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By John Cunningham, August 19, 2010 6:45 am

For the past several weeks I’ve been hard at work writing a law journal article that seeks to answer the above question under the Massachusetts LLC Act. 

I’ve concluded that in order to be able to form LLCs competently under that act, you need to possess a rather shockingly large amount of business organization law knowledge. 

Specifically, I’ve concluded that in order to handle non-tax choice of entity for your LLC formation clients, you need to know (i) the chief business organization law features of LLCs under the Massachusetts LLC Act and (ii) the similarities and differences among these features and those of all other types of Massachusetts business organizations. 

And I’ve concluded that in order to competently plan, negotiate and draft operating agreements for your clients you need to know:

• The provisions of the Massachusetts LLC Act that are relevant to LLC formation practice (which, by my count, comprise 152 provisions);
• Whether each of these provisions should be characterized as definitional, mandatory, default, non-self-enabling permissive or self-enabling permissive;
• The tactical significance of these characterizations in forming Massachusetts LLCs;
• Massachusetts LLC case law relevant to LLC formations;
• The “gap issues” in Massachusetts LLC law—i.e., the issues on which this law is silent or ambiguous (so that, in the operating agreement, you won’t overlook any of these issues);
• The principal business organization law issues relevant in Massachusetts LLC formations (so that you won’t overlook any of these issues) and the various alternative methods of resolving each of these issues in your clients’ best interest;
• The rules of Massachusetts LLC law that govern Massachusetts LLCs that lack operating agreements (so that you can explain to your clients why they absolutely need to have these agreements); and
• The potential adverse impact of these rules on Massachusetts LLCs and their members.

If the above question is one that you yourself have thought about, I’d be very grateful for your reactions to the above list.  In putting the list together, have I gotten just a bit carried away?

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By John Cunningham, July 24, 2010 8:01 am

The tools you need the most in your LLC formation practice are model operating agreements.  As discussed in the last two posts in this blog, these include general-purpose and special-purpose model agreements. 

What purposes should these model agreements be designed to fulfill?  In my view, they should be designed to provide you with optimum assistance in addressing each of the four main tasks you must perform in forming LLCs. 

1. Issue identification.  They must assist you in identifying with your LLC formation clients all of the legal and tax issues likely to be significant for them in the operating agreements for the LLC they want you to form.
2. Issue resolution.  They must assist you in determining with your clients the best way to resolve each of these issues in the operating agreement in your clients’ best interest.
3. Negotiation.  They must assist you in effectively negotiating these terms on behalf of your clients with the other parties to the formation.
4. Drafting.  They must facilitate your drafting of operating agreements in a manner that accurately and enforceably reflects the outcome of these negotiations.

Well-designed model operating agreements provide you with optimal assistance in  accomplishing all four of these tasks.  In future posts in this blog, I’ll explain how.

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By John Cunningham, July 19, 2010 10:50 am

The words we use to discuss a topic can exercise a subtle tyranny over the way we think about that topic.  And if the topic is one that involves action, these words can exercise a subtle tyranny over how we act in respect of the topic.

This is true with regard to the topic to which this blog is devoted—namely, LLC formation practice.  If you don’t use the right terms in thinking about LLC formation practice, there’s a risk that you won’t properly think about that practice or properly conduct it.

To illustrate:  People sometimes ask me if I can give them a “good LLC form” for, say, an LLC under the Arkansas LLC Act.  

In my view, this question makes no sense.  It’s as if one carpenter were to ask another, “Hey, can you lend me a tool?”  Obviously, the first carpenter’s request will be meaningless unless he specifies the type of tool he wants; and if he can’t do that, he’s a terrible carpenter.

It’s the same with LLC lawyers.  In my last post in this blog, dated July 10, 2010, I expressed the view that there are five quite distinct types of forms that lawyers need in order to be well-equipped for their LLC formation practice.  These are:

• General-purpose model operating agreements;
• Special-purpose model operating agreements;
• Model non-tax plug-in provisions;
• Model tax plug-in provisions; and
• “Miscellaneous” forms.

However, the usual understanding of the term “LLC form” among LLC lawyers—basically, that “forms” mean “general-purpose model operating agreements”—can exercise a subtle tyranny over how they think about their LLC formation practice and how they conduct it.  More specifically, the term may tend to keep them from focusing adequately on the fact that there are many different basic types of LLCs; that each of these LLC types needs its own general-purpose model operating agreement; that there are many specialized types of LLCs; that each of these specialized types of LLCs needs its own special-purpose model operating agreement; that operating agreements based on general-purpose and special-purpose model operating agreements often need substantial tailoring through the use of tax and non-tax plug-in provisions; and that many of these operating agreements need to be accompanied by exhibits in the form of bylaws, agreements with managing members and other specialized forms.

