Understanding your LLC

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Forming an LLC is an important first step in protecting your personal liability. But, before you take that step, you need to make a few decisions like; who are the members going to be, what will you accept as consideration for buying interest in the LLC, how will the LLC be managed?

Before forming an LLC be sure to take into consideration the business laws of the state in which you wish to operate. Most states will accept one member LLC and some states require you to post a notice in the local paper when forming a new LLC. In some cases if you are converting an existing business into an LLC you must notify current creditors, lenders and leasers before you can convert to an LLC.

Also, if you are a CPA, engineer, doctor, lawyer, or other licensed professional, many states don’t allow you to use an LLC. The states worry that you would use the entity as a way to shield personal liability.

The Players in an LLC

LLCs are made up of members who act in similar capacity to shareholders in a corporation. Anybody can be a member of an LLC, unlike the limitations of shareholders in an S corporation. In fact corporations could even be member. There can be one member or multiple members; it’s really up to you.

The members buy interest in the LLC with cash, property, services or the promise of payment. In exchange for their investment the members receive ownership interest. In most cases the investment of cash is not a taxable event. In the case of property, services, equipment or promise to pay there are tax issues that should be looked at.

There can be different designations of members based on active decision makers or passive investors. This is a decision that must be made when outlining the operating agreement. If the LLC is managed by its members then it is considered “member managed”. If the LLC chooses to hire an outside manager or designate the position to a member, then the LLC is considered “manager managed”.

How the LLC is going to be managed usually depends on the long term outlook for the company. If you are planning to only allow a few people to participate in the LLC and you are all on the same page, then you might want to look at having the LLC member managed. If you are operating multiple ventures out of one company with active and passive investors then you might be better off hiring a professional manager or electing an active member to be the manager to avoid any unnecessary conflict when it comes to decisions made by the LLC. How an LLC is managed is outlined in the articles of organization before it is filed with the state and in the operating agreement.

Some people will choose to have a corporation as the manager of the LLC. This allows income to be split between the LLC and the corporation usually causing a favorable tax outcome. Then you could pay management fees to the corporation for overseeing the LLC.

If payments to a managing member are outlined in the operating agreement and documented as a wage to the manager then it would be treated like a salary and become a deduction to the LLC. If the manager is paid on a percentage of profit and loss of the LLC, then the payment would not be considered a deduction to the company.

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Officers

An LLC may elect officers just like a corporation. You can have a president, secretary and treasurer. The officers are voted on by the members and elected once a year.

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Articles of Organization

The Articles of Organization is simply a form you file with the state in which you wish to form the LLC. The articles of organization contain the names of the members and/or manager, the business address and who the Resident Agent will be for the LLC.

The resident agent is the location where any legal documents for the LLC can be delivered. In most states you can be your own resident agent or you can hire a service to act as your resident agent. It is usually recommended to hire a service to act as your resident agent. They will accept service of process at their offices versus having a process server come into your place of business and serve you with papers. It’s usually a nominal fee and many resident agent services offer priceless information on how to operate your company and keep you informed of changing rules and regulations imposed by the state.

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Operating Agreement

One of the first things you need to develop after you file your articles of organization with the state is the Operating Agreement. While operating agreements are not required by all states, it’s important to take the time and develop a working operating agreement that fits the needs of the LLC.

The operating agreement outlines the inner workings of the LLC. It defines ownership, if the LLC will be member managed or manager managed. The operating agreement also outlines how distributions will be handled and who has voting rights. Developing an operating agreement allows the parties involved to sit down and agree on a course of action for the company. It’s a great tool to start looking at the long term goals of the company with everybody having input on how the company will be run. It also prevents any disputes over ownership and distribution rights as all the members should participate in completing the operating agreement.

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Federal Tax Classification

One of the great flexibilities of an LLC is the ability to select how you want the entity to be taxed. If you are a single member LLC the IRS will automatically tax you as a partnership, which means the profits and losses of the company will flow through to you personally. You also have the option to be taxed as a corporation. This makes the LLC its own taxable entity and you are taxed on dividends and/or salary received from the LLC.

The form you use will depend on what kind of entity your business is for federal tax purposes. Following are some general guidelines and the forms which go with each entity:

If your business has only one owner, it will automatically be considered to be a sole proprietorship (referred to as an entity to be disregarded as separate from its owner) unless an election is made to be treated as a corporation. A sole proprietorship files Form 1040, U.S. Individual Income Tax Return and will includeForm 1040, Schedule C, Profit or Loss from Business, or Form 1040, Schedule C-EZ and Form 1040, Schedule SE.

If your business has two or more owners, it will automatically be considered to be a partnership unless an election is made to be treated as a corporation. A partnership files Form 1065, U.S. Partnership Return of Income. If an election is made to be treated as a corporation, Form 1120, U.S. Corporation Income Tax Return, is filed. The election referred to is made by filing Form 8832, Entity Classification Election.

