC passes profits like in a partnership, but

members bear the profit/loss in proportion to their

ownership stakes

Cont. ■ Sole proprietorships

– Similar to partnerships, usually subject to self-employment tax

■ C Corporations

– Not considered a “pass-through” entities, instead they are taxed at the corporate letter. Other amounts distributed to members are taxed again at the individual level

■ Tax-exempt entities

– Pays not federal tax, usually engaged in political or educational activities

VI. REAL ESTATE

Purchasing Real Estate:

■ The flexible nature and easy creation of LLC’s make them prime option for reducing risk in real estate purchases

■ LLC’s can also be used to shield identities, as LLC’s do not typically disclose their owners

■ Risk can be spread across multiple LLC’s

– Be wary of using too many, or not enough, individual LLC’s.

Consistency:

■ Ensure you remain consistent in your set-up and

practices.

■ It is important to make sure that the correct policies,

documents, and responsibilities are aligned to each

individual LLC involved.

VII. INTERESTS

Membership Interests:

■ Membership interests are NOT corporate shares.

The number, nature, and power of these interests (or

units) are often determined by the LLC’s

members/operating agreement.

■ There are local and federal laws, as well as statutory

defaults that factor into these decisions as well.

Economic vs. Operational Benefits: ■ Some companies will create different processes for

how economic or operational benefits can be transferred.

■ In some states, this dichotomous approach can create more problems than benefits

■ Usually, it is best if a membership unit is treated as a single, complete unit and transferred in its entirety

Operating Agreement: ■ A company’s operating agreement should outline things

like:

– How many units the LLC will authorize

– Whether the LLC can authorize additional units

– What will happen to the original member’s dilution if

more units are distributed

– How members can transfer their units

– What will happen when a member dies or leaves

their position

Other Considerations: ■ Will the LLC “certificate” their units?

– They can easily be misplaced, damaged, etc.

– They also serve as evidence of ownership to other

parties without revealing other information

■ What happens in the event of an involuntary transfer?

– Usually in the case of bankruptcy, death, or divorce

– The LLC should decide if this type of transfer results in

a purchase option for the company, a loss of voting

rights, or both.

VIII. SHOPPING

Forum Shopping:

■ Typically, it makes the most economical and

practical sense to set-up your LLC in the state where

you reside or primarily conduct business.

■ Trying to set-up an LLC in another state to avoid

taxes or get a tax break usually results in paying

more fees and taxes.

IX. PROTECTION

Asset Protection Options:

■ While an LLC limits your liability to a certain extent,

there are additional options a company can use to

further protect them selves

■ Insurance plans, credit optimization, and consulting

with an estate planning attorney are all viable

options for companies.

Insurance:

■ An insurance broker can walk you through your

options, and help you decide what makes the most

sense

■ Types of insurance brokers: Commercial General

Liability, Directors and Officers Liability,

Cybersecurity, Buy-Sell, Key Person, and Professional

Liability.

X. GOVERNANCE

Operating Agreement:

■ Crucial to the successful operation and decision-making of an LLC

■ It should be customized to the unique needs of each LLC (NOT an online template)

■ The operating agreement should define: 1) how members are paid, 2) exit plans (if applicable), and 3) dispute resolutions

1. MONEY

Compensation:

■ The money paid to employees based on their work

for the company (salary, bonuses, etc.)

– Usually subject to tax withholdings and taxed at

the typical income rate

■ Compensation is rarely mentioned in an operating

agreement. However, a statement regarding who can

set compensation rates is often good to add.

Tax Distributions:

■ The money given to employees to cover taxes

■ This is NOT compensation or paid as a reflection of

work

■ These distributions can be mandatory, discretionary,

or not applicable, depending on the company’s

operating agreement

Profit Distributions

■ The earnings from a given year that have not been shared

with members

■ Companies can be penalized with taxes for retaining these

earnings

■ Usually, LLC’s will distribute these profits to their members

(the proportions should be outlined in the operating

agreement)

2. EXIT

Exit Provisions: ■ Important questions to discern:

– Can a member voluntarily “withdrawal” at will?

– If so, what are the terms?

– Does the LLC have an option to purchase the exiting member’s interest?

– How is fair market value calculated?

– How will the purchase be paid out?

– When is a payout option not applicable? (like in cases of fraud)

3. DISPUTE RESOLUTION

Dispute Resolution: ■ Traditional litigation v. alternative dispute resolution

(arbitration/mediation)?

– Traditional litigation in faster and less expensive

– Alternative dispute resolution is more private and easily accessible

■ Choice of law and choice of venue

– What type of court?

■ Attorney’s fees

– Can be a good leverage point, and help to settle disputes quicker

XI. DISPUTES

Before its too late:

■ Fairly early into the development phase, LLC’s should develop the following provision before issues arise:

– A dispute resolution policy

– A deadlock provision (for bigger issues like selling the business)

– A withdrawal option, so members can make a clean break and leave when needed

CONCLUSION

Review:■ When starting an LLC, make sure you:

– Know all of your options (and their differences) before making any big decisions

– Know all the applicable laws and tax rules

– Have well-versed advisors to help you

– Select strong co-partners or managers (if needed)

– Build a strong legal infrastructure

– Have the correct safeguards in place to help you when issues arise

Ryen Rasmus, Esq.Berenzweig Leonard, LLP

■ Ryen Rasmus is a Senior Associate Attorney at Berenzweig Leonard, LLP in McLean, VA. Ryen specializes in the drafting of contracts and operations documents; resolution of business and intellectual property-related disputes; and counseling in the fields of corporate, employment, and entertainment law.

■ Prior to his joining the firm, Ryen served as law clerk to Chief Judge Karen J. Burrell and the Hon. Louis A. Sherman of the Norfolk Circuit Court. While in law school, Ryen worked at a Top 200 law firm in Washington D.C., a Hampton Roads law firm specializing in entertainment law and small business-related issues, and the office of legal counsel at a major state educational institution. Outside of his work with the firm, Ryen volunteers time with several non-profit organizations that seek to promote education and positive youth development.