The only way to overcome this subtle tyranny is to get analytical.  To do so, ask yourself these questions:  “Wait a minute, what do I mean by ‘LLC form’?  Is it possible there’s more than one basic type of LLC form?  Is it possible that there are five basic types.”

Because there are.

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By John Cunningham, July 10, 2010 1:23 pm

What forms do you need for your LLC formation practice? 

I addressed this question in my March 23, 2010 post in this blog, but since that date, my thinking about the question has significantly evolved.  My current thinking is that you need five distinct types of forms.  These forms are listed below.  I’ll be grateful for any comments you may have on this list.

1)     General-purpose model operating agreements.  You need general-purpose model operating agreements.  These model agreements should be designed to provide a basis for planning, negotiating and drafting all of the basic types of operating agreements that any LLC formation client is likely to need for any purpose (except the purposes addressed in the special-purpose model operating agreements discussed below). 

The best way to organize general-purpose model operating agreements is on the basis of their three main structural features—namely, (i) their ownership structure, (ii) their management structure and (iii) their federal income tax structure.  If you organize them this way, you will find that there are 10 main types of LLCs (click here for a list of these types); and you will find that you need 28 specific general-purpose model operating agreements.  For a list of these 28 model agreements, click here. 

In the summary and detailed tables of contents after the title page in each general-purpose model operating agreement and in the captions of its provisions, each of these agreements should identify all principal legal and tax issues relevant to the type of LLC for which the agreement is designed.  The tables of contents of the agreement should provide you with a comprehensive issues checklist in handling LLC formations. The provisions of each model agreement should provide you with optimal starting-points for resolving each of these issues. 

For an example of a general-purpose model operating agreement for multi-member LLCs, click on the “forms” button of the top navigation bar of this blog and then click on the button marked “Form 6.2.”

2)     Special-purpose model operating agreements.  Depending on your practice, you probably need one or more types of special-purpose model operating agreements.  These may include, for example, model agreements for (i) husband-wife LLCs; (ii) Delaware series LLCs; (iii) promoter-controlled and investor-controlled investment funds; and (iv) LLCs whose members want short-form operating agreements. 

3)     Model non-tax plug-in provisions.  You need a wide variety of model non-tax plug-in provisions that you can copy and paste into operating agreements you are drafting on the basis of general-purpose or special-purpose model operating agreements.  The purpose of these plug-in provisions is to supplement or replace the standard non-tax provisions in these model agreements when these provisions don’t meet your clients’ needs.  Examples of model non-tax plug-in provisions are (i) right-of-first-offer and right-of first-refusal provisions; (ii) drag-along and tag-along provisions; (iii) provisions to eliminate fiduciary duties in Delaware LLC agreements; and (iv) securities law compliance provisions.

4)    Model tax plug-in provisions.  You need various model tax plug-in provisions.  These are individual model provisions or sets of related model provisions on federal and state tax issues that you can copy and paste into general- and special-purpose model operating agreements to meet special tax needs of your clients.  Model tax plug-in provisions include, for example, (i) sets of plug-in provisions under IRC §§ 704(b) and 704(c)(1)(A); (ii) plug-in provisions under Prop. Reg. § 1.1402(a)-2 that will enable your clients to avoid the Self-Employment Tax on their shares of LLC income; and (iii) plug-in provisions for tax matters partners. 

5)     Miscellaneous forms.  You need miscellaneous forms, including (i) forms for articles of organization or similar documents to file with relevant state officials to create LLCs; (ii) bylaws for use by LLCs with corporate management structures; and (iii) documents, in the form of attachments to operating agreements, which set forth the rights and duties of managing members and management committees.

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By John Cunningham, July 5, 2010 11:22 am

On June 29, 2010, I taught for National Business Institute (“NBI”) a 90-minute national teleconference seminar on LLC charging protections.   About 82 lawyers and other professionals attended the seminar.  During the seminar, I discussed, among many other topics, the recent decision of the Florida Supreme Court in FTC v. Olmstead.  I revised the sentence outline for the seminar shortly before teaching it.  The revised outline is 22 pages long and has two exhibits.  You can access and download the outline here.

