The LLC Protects You Against The Schmuck Factor

My neighbor is a one third member in a meat wholesale business (yes, the $300 box-o-meat that is too big for your freezer).  She and her brother both put up capital — she for the trucks, and her brother for the deep freezer (meat comes in palates, hmmm).  What about the other guy (we will call him Guy).

Guy is a high school buddy of her brother.  He has successfully put nothing into the business and is assumed to have 1/3 ownership.  This guy now wants my neighbor and her brother to convert the LLC to a corporation.  He notes the corporation (and he of course sited the Nevada Corporation), gives better protection and greater tax breaks.  Aaaaaggghhh!  Who keeps perpetuating this junk??!  So lets review what we have written already here on STARTright Talk as to why a conversion would not only be a useless, but a dangerous change.

Why Guy’s “Convert The LLC To A Nevada Corporation” Suggestion Is Flawed

There are three main areas where a conversion in this situation would not only be an unnecessary idea, but a bad one. Those three are 1) Corporation holds no tax advantage over a Limited Liability Company and they are immediately boxed into the more complex corporate tax structures. 2) The corporate veil for a Utah LLC provides equivalent protection for that of a Utah corporation and the Nevada Corporation is not superior. 3) A corporation to LLC conversion would ensure the schmuck walked away with a third of the company for nothing and would open the door to all his creditors.

1. A corporation offers no tax benefits over a corporation.

I have discussed the Federal check the box tax laws, the flexibility of LLC tax and discussed how Utah LLC tax Law follows the federal check the box system.  A suffice it to say here, that she and her business partners/members could choose any style of tax they wanted and yet under their LLC structure.  If they switch to a corporation, they lose the most important option - partnership tax structure - which is the one they currently operate under and understand.

2. A Corporation Does Not Offer Superior Protection To An LLC

I have also discussed the supreme double protection of the LLC on Talk.  In this situation, if they were to convert to a corporation, anyone who sued Guy (the Schmuck) would be able to get at his shares and then have his 1/3 management vote.  Bad idea.  In an LLC, members are protected from an unwanted partner by statutory and operating agreement provisions that make the membership management rights non-transferable even to courts unless the other members consent. Default is 100% consent.

3. The Schmuck Would Ensure Himself His Whole 1/3 Of The Pie

The worst part about this conversion is this however.  These guys like many businesses are operating by the seat of their pants and do not have an operating agreement. Because of this, they are dependent upon the Utah State LLC Act to tell them their membership rights.  In all cases, LLC acts generally bestow membership according to contributions made or capital invested.  No contribution? No membership!  This would be her best way of insuring that this Schmuck did not end up with a third of the profits or liquidation value when he has paid nothing into it.  If they convert to a corporation, ownership is determined by shares.  Whether in hand or on a ledger, shares are shares regardless of contributions.  This means he gets a whole lot of something for nothing.

In my last post, The Limited Liability Company Operating Agreement Part 1; The LLC Business Plan & Owners Manaual, I explained how filing the articles of organization with the appropriate state agency to activate your LLC is just the beginning.

Business owners form LLCs to take advantage of statutorily prescribed protections and tax benefits. Whether or not the protections and benefits will be applied to your LLC when it comes before a judge, is a question of operation. If the LLC was operated consistent with the requirements in the state’s LLC Act, and the provisions of the LLC operating agreement, the LLC will receive all potential protections.
Understanding that you need an operating agreement is the first step to running your LLC, understanding the operating agreement is the next step.  For most people, the idea of understanding either the provisions of a large legal document such as an operating agreement or a state’s LLC Act seems overwhelming.  The thought of perusing all the “thereins” and “heretofores” makes them feel like they are shrinking dizzily under a mass of words.  It does not, however, have to be this overwhelming.  If we understand a few critical concepts the LLC turns out to be quite easy to own and operate.

The LLC is Not Governed By Hidden Laws About Fiduciary Duties

As I mention in the History of the LLC, the LLC is different from a partnership and corporation in that it is a purely contract and statute derived business structure.  Both partnerships and corporations have decades of case law where judges added little bits and pieces to the laws that govern these entities.  Businesses have to rely heavily on attorneys to stay on track and comply with all the hidden fiduciary duties that are not in state statutes and somehow override their partnership agreements and corporate bylaws.  The LLC is different however.  It does not have the long legal history in the courts where judges made up additional rules, and when the LLC has been judged in courts, judges have been forced to leave it alone because the state LLC Acts are clear that judges should not add to what is already in the act.

