LIMITED LIABILTY COMPANY FORMATION: PROTECTING YOURSELF FROM LIABILITY

Protecting your business assets is important, but not as important as protecting personal assets. Accordingly, making sure to create a separation between personal assets and business assets is essential to any entrepreneur’s business model.  This is where corporate formation comes into play.  In this case, we will discuss forming a limited liability company. 

What Is A Limited Liability Company?

A Limited Liability Company (LLC) is a formal registration of a company with the department of State (usually) within the state the company is located. It essentially serves as an official entity that forms a legal separation between a business and its owners.  Once an LLC is formed, all contracts and most legal liability is then associated with the LLC directly, not to the owners. In contrast, partnerships and sole proprietorships the owners are personally responsible for all legal liability which can include personal property.

Why Is It Important To File An LLC?

The main reason to form an LLC is for the legal protection of personal property, by the owner, from the liability that a business assumes. As long as business is conducted in a correct manner and separate from the personal activities of the individual, a creditor and/or potential plaintiff is prevented from seeking recourse against anything other than the entity in which it contracted or did business with.  Accordingly, with an entity such as an LLC most contract disputes and other legal liability is solely the responsibility of the LLC.  Thus, a potential plaintiff and/or creditor is prevented from going after the business owner’s personal property.  This protection, however, is not absolute and a plaintiff and/or creditor may “pierce the corporate veil” is a business owner fails to run his/her business in the correct manner (i.e. commingling assets, failure to keep corporate minutes and conduct annual meetings). 

LLC and Taxes

Another advantage LLCs have is their flexibility for dealing with taxes. An LLC may pay taxes as a sole proprietor, partnership, C-corporation, or S-corporation. Each has its advantages and disadvantages, although S-corporations are said to have the best tax benefits due self-employment tax savings, though this may depend on the company.

By default, the IRS treats LLCs as a “pass through” entity. If there is only a single owner, the LLC is essentially ignored and that person must file the entire LLCs earnings on their income tax return. If the LLC has multiple partners, they must file a IRS form 1065 and receive a K-1 (reporting their share of income or loss) to file with each of their personal tax returns.

If the LLC chooses to be taxed as a corporation (either C-corp or S-corp) they must file IRS form 8832. The reason why S-corporations are so highly regarded as a way to structure an LLC’ is that they have simplicity and flexibility of a partnership along with the tax benefits (self-employment tax savings) and structure of a corporation.

How to form a LLC

Where – The first step to forming an LLC is to decide in what state to register. Each state has different requirements, so businesses must be sure to research exactly what is required in order to register successfully. Registering an LLC is done through the Department of State (or Secretary of State) in the state that the business is registering.

Pick a company name – The first step before submitting your articles of organization with the department of State is to choose a company name. Each state has specific requirements, but the general rules require the name to be unique, using nothing restricted (by trademark or other laws), and must end with “limited liability company” or the abbreviated: “LLC” or “L.L.C.”.

Articles of organization – Filing articles of organization with the department of state is the first official step for registering an LLC.  It is a simple, yet quite specific format to follow, again, unique to each state. Be sure to follow the format exactly or the registration will be rejected. This is also the time where any filing fees are usually expected to be paid. Some small businesses choose to have a professional service take over at this point of the process so as to ensure the proper formatting and specifics are followed precisely.

Operating agreement – Most states require an operating agreement to be completed along with the registration of an LLC. The purpose of the operating agreement is to name the members, manager(s), tax matters partner, and develop terms for equity distribution. While this isn’t something you usually need to submit to the DOS, it also isn’t a step to be taken lightly. It is particularly important for LLCs with more than one member to have a proper operating agreement with exit clauses to ensure the health of the company and fair share of equity to all members, particularly in their leaving. Hiring a lawyer to help draft the operating agreement is highly recommended for multi-member LLCs.

Designate registered agent – Another requirement of the formation of an LLC is the designation of the “registered agent”. Put simply, the company must choose a member of the LLC as the person for which all official correspondence is to be sent. For example, if a lawsuit is brought to the LLC, the registered agent will be the recipient of the subpoenas and other legal documents.

Other requirements – Be sure to comply with any other state requirements of forming an LLC.

How to maintain maximum LLC protection

While the protection an LLC gives is a huge advantage, there are a number of actions that can weaken or even cause a company to lose this protection. In order to ensure this does not happen, there are a number of things that a company must ensure:

  1. Make sure all taxes are paid on time
  2. Ensure the LLC registration and associated fees remain current (see your state’s requirements)
  3. Members must not commingle personal funds or property with those of the LLC
  4. Take steps to ensure that the company is always held out as a separate legal entity
  5. Keep detailed minutes of official company meetings for official records of all contract negotiations and dealings.
  6. Review the LLC’s operating agreement to be certain that none of the company’s actions violate that agreement
  7. Members should not use the LLC’s assets solely for personal use.

Despite these steps, the protection that an LLC carries is not absolute. As well as the limitations of State Shield laws, members can and will be personally responsible for their own actions, even if on behalf of the company. There are well documented cases of corporate shield failing to protect members from cases of personal torts. If a member of an LLC commits fraud, is personally neglectful, or is otherwise personally responsible for liability against another entity, LLC protections can quickly disappear.

Conclusion

For most small businesses, forming an LLC as a way to protect the personal property of its members is an absolute must. Understanding the nature, limitations, and ways to maximize this protection however, is equally important. Because each state has its own laws relating to the limits of these protections it’s important to do the proper research for the state in which the LLC is registered. Still despite the limits of these protections, the advantages are clear, so ignore them at your own risk.

Employee v. Independent Contractor: What is the Difference?

Case law establishes that no employment relationship exists if the individual performing services for a principal is an independent contractor. (See Lab. Code §§ 2700, 2750.5; see, e.g., People v. Palma (1995) 40 Cal. App 4th 1559, 1566; Grubb & Ellis Co. v. Spengler (1983) 143 Cal. App. 3d 890, 897-898.)  The critical legal distinction between employees and independent contractors is the right to control the manner and means by which the work is performed.  (Id.)  A bona fide independent contractor is customarily engaged in an independently established business and retains the right to control the manner in which he or she performs the contract. (Id.)  An employee, on the other hand, is subject to the absolute control and direction of the employer. (Id.

 The essence of the employee versus independent contractor test is the “control of details”—that is, whether the principal has the right to control the manner and means by which the worker accomplishes the work.  Further, there are a number of additional factors in the modern equation, including: (1) whether the worker is engaged in a distinct occupation or business, (2) whether, considering the kind of occupation and locality, the work is usually done under the principal's direction or by a specialist without supervision, (3) the skill required, (4) whether the principal or workersupplies the instrumentalities,  tools, and place of work, (5) the length of time for which the services are to be performed, (6) the method of payment, whether by time or by job, (7) whether the work is part of the principal's regular business, and (8) whether the parties believe they are creating an employer-employee relationship. (S. G. Borello & Sons, Inc. v. Department of Industrial Relations (Borello) (1989) 48 Cal.3d 341, 350–351; Tieberg v. Unemployment Ins. App. Bd. (1970) 2 Cal.3d 943, 949; Empire Star Mines Co. v. Cal. Emp. Com. (1946) 28 Cal.2d 33, 43–44; JKH Enterprises, Inc. v. Department of Industrial Relations (2006) 142 Cal.App.4th 1046, 1064–1065.)  The parties' label is not dispositive and will be ignored if their actual conduct establishes a different relationship. (Borello, supra, 48 Cal.3d at p. 349; Toyota Motor Sales U.S.A., Inc. v. Superior Court (1990) 220 Cal.App.3d 864, 877–878.)

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