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Members List

Just like a corporation keeps a stock ledger, LLC’s need to keep a record of whom their members are along with names and addresses. This list needs to be available for review by any member of the LLC.

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Tax Identification Number

If the LLC is going to have multiple owners or employees you will need to obtain an Employer Tax Identification Number (E.I.N) for the LLC. You will be required to obtain an EIN number before you can open up a bank account and if you are accepting payments from an outside service, many times they will request the company’s EIN number so they can report payments to the IRS.

The IRS uses the number to identify taxpayers that are required to file various business tax returns. EINs are used by employers, sole proprietorships, corporations, partnerships, nonprofit associations, trusts, estates, or decedents, government agencies, certain individuals, and other business entities.

You will not need a new EIN if you change the name of your business or change the location of your business. If you purchased the business from another party you cannot use their EIN number, you will need to file for a new one.

You can apply for an EIN number by phone, fax or by mail. If you apply by phone you can have an EIN number right away. Simply have the person authorized to sign the SS-4 form call 1-888-816-2065 and you will receive an EIN number within minutes.

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Company Name

When deciding on a company name most secretary of state web sites allow you to go on-line and make sure that the name you are looking for is available. Nobody else in the state can be using the name that you want. If the name you want is not available sometimes just altering the name slightly will make it available. When you designate a name be sure to include LLC or LTD at the end of the company name. This lets the secretary of state know you are forming an LLC and it lets people you are doing business with know your company is an LLC.

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Buy Sell Agreement

You should also look at including a buy/sell agreement in the operating agreement. The buy/sell agreement outlines the steps a member has to go through to sell their ownership interest, or if a member dies or becomes ill. It lays the ground work to avoid future legal battles over control and ownership.

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Acts of the Limited Liability Company

The premise of using and documenting company decisions for an LLC are the same as a corporation. A resolution is a formal record showing a decision was made based on a majority of the members. Many times the LLC will have a meeting and the resolution is the documentation that shows what decisions were finalized and approved at the meeting.

Because LLC’s are still being defined as far as their requirements for corporate formalities you may find that certain states have enacted different regulations when it comes to documenting business decisions made by the LLC. Different states have their own requirements as outlined by the Model Business Corporation Act or the LLC Act. They are trying to come to a formal decision that governs all the states but until they do it is always recommended to treat your LLC like a corporation when it comes to maintaining corporate records.

The “brain” of the LLC are the members. Many times when important business decisions need to be made concerning the financial obligations of the LLC the members will pass a resolution. Resolutions are passed based on a majority vote of the members or in some states a unanimous vote of the members.

While LLC’s don’t have directors they can have officers, members and a manager. You can think of the manger as the President of the LLC.

The Compass Group will document the resolutions, minutes and meetings for your limited liability company.

Resolutions are also used to set the level of decision making authority for members and or the manager of the LLC. If you have members who want to be active in the decision making process of the LLC but can’t be involved with the day-to-day operations they might pass a resolution restricting the authority of the manager. This would require the members to come together at formal meetings to pass written resolutions before the manager can make certain business decisions.

If this is the case and the members don’t have the confidence in the manger they selected to make business decisions then maybe they should look at getting a new manager.

The documentation can also be a great tool to use when disputes arise between members. If all important business decisions are presented to the members and a vote is received and documented it would be hard for a member to come back later and say that a decision was not disclosed to them.

Especially when you are using a manager and you have members who have a financial interest in the company you would be better off to document all major business decisions. Especially if a decision is made not to issue a distribution.

For example: You decide to get a few family members together and start an LLC as a way to buy and sell real estate. The members have other obligations so nobody is in a position to manage the new company but they still want to have some control because it is their money they invested. The LLC would hire a manger to handle the day to day operations of running the business but due to the fact that the members want some control, they may pass a resolution restricting the authority of the manager. Maybe the manager can only manage current properties and lead the negotiations for new properties but doesn’t have the authority to sign the final purchase agreement without the consent of the members.

You would use resolutions to open a bank account, purchase property, sign a long term lease, or make a financial obligation for the LLC. Some business transactions that take place require a resolution showing that the decision makers of the company knew of and approved the decision: For instance some banks, leasing companies or loan companies require resolutions.

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Summary

If there is going to be multiple owners it’s important that you take the steps to start your company off right. If you don’t feel comfortable developing an operating agreement, buy/sell agreement, or you’re not sure what tax selection you should make, be sure you take the time to consult with a professional. This extra step could save you extra expense and headaches in the future.

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DISCLAIMER: Compass Group and its employees or agents are not in the business of providing tax or legal advice. If legal advice or other expert assistance is required, the services of a person in those professions should be sought. Compass Group, its employees and agents do not make any factual determination as to the validity of any business deduction for tax purposes. Compass Group does not expressly or impliedly endorse, accept, or validate any business record produced by Compass Group on behalf of Client. The Completed Documents produced by Compass Group through this written request are based solely upon the information provided by the client.