The Four Divisions Of LLC Act Provisions; It Isn’t Hard To Understand

The fact that judges have not added to the law governing LLCs for the most part means that LLC owners have to worry about two things, 1) knowing in basic terms the main issues addressed in the state LLC Act, and 2) having an operating agreement that customizes the LLC to fit the owners business model.   A New Hampshire attorney named John Cunningham is the nations foremost expert on LLC law, and has done an amazing job at reducing the complexity of LLC statutes.  To cut to the chase, the provisions of an LLC Act address issues affecting the LLC, its operation and members.  A provision is an individual section. It contains a title and one or more paragraphs addressing one or more issues.  Cunningham sorts the LLC Act provisions into the following four areas.

1. Definitional provisions: These provisions define the parts and terms of an LLC. An example of this is the “LLC interest” definition in most statutes. In most LLC statutes, the LLC interest is defined as “personal property”.  This is important because it affects how one can transfer or sell the interest, and also affects how the property is treated in bankruptcy.
   
2. Mandatory provisions: All state LLC Acts have a few “thou shalts!” or mandatory provisions.  The way the provision is written is the way the law is and will be applied in court.  An example of a mandatory provision in some states is the requirement that managers refrain from taking a “business opportunity” that the LLC is in the business of.  The manager must make the members of the LLC aware of the opportunity and give the LLC rights to the opportunity.  In some states however, this same issue of whether a manager may act on a business opportunity in the LLC’s line of business, is a default provision and members may override the provision in the state statute by writing a different course of conduct for such situation in the operating agreement.
3. Default provisions: As just discussed, default provisions prescribe a course of conduct for certain issues, but leave it open for LLC members to write a different course of conduct concerning the issue into their operating agreement.  An example of this is the New Hampshire statute RSA 304-C:40 which essentially prohibits interim distributions (or the distributions of money to LLC members at times other than the disolution of the LLC) unless they are provided for in the LLC operating agreement.  Thus, members cannot distribute LLC income to themselves to pay taxes or for other needs under the statute provision, but they can override this provision in their operating agreement.  Arizona takes the oposite approach and makes such interim distributions at the discretion of the members, but allows them to prohibit such distributions if they wish by writing such a provision in the LLC’s operating agreement.
4. Permissive provisions: Permissive provisions are basically suggestions that are put in the LLC Act to bring attention to a certain issue.  These provisions generally explain an issue such as whether or not an LLC may indemnify its managers from legal liability for certain actions, and then says — if you want to do so, you may, but you must write it into the LLC operating agreement.

If you understand these four basic categories, you are way ahead in understanding the LLC.  In my next post I will explain how STARTright assembles an operating agreement for its users and how they can use the digital editor to better understand and customize their agreement.

There are virtually hundreds of services available to help individuals form an LLC. For those who have used one of these services and subsequently suffered legal problems or misunderstandings and disagreements among co-members, the agonizing reality becomes clear that forming the LLC is just the beginning.
Submitting the proper documents in the correct form to have your LLC recognized by the state is the easiest part in forming and operating an LLC. People generally form an LLC for two reasons. 1) First, they want to ensure liability protections for themselves personally and business liability protections for their business. 2) The second reason people generally form an LLC is to choose from the different tax structures available to an LLC. The LLC falls under the IRS’s “check the box” tax regulations.

When you use a use a document preparation service to form your LLC, however, both purposes are extremely under served. Submitting the Articles of Organiztion to a state’s filing agency is a very simple task in reality. All states require a fairly minimal amount of information to be submitted to the Secretary of State (or other filing agency) in order to form an LLC. All but a few states provide a template set of Articles of Organization. Once stamped as filed the LLC is active. This initial activation of the LLC creates only the possibility to qualify for all of the statutorial protections available however. To truly qualify for the protections inteded for the LLC, the LLC must be run correctly. An LLC operating agreement is the user guide and strategic plan to help business owners properly operate their LLC. The dangers of an inaccurate, under-encompassing, or inapplicable operating agreement cannot be understated.

