LLC Formation: Takeaways
- Proper LLC formation requires both a formation document and an operating agreement.
- The operating agreement structures the governance of the LLC, the division of profits, the relationships of the owners and managers to each other and the LLC, and other essential matters.
- LLCs that were improperly formed should be rehabilitated to define the business structure and take advantage of planning opportunities.
The term LLC formation is poorly understood. Many founders mistakenly assume that the LLC is properly formed with the formation document is filed with the appropriate state agency. That is not the case. This article explains the steps involved in proper LLC formation.
LLC Organic Documents: Formation Document and Operating Agreement
An LLC is properly formed when its organic documents—sometimes called governing documents—are in place. There are two organic documents: the formation document and the operating agreement.
Formation Document
The LLC formation document—often called articles of organization, certificate of formation, or certificate of organization—is a simple form that is filed with the Secretary of State (or equivalent state agency) to form the LLC officially. In most states, the formation document can be found and completed online.
The formation document is a public record and contains the minimum amount of information necessary to let others know basic details and contact information about the LLC. The formation document does not specify the details of LLC governance, distributions of profits, and the rights and obligations of the owners. It simply notifies the public that the LLC exists.
Operating Agreement
The operating agreement is an essential LLC formation document. The operating agreement fills in the details omitted in the formation document—how the LLC will be governed, how profits will be distributed, the economic and informational rights of the owners, and the duties that the owners and managers owe to each other and the LLC.
As detailed in our discussion of LLC law, LLCs are contractual in nature. State LLC acts assume that LLCs will be governed by the operating agreement. The provisions of state law are gap-fillers that apply only if the parties have not specified their wishes in the operating agreement.
In much the same way that state intestacy laws specify what happens if someone dies without a will, state LLC acts are fallback provisions for business founders that fail to do proper planning and specify their wishes in the operating agreement. They are simply legislative guesses about how the founders may wish to govern the LLC. The operating agreement removes the guesswork. With few exceptions, the provisions of the operating agreement trump the provisions of state law.
Attorney Practice Note: Given that state LLC acts all promote freedom of contract and are designed to work alongside a valid operating agreement, it is disturbing how many LLC formation services get this wrong. Most LLC formation services simply file the formation document with the Secretary of State—a simple task that anyone could do—and leave the owners to rely on the default provisions of state law to define their business arrangement. This almost always results in loss of strategic and asset protection opportunities and often defeats the purpose of forming the LLC.
Unlike the formation document, the operating agreement is not a public record. In most cases, only LLC members and managers have the right to examine the operating agreement.
Two-Step LLC Formation
Basic LLC formation involves two steps: filing the formation document and organizing the LLC. Although these steps occur sequentially, both are necessary to form the LLC properly.
Step 1: Filing the Formation Document
The first step is filing the formation document with the Secretary of State or equivalent state agency. As stated above, the formation document is little more than a notice. It is a public filing with the minimum amount of information required to let the state agency and third parties know the essential details about the LLC. It is a necessary, but not sufficient, part of proper LLC formation.
Even though the formation document does little to specify the owner’s wishes regarding the management and operations of the LLC, it is best to start with filing the formation document. Filing the formation document allows the owners to verify that the name they want to use is available, sign up with a registered agent, and get the necessary information on record.
Step 2: Organizing the LLC
With the formation document in place, the owners can turn their attention to the more important aspect of organizing the LLC. During this phase, the following documents should be prepared:
- Operating Agreement. As stated above, the operating agreement is a crucial LLC formation document. It should be finalized and signed as soon as possible after the formation document is filed with the state agency.
- Organizational Resolution. The organizational resolution—which can go by many different names—allows the owners and managers to take actions on behalf of the LLC.
- Form SS-4. Many—but not all—LLCs need an employer identification number (EIN), also called a tax identification number. To obtain an EIN, the LLC organizer files a Form SS-4 (Application for Employer Identification Number) with the IRS.
- Authorization to E-file Form SS-4. Like the formation document, the Form SS-4 is a relatively simple document. It can be filed online by the LLC organizer, as long as the organizer first obtains a third-party designee authorization. The authorization to e-file the Form SS-4 provides the required authorization.
Attorney Practice Note: The Form SS-4 and Authorization to E-file Form SS-4 can be completed by the attorney that forms the LLC or by the LLC’s tax adviser. To avoid duplication, it is important to inform the LLC’s attorney if the tax adviser will obtain the EIN, and vice versa.
Partial Formations and LLC Rehabilitation
Ideally, the steps involved in LLC formation occur in close sequence, as part of a coordinated plan. But that doesn’t always happen.
It is not uncommon for the LLC attorney to advise eager founders that filed the formation document without fully understanding the implications. The founders may have selected the wrong management structure, used an ownership structure that forfeits tax-saving opportunities, or failed to take advantage of asset protection strategies.
If the LLC was not formed correctly, the LLC attorney must rehabilitate the LLC to put the proper documents in place. LLC rehabilitation usually involves drafting an operating agreement and related documents. The attorney may also need to amend the formation document to bring it in line with the overall legal strategy for the LLC.
Funding, Operating, and Maintaining the LLC
If the owners and managers do not treat the LLC as a separate business entity, a court may set it aside and “pierce the veil” of protection that the LLC would otherwise provide. To protect against veil-piercing, the owners must treat the LLC as a separate business and not commingle personal and business funds.
Adequate capitalization is important to avoid a veil-piercing claim. Transferring business assets to the LLC serves three purposes:
- Asset-Related Liabilities. LLCs are usually formed to protect the owners from liability related to business assets. This protection only works for assets owned by the LLC. If the owner keeps the property in her personal name, she is unprotected for liabilities relating to the asset.
- Ownership and Control of Business Assets. The LLC has no ownership or control of assets that are not transferred to the LLC. For the operating agreement to control the management of an asset or the income from it, the LLC must own the asset.
- Adequate Capitalization. An undercapitalized LLC is at an increased risk for veil-piercing. The owners should transfer enough assets to the LLC to be sure it has enough assets to cover its ongoing operations.
Attorney Practice Note: It is especially important to transfer real estate to an LLC. Transferring real estate to an LLC requires a deed to the LLC. The deed should be filed as soon as possible after the formation document and operating agreement are in place.
If the LLC is an operating business that receives and makes payments, the owners should set up a bank account for the LLC and keep the LLC funds separate from the owners’ personal funds. For example, if an owner uses the LLC bank account to buy household groceries, a court may decide that the owner treated the LLC as a “mere alter ego” of the owner and disregard its liability protection.
See our discussion of veil-piercing for a more detailed explanation.