WHY A LIMITED LIABILITY COMPANY (L.L.C.) MIGHT BE THE RIGHT FIT FOR YOUR START-UP INTERNET BUSINESS
2008
By: Ethan M. Watts
When starting an internet based business (or any business), one of the important issues you will face is whether to form a business entity, and if so, what sort of business entity to form. This article explores the advantages and disadvantages of forming a limited liability company (LLC) in California, and why an LLC may be the right choice for your start-up internet based business.
Protection from personal liability for business debts is of course one of the main reasons to form a business entity such as an LLC. Generally, only the LLC (which is considered a separate legal entity) can be held responsible for the entity's debts. Thus, like corporate shareholders, LLC members are generally not personally liable for the LLC's liabilities. Corp. Code § 17101(a).
An LLC also has characteristics of a partnership in that it is given the “pass-through” tax treatment of a partnership. Although an LLC is taxed like a partnership, it need have only one member (i.e. owner). Corp. Code § 17050(b). LLC owners do not have to be U.S. citizens or permanent residents.
An LLC enjoys perpetual existence. Even if an LLC owner dies or leaves the business, the LLC persists. An LLC may be dissolved by the vote of a majority in interest of its members, or as otherwise provided in the articles of organization or a written operating agreement. Corp. Code §§ 17051(c)(3), 17350.
An LLC member's capital contribution to the LLC may consist of money, property, services performed, or a binding obligation to contribute any of the same. Corp. Code §§ 17001(g), 17200(a). This is in part different from the issuance of corporate shares in that an “obligation” to contribute property or services is not lawful consideration for the issuance of corporate shares. Corp. Code § 409(a)(1).
By default under the Corporations Code, LLC profits and losses (or money or property) are allocated in proportion to each member's capital contribution to the LLC. However, such profits and losses may be allocated differently as provided in the operating agreement. Corp. Code §§ 17202, 17250.
In order to form an LLC, articles of organization must be filed with the Secretary of State. Corp. Code § 17050(c). The person or persons who execute the articles need not be members of the LLC. Corp. Code § 17050(a). To validly form an LLC, the members must also enter into an operating agreement either before or after filing the articles. Although not recommended, the operating agreement may be oral. Corp. Code §§ 17001(b), 17050(a). A Statement of Information must also be filed within 90 days of the filing date of the Articles. Depending on whether the LLC is member-managed or manager-managed, the LLC, unless it qualifies for an exemption, may need to comply with state and federal securities registration requirements.
Regarding managing the LLC, the LLC requires fewer formalities than a corporation. LLCs need not hold annual meetings or record meeting minutes (although not necessarily recommended). Each member has the right to vote in proportion to such member's interest in the current profits of the LLC, unless the articles of organization or operating agreement provides otherwise. Generally (with a few exceptions – e.g. to amend the articles of organization or operating agreement), the vote of a majority in interest suffices in determining the actions of the LLC. Corp. Code § 17103(a)(1),(3). Management of the LLC is vested in all its members unless the articles of organization provide otherwise. Corp. Code § 17150 et seq. If an LLC is managed by all its members, each member is deemed an agent of the LLC in dealings with third persons and can bind the LLC. Corp. Code § 17157.
An LLC may also be managed by one or more designated managers (“centralized management”), if the articles of organization so provide. Corp. Code § 17151. By default, LLC managers owe the same fiduciary duties of care and loyalty to the LLC and the LLC’s members as are owed by a partner to a partnership and its partners. Corp. Code §§ 17005(d), 17153. Generally, LLC managers are not personally liable for any LLC debt, obligation or liability, but a manager may agree to personal liability in the LLC articles of organization, a written contract or a written operating agreement referencing section 17158(b). However, similar to a corporate officer, an LLC manager will likely be liable for his or her own torts.
In order to transfer a member’s interest in an LLC, the consent of members having a majority interest in the LLC must consent to the transfer (excluding the vote of the transferee of the LLC membership interest), unless otherwise provided in the LLC's articles of organization or operating agreement. Corp. Code §§ 17100(a)(1), 17303(a). However, an LLC member can freely assign his or her economic rights (e.g. rights to share in profits), unless otherwise provided in the articles or operating agreement, so long as the assignment does not transfer any of the member's voting, inspection or other rights. Corp. Code § 17301.
In summary, a limited liability company, because of its relative flexibility and the members’ ability to manage it with as little formality as desired, may be the right fit for a start-up internet business seeking limited liability protection.
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The above discussion is intended to be a general commentary on legal issues. Each situation is different and this article is not intended as legal advice. Further, nothing in this article is intended to create an attorney-client relationship.