The LLC Operating Agreement Must Be a Guide To Effective Operation

To manage an LLC effectively, the owners of an LLC must have a plan (or legal proposal) that declares the LLCs operating structure, and a manual (descriptive course of conduct) to help the LLC members and managers effectuate that plan. The operating agreement serves both purposes. Unlike the Articles of Organization, the LLC operating agreementis an “internal document” and is not filed with the state. For all potential issues the LLC and its members could potentially face, the operating agreement should contain an identification and explanation of the issue, a declaration of policy concerning each issue, and course of action to address the issue. Each state’s LLC act identifies many such issues, and attorneys familiar with forming LLCs are generally familiar with additional issues not discussed in the LLC act. The Limited Liability Company Operating Agreement Part 2; Agreement Construction will address how the operating agreement must reflect these issues. The members and managers of the LLC should have a basic understanding of the operating agreement sections, and the issues they address.

Why It Really Matters

In essence, if the LLC is ever in question before a court, the judge will first read the operating agreement and determine whether or not the members and managers performed the LLC business operations according to it. On issues the LLC operating agreement does not address, the judge will look to the statute to determine what the state’s default law on the subject is. Often times, if it is not in the operating agreement or LLC Act (the state’s LLC statute), a judge will determine it to be an issue that may not be addressed by the court.

How STARTright Factors In

It is essential that you both have, and understand your LLCs operating agreement. The operating agreement must be editable, because situations in your business change, and the law in state’s often change. Many attorneys do an excellent job of drafting effective operating agreements. This will usually be expensive however. STARTright is geared around providing a usable, and editable operating agreement that may mold and change to fit your businesses needs. The images in this blog post are taken from the performance support videos in the LLC set up wizard that help better explain operating agreements and other LLC aspects. I will be writing two more blog posts about operating agreements to fully explain this concept, and how STARTright factors in.

Benefits and drawbacks of the corporation:
The corporation provided corporate veil protection, which protected shareholders assets, but for a small closely held corporation, the corporate tax model was cumbersome. The lack of barriers keeping out unwanted shareholders if another shareholder was sued also made the corporation a drawback. Corporate shares were really too alienable or transferable for small corporations.

Partnership Problems
The partnership was easy to form and easy to operate. In reality, any two people coming together to work jointly became a partnership, and without doing anything, the business was protected by the state charging order statutes. The tax structure for a partnership was also simple. Partnerships are taxed under the IRS schedule K. All income from the entity is treated as though it flows through in proportion to the owners. The problem with the partnership was that all liability also flowed through to the owners. Even with a limited liability partnership, there was always a general partner who took the full brunt. If any limited partners engaged in the management of the business in anyway, they could be said to lose their limited liability protection. Also, sole proprietors who were not going into business with anyone had only the corporation to choose from.

Judicial Imposition of Fiduciary Duties
Another problem that set the stage for the LLC was the long standing judicial imposition of Fiduciary Duties.  Over the course of many years, judges had decided that the statutes that governed partnerships and corporations had holes in them and did not deal with certain situations well.  To address these “holes” in the statutes, the judges imposed fiduciary or required duties that one party owed another.  Many business owners were tired of these unasked for burdens, and wanted a legal entity where they could control everything by contract.  Business owners wanted to be able to set all terms of their relationships as business partners in an agreement, and if it was not covered in the agreement, or the state statute governing the entity, it was “hands off” for judges.

Wyoming Creates An Answer
The answer to this need came from an unlikely place. In 1977, the first LLC Act was enacted in Wyoming. The new statute provided for parties seeking to participate in a business for profit to operate in an entity that brought together both the charging order protection of a partnership, and the limited liability for all interest holders unique to a corporation. In 1988 when the IRS decreed the LLC would be taxed as a partnership, the entity really started to catch on. Many other states started to enact their own LLC Acts. Today the LLC has surpassed the corporation as the most formed entity in the United States.

This picture is from one of STARTright’s training videos that help business owners understand the LLC and how it runs.

Creating a straw-man member when forming an LLC doesn’t necessarily fix the single-member LLC problem.  As I always try and do in these posts, if we understand the theory behind the law, we better understand how things play out in application.

The History Behind The Single Member LLC Scare
The landmark bankruptcy case, In re: Ashley Albright, (US Br Dist. of CO) single handedly cast a massive black cloud over the magical world of total LLC protection.  Before that case, business owners would form an LLC seeking protection for there personal life if the LLC was sued (LLC corporate veil protection), and still shield the LLC from trouble in their personal lives.  This applied even in bankrupcty.  The LLC owner would continue to run the LLC and not distribute income or assets, and the Bankrupcty trustee was left holding a worthless assignment of economic rights.  It was a glorious day.  Well, in reality, that day still exists in most states.  I personally have a few single member LLCs for various investments.  Utah and Arizona, the two states where I do business aside from STARTright have been very careful to protect the single member LLC by ensuring charging order protection for single members of a Limited Liability Company.

Understanding The Theory Behind An LLC Co-Member
For those who want to take the very prudent and practical step to ensure their LLC warrants full charging order protection, the following will explain the thoughts to consider when adding another member.  Whenever you are wondering about a legal question, ask yourself “WHY?”.  Why do they have charging order protection for the limited liability company?  The answer is this: because the LLC functioned more like a partnership than a corporation, legislatures and courts wanted to ensure the members of a limited liability company did not end up with a new unwanted partner if their real partner got sued and lost his membership.  Thus, unlike corporate shares which may be fully attached in a creditor law suit, the member’s LLC membership may only be “charged” with the debt.   So the underlying theory is to protect partners (LLC Members) who have a legitimate interest in the LLC from having to deal with an unwanted or un-bargained for partner if their previous partner gets sued.  The law is meant to protect members of an LLC who have a legitimate interest.

Protecting that “legitimate interest” is exactly what the judge in Albriet based his opinion when deciding not to extend charging order protection the Single-Member LLC.  He explained that a legitimate interest could potentially be as little as 5% or even smaller.  He wasn’t saying.  In reality, I think the circumstances define “legitimate”.  Say  your aging mother who lives on social security (if it can be called living) is made a 2% member of an investment LLC.  She has no mangement responsibilities, and thus receives any income paid to her by the LLC at a 15% passive income tax rate.  If the LLC makes $50K/month, she would receive $1,000 each month as a member of the Limited Liability Company.  To her, this 2% interest is a massive part of her monthly income.  Your aging mother has a massive interest in the LLC continuing to be run as is, even if you file for personal bankruptcy.  This is how the judge will look at it.

Things To Be Concerned With When Adding A Co-Member
Things to be concerned with if you do go the “minimal co-member” route are as follows:

1. If you do not have an Operating Agreement (which you should have if you use STARTright to make an LLC) the default laws of the state could give the co-member rights over some situations.  Also, some states have laws that unless superseded in a well written operating agreement, allow for foreclosure on the charging order which can get ugly.
2. If you have an Operating Agreement from STARTright or someone else, it is important to go through all the provisions that allow members to vote, and determine what you do and do not want the other member to have influence in — set the voting percentage in the provision appropriately.

This basically gives us two questions.

1. How do I get an existing note (loan) taken out of my name and put in the name of the LLC that holds the property after the transfer, and
2. How do I purchase real estate in the future in a way that the note is made in the name of my LLC and not my own personal name.

To understand the answer to these two questions, we have to understand the law that lenders are looking at if they consider extending credit to an LLC instead of a person.  The Arizona LLC Act is probably closest to the Uniform LLC Act (ULLCA) in its treatment of creditors of the LLC.

29-651. Liability to third parties

Except as provided in this chapter, a member, manager, employee, officer or agent of a limited liability company is not liable, solely by reason of being a member, manager, employee, officer or agent, for the debts, obligations and liabilities of the limited liability company whether arising in contract or tort, under a judgment, decree or order of a court or otherwise.

As we see from this statute, a lender who makes a loan to an LLC cannot go after the member’s personally to repay the note if the loan is defaulted upon.  Sure they will have a mortgage on the property that will allow them to take the property if the debt is not paid, but they want more.

A Reputation Gives A Lender Some Leverage To Twist

Lenders want something more than the ability to reclaim the asset the loan was made over.  Especially in today’s market.  Foreclosing on a property is expensive.  Fixing the abandoned property after the foreclosure is also expensive.  With the way assets have devalued in the last two years, there are no guarantees that the asset will even come close to repaying the debt if sold, or that the asset will sell at all.

For a real estate investor, marketing the property is the full time job.  For the bank or lender, the property sits on its books and does not get marketed.  For this reason, a lender or bank does not want the property back at all.  The bank wants to have an arm to twist that is attached to something that will feel the pain.  This is why individuals’ credit scores are so important.  The bank views an applicant with a low credit score as extremely risky because hammering this person’s credit will not twist his arm at all.  A borrower with a good credit is generally concerned with keeping credit worthiness and the bank knows it can cause some real pain to ensure repayment.

When a bank considers making a loan to an LLC, the bank is concerned with the same issue — who is going to feel pain when we need to twist an arm to ensure payment.  An investment LLC is can be effectively viewed as a diaper.  The LLC is fungible and a new LLC may be formed easily.  The LLC has value only until “crap happens” and then they are easily thrown away.  By filing a dissolution with the state, and a final tax return with the IRS, the members of the LLC can say - “take the assets, have the LLC, according to law we have not been grossly negligent, but just doing business, so you cannot touch us.”   This is the reason most lenders and banks will never dream of extending credit to an LLC, especially a new one.

So How Do I Get Credit For This LLC

Now that I have fully explored why most LLCs never get credit extended to them, lets talk about those that do.  Knowing that a bank will not lend to an LLC because it wants an arm to twist helps us see the banks real motive.  They do not care whether they lend to a person or a business.  In fact, who do you think your local bank would rather lend to, you? or Apple (with their $50Bill stockpile of cash)?  Probably Apple right?  Well, that is because there are enough arms that could be twisted to cause some real pain if Apple just decided not to repay a loan.  Here are some ideas that generally make a bank want to lend to a company.

1. Credit Worthiness: Just like a person, a business that has built up its credit has an arm to twist.  It takes a long time to build credit worthiness for a business.  A business that has credit worthiness is a real asset in itself.  The lender is pretty sure members will not lightly cut the LLC loose.  The next two ideas are ways to get banks to lend to the LLC, but also help to build credit worthiness.
2. Joint Venturing: If it is real estate you want to get your paws on, or rehabing you need money for, do what the big guys do and joint venture with banks and lenders.  Big companies often put down as much as 30% so the lender is only taking a 70% chance.  The contracts are often written in a way and the deeds often executed such that the banks do not have to go through the normal foreclosure process to take the property.  For many investors who are just starting, a lender may not joint venture with the LLC or extend credit to the LLC on a property for which the LLC puts less than 60%.  This seems like a waste of time because you could probably get the current owner to carry-back 40% of the purchase price on an owner financed loan, but the point is to build credit worthiness so the exercise has merit.
3. Posting Assets: The bank likes to see that the LLC already has other assets and is not worth cutting off.  The banks or lenders especially like to see that the LLC will put a deed to a current asset in escrow so in the event of a default on the loan, the lender is assured an easy to sell asset that more than compensates for the loan that was defaulted upon.

These are just some of the ways to build credit worthiness and get a bank lending to the LLC rather than to you personally.

There are two questions there.  The first question addresses the need to protect real estate in multiple ways.  The second stems from the desire to make real estate the businesses problem completely.  I will address each in turn.

1. There are multiple ways that real estate can be vulnerable.  How do I protect my real estate?

I get asked about the virtues of “putting a piece of real estate in an LLC” all the time.  Lets consider what the issues might be.  First lets look at the rental.  

So even though your rental might not look like this, the reality is, the property could be such that it is the cause of an injury and thus creates a legal cause of action.  The question to understand here, is that if the house is the source of an injury that creates a legal cause of action, who is on the hook?  In a word, the owner of the property.  This is why people form an LLC and put their piece of property in the LLC.

The LLC was the first entity to offer the corporate veil protection without the corporate tax.  The following diagram explains corporate veil protection.

If the corporation is sued, there is essentially a veil, or barrier that stops the law suit from proceeding to take hold of the shareholders personal assets. Corporate tax law makes the corporation an unsuitable structure for holding property as an investment.  The flow through (partnership or sole proprietorship) tax treatment of the LLC makes it an ideal entity for holding investment properties.  You get the wonderful flow through tax treatment of a partnership enabling you to benefit from passive activity income from the LLC holding the property while enjoying corporate veil protection that separates the LLC any legal causes of action the LLC might create from your personal life.

To quickly explain what I mean about “put your property in an LLC” you follow a three step process.  1) Form an LLC.  STARTright can help you do that with incredible ease.  2) Once the LLC is an entity acknowledged as existing and viable by the state, you create a deed and deed the property over to the LLC.  This is not a fraudulent transfer, and the courts will acknowledge this as perfectly fine because in essence, you are “capitalizing” or putting assets into a business.  People put assets into their business all the time.

Ok, so now to the original question, what if you have two or three of the beauties that we see above? Do I need an LLC for each property?  Well, the sad reality is that there is no definitive answer. There are three options and each have their pros and cons.  The answers are:

1. Put all the eggs in one basket.
2. Put all the eggs in separate baskets (multiple LLCs)
3. Get a basket with multiple compartments (the new series LLC)

1. Put all the eggs in one basket:

• Pro: To many people wait to get any protection for their rentals because they spend all their time dreaming about the massive and intricate “Asset Protection Web” that puts houses in strange trusts and gives beneficial interests back to … blah blah blah.  The pro of forming one LLC and deeding all rentals back to that LLC is that it is cheap, fast, and better than day dreaming about the massive scheme.  Get something in place.   The other problem is that if your LLC does business in California, you will have to pay an additional FTB tax of $800 annually for each additional LLC.  Attorneys never seem to care about the immediate costs to your business when dreaming up the elaborate asset protection scam.  The reality is that very few people actually get sued.  Run your business intelligently from a protection stand point, but also from a “efficacy now” stand point.
• Cons: The reality is that if one of the properties creates a law suit, you are protected personally, but all other properties in the LLC are exposed as loot to satisfy the claim.

2. Putting eggs in separate baskets.

• Pro: I am not a fan of creating a separate LLC for each and every property.  I believe it is overkill and a scheme that attorneys dreamed up to make lots of money.  I prefer the concept of strategic grouping.  If your investment portfolio gets larger than say two or three properties, it may be a good idea to create two or three LLCs, and divide assets between them.  Put quick-flip properties in a different LLC than rentals, and determine which rentals can safely be grouped, and which rentals may need to be isolated in a single LLC.
• Cons: Yes, a completely separate LLC for each property ensures isolation, but as the portfolio grows, it becomes a management and tax headache.   If you are in California, you start paying the annual $800 FTB tax for each LLC.

3. The basket with individual compartments:  much has been made of the series LLC, and yes, “they are all that and the bag of chips.”  A series LLC is best explained if you think of the LLC as a large box.  By putting the property in the box, you isolate all legal actions the property would cause in that box.  The series takes the LLC concept one step further.  It allows you to create “series” inside the LLC by doing nothing more than 1) creating series agreement (this is essentially an operating agreement for the individual series), 2) getting a separate bank account for the series, and 3) registering a DBA for the series.  The series now becomes an isolated and individual compartment within the larger LLC box.  The compartments become completely safe from one another, but for tax purposes it is as though you just threw all your eggs into one basket.

• Pros:  I think the pros are self evident from the above explanation.
• Cons: The biggest problem is that all states do not support series LLC, so forming a series LLC in one state and taking it to another state to do business expecting that they will reverence the laws of your state of formation is always scary to me.  there is literally no case law on how this type of thing would play out.  California seems to hate the idea of the Series LLC already.  They hate it for tax purposes because it totally kills their revenue.  It is in many respects an unknown legally.

So that’s it.  Like a real attorney, I gave the “well it depends answer”.  Hope this is helpful.   Also, I will answer the question about getting credit for new companies on Monday.  Should be good.

Today I want to write a quick note about California filings as the California LLC is one of the few LLC’s we offer a submission service for.  The business model for STARTright was to make forming an LLC yourself so easy that you would not need to pay extra costs except for the State LLC filing fees.  

If you are going to form a California LLC, here are some things about the submission process that you should understand. California has some interesting rules for the California LLC formation process. When forming a California LLC, you need to create the Articles of Organization for a California LLC. That is the easy part. California LLCs have the most basic and easy to fill out Articles of Organization in use. Next, you have to submit the Articles to the California Secretary of State who will stamp the files as received one they determine the LLC name is distinguishable from other LLC names in use by California LLCs.   Once the Articles are stamped as received, the California LLC is alive and well and can be used to do business from.

Now the tricky part is this. The California submission process allows for two ways of submitting the California LLC Articles of Organization. The first method is by mail. Though it may not take this long to actually have the Articles of Organization for the California LLC stamped as filed, the Office of the Secretary of State claims that they will not ensure any faster filing than that of 30 to 45 days.  This depends upon the volume of all filings received, not just California LLC filings.  That is a very long time to wait to start doing business in a California LLC.

The second option is to hand deliver the California LLC Articles of Organization. This is done by actually walking the California Articles of Organization in the front door of the Secretary of State office in Sacramento California. They want you to do this because they charge up to $15 for entrance. It is like a cover charge just to get your California LLC Articles of Organization in the door. This is by far the fasted method to get your California LLC formed. The California Secretary of State claims that they will do a standard processing for a walk-in during a 5 to 10 business day window. Unlike a California LLC that mails in the Articles, expedited filing is available to all California LLCs that walk the Articles through the door. With expedited filing, you can get the California LLC Articles stamped in either 24 hours ($250) or 4 hours ($400). This is not a cheap option, but it can be done fast.

The following is an email that we received from a user who went with the submissions service.  Their experience has been typical of many, but we cannot make any promises that turn around times will always be this fast.

I used your website to form a California LLC. I paid the $49 for the membership. I then decided to use the STARTright Submission Service to have my California LLC Articles of Organization delivered to the California Secretary of State. They told me it would take between 10 and 15 business days and I had to pay $100 for the submission service.  I also had to pay a $70 fee that would be taken to the secretary of state as the filing fee. Thus I paid: $49 membership fee to STARTrightllc.com, $100 STARTright submission service fee, and $70 state fee for filing. All this adds up to about $119.  Not bad, but I was not excited to wait half a month to get my business started.  I have seen other services that do a lot less in a lot longer time.  [Competitor's name removed] will do a California LLC for around $500 and I still would have had to pay the $70 state filing fee. They promise it to be done in 15 days.  Yikes!   Anyway, the STARTright service somehow got my California LLC Articles of Organization finished in less than 24 hours and had sent me an email with scanned in copies of all the documents.  This was a very good experience.

We hope the STARTright submission service can wow the socks off more of you.  Keep in mind that we do not get any of the $100.  We continue to pay a service in Sacramento to ensure fast and quality care of our customers’ California LLC filing documents.

Why form an LLC?

Forming an LLC is the right decision for almost any small business owner or partnership.  Most business owner’s are worried about three issues when starting their business.  Those issues are 1) start up costs, 2) lowering tax liability, and 3) liability protection.  I will discuss how forming an LLC is the best solution for each of these.

1. Forming an llc minimizes start up costs.

There is no question that hanging your sign and opening your doors for business will have the lowest start up costs.  This may not be the most prudent approach, however.  It also may not end up saving that much over forming an LLC.  When you start a business without forming a legal structure from which to operate that business, you still need to get a business license in order to open a business account at a bank.  In most counties, a business license can run upwards of $100.  If you form an LLC, you can usually get the Articles of Organization filed with the state for under $100 (states vary, but the vast majority do not charge over $100).   Almost any financial institution will open an account for your LLC based upon a filed copy of the Articles of Organization.   With that said, the savings you gain by not forming an LLC which is recognized and given state LLC law protections may be minimal and probably not worth it.

If the question is whether to form an LLC or another entity, the choice to form an LLC to save on startup costs is even clearer.  For a single business owner, the only other legal entity available is a state corporation.  Both the LLC and corporations offer legal protections which we will address shortly.  Fees to form an LLC as opposed to the fees to form a corporation are cheaper in most state.   LLCs are generally less complex and require fewer formalities.  This enables business owners to properly manage much of the LLC themselves cutting down on legal bills.  Many business owners that have corporations may choose to manage their corporation themselves, but few do it right.  Corporations have strict formality and structural rules.  As we will discuss later, the protections for those corporations are dependent upon those formalities being executed properly.   

2. LLCs have the most tax flexibility.

Many people complain about the complexity of the federal tax code, but it was designed to deal with the fact that no two businesses are completely alike.  For some businesses the ease and convenience of flow through taxation (that of a sole proprietorship) where the business is listed as an extension of the business owner’s person assets fits.  For others, the “self-employment tax” minimization of an S-Corporation fits, and for others, the large benefit write-offs of a C-corporation fits.  Before business owners could form and operate from an LLC, federal tax choices did not line up well with state structure and liability choices.   A business owner seeking corporate veil protections could not also get sole-proprietor type tax flexibility and vice versa.   By forming an LLC, you can keep the structure and formalities of your business simple and minimal, the protections at the highest levels allowed in any state, and choose the tax structure that works for you.

3. Forming an LLC gives you premier legal protections.

An LLC carries the greatest level of protections from legal liability available today.   Most people do not realize that the liability pendulum can swing from two directions.  The LLC offers both 1) corporate veil protections as well as 2) statutory business asset protection (the charging order).   

The LLC’s corporate veil protection is superior for one main reason.  The corporate veil is only as good as a judge says it is, and whether or not a judge will acknowledge or pierce the corporate veil depends upon the state law requirements for maintaining the businesses’ veil protection.  Corporations have lists of formalities and structural requirements such as shareholders, directors and officers that require lots of documentation to ensure corporate veil protection.  An LLC usually requires the owner to keep his business and personal finances separate and that will generally ensure legal protections.  Much easier.

Now we will look at the other way the liability pendulum will swing. Most business owners realize that they want to protect their personal lives from their business, but what they often fail to do is to protect their business from their personal life.  By forming an LLC, a business owner ensures that anyone who sues him personally will not get instant and unlimited access to the business and its assets.  Instead, the LLC is protected by state statutes that require a judge to limit the plaintiffs access to the business.  This is called a charging order.  Unlike a state corporation where a plaintiff could take all the shares and control the corporation including forcing it into liquidation, by forming an LLC, you ensure that you as the business owner retain control of the LLC management even if you are sued personally.  I will write more on charging orders later, and this is supposed to just be a quick overview.  It is important to understand the limitations involved with a single member LLC when it comes to statutory business asset protections also.  Please read “The Single Member Hitch” for more on Single Member LLC Protections.

An LLC is designed to incorporate the most favorable aspects of corporations, general partnerships, limited partnerships, and other entities.  It provides a single tax at the shareholder level.  Losses may pass through to the owners.  The LLC may make special allocations of income, gain, loss, credit, and deductions to members.  A member may increase his basis in the membership interest by the amount of LLC debt.  The members, owners, and managers of the LLC receive the same limited liability protection as shareholders, officers, and directors of a corporation.  Overall, the LLC is the most flexible vehicle for a business.

Hold on if you feel like your head is whirling from that little paragraph.  Lets slowly take his statement apart.
1.    The first line of Cartano’s statement points out that the LLC is not a creation unto itself, but is made from two parts.   It is a creation from the two most widely used business models, a corporation and partnership.   It is essential to remember that an LLC cannot be analyzed by itself.  In every circumstance one has to determine whether we are dealing with a part of the LLC that is from the corporation, or the partnership.  For a thorough explanation of this concept read the “definition of an llc: part-1” on STARTright Biz-Law blog.

The rest of Cartano’s statement speaks from a position where the tax election, or the manner in which the LLC will be taxed is a foregone conclusion.  This drives me nuts.   His final statement “Overall, the LLC is the most flexible vehicle for a business” is profoundly true.  But from a tax standpoint, his approach ignores one of the most flexible aspects of the LLC.  An LLC may choose the manner in which it will be taxed.   Since 1997 when the IRS instituted check the box taxation, an LLC may choose to be taxed as a Partnership/Soleproprietorship (depending upon the number of members), an S-Corporation or a C-Corporation.

This flexibility to choose the LLC’s manner of Federal Tax (and most states allow the LLC to be taxed in the same manner it is taxed Federally) is called “Check The Box Taxation”.    Over the next couple of weeks I will address these three different styles of tax in detail.   The point I want to make is that even though the default manner of tax for the LLC is Flow through, there are other options.  For the majority of LLCs, flow through taxation is preferable.  It is best to understand your options however, because there are times when the other two are very useful.