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By John Cunningham, June 15, 2010 5:07 pm

For 2010, Social Security taxes apply to individuals, including individuals who are members of LLCs, at a rate of 15.3% on the first $106,800 of their “net earnings from self-employment” (“NEFSE”), including their shares of LLC income; and 2.9% on any excess.  NEFSE means, basically, active income—i.e., income from providing services.  In the case of employees, Social Security Taxes are called “FICA” taxes (for “Federal Insurance Contribution Act”).  In the case of sole proprietors and owners of entities taxable as partnerships, they are called Self-Employment Taxes (the “SET”).

In recent years, Congress has increased the “Social Security base”—the above $106,800—a thousand or more dollars every year. 

Because of their rate and for other reasons, Social Security taxes are a big concern for many individuals who are LLC formation clients. 

The easiest way for an LLC to protect these individuals from Social Security taxes on their shares of LLC income is to make an S election—i.e., an election to be taxed under Subchapter S of the Internal Revenue Code.  And LLCs are making these elections at a rapidly increasing rate.    

But what can an LLC do if (i) it wants to protect individuals who are its members from SET on their shares of LLC income; but (ii) it also needs the benefits of federal income taxation under Internal Revenue Code Subchapter K (partnership taxation), not under Subchapter S?  This can happen if the LLC needs the remarkable flexibility of partnership taxation; or if it can’t meet onerous Subchapter S eligibility rules.

The solution for such an LLC may well be a 1997 proposed IRS regulation designated Prop. Reg. § 1.1402(a)-2 (the “Prop. Reg.”). 

Even among sophisticated tax practitioners, the Prop. Reg. is little known; and many tax practitioners who are familiar with it are hesitant to use it because it is a “mere” proposed regulation, not a final one.  They don’t want to create audit risks for their LLC clients.

However, the Prop. Reg. has been on the books without amendment since January 13, 1997.  And on a number of occasions, the Internal Revenue Service has announced publicly that the Prop. Reg. constitutes its SET audit guidelines.  The IRS did so most recently at a December 2009 meeting of the Tax Section of the District of Columbia Bar Association. 

For this and other reasons, it is very unlikely that the IRS will challenge the SET liability reported by LLC members as long as their LLC complies with the Prop. Reg.

In a soon-forthcoming post in this blog, I’ll provide a brief, plain-English explanation of the Prop. Reg. for the benefit of LLC lawyers who are not tax specialists.  

However, if you want a comprehensive technical discussion of the Prop. Reg. and a critique of it, and you want this right away, click on www.llcformations.com; then on the button on the left-hand navigation bar of that website marked “LLC Library”; and then on Item 12 under the heading “John Cunningham’s Writings,” etc.

Happy reading!

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By John Cunningham, June 15, 2010 4:41 pm

From 11 am to 12:30 pm on Tuesday, June 15, 2010, I taught a national teleconference CLE-credit seminar for National Business Institute about what I perceive as ten of the most common errors in drafting LLC operating agreements.  The seminar materials consisted of a 14-page sentence outline and five exhibits.  In case these materials are of interest to attendees of the seminar or to other LLC lawyers, I’m posting all of them here except the tables of contents of Form 6.2.  You can download this form and its tables of contents by clicking on the button on the right-hand side of the top navigation bar of this blog and then on “Form 6.2.”

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By John Cunningham, June 9, 2010 11:22 am

Every LLC lawyer will agree that the most important threshold task in forming LLCs is a task often referred to as “choice of entity.”  In the months and years to come, this blog will address dozens of choice-of entity issues.

But the key fact you have to realize before you undertake any choice-of-entity analysis is that there is, technically, no such thing. Rather, choice of entity requires three types of analyses, each of which is entirely different from the others. When you’re doing choice-of-entity, you should, to the extent of your competence, do all three analyses and then, if there are any conflicts among them, reconcile these conflicts.

To explain:

• Non-tax choice of entity. The first type of choice-of-entity analysis is non-tax choice of entity. This is the process by which lawyers choose the best type of business organization for their clients on non-tax grounds—mainly on business organization law grounds. The key types of business organizations are sole proprietorships, divisions, general partnerships, limited partnerships, corporations and LLCs. The key issues are, for most clients, (1) Does the client need a liability shield? (2) If so, which type of organization will provide the client with the best shield? (3) Does the client need the special statutory business asset protections referred to by LLC lawyers as charging order protections? (4) If so, should the client obtain these protections through a general partnership, a limited partnership or an LLC? (Most corporate statutes don’t provide charging order protections.)
• Choosing the right federal income tax regimen for federal income tax purposes. The second is choice of federal income tax regimen for federal income tax purposes. The relevant regimens are disregarded entity taxation and Subchapters C, K and S. Key issues include: (1) Which regimen will provide the client with the lowest tax rate? (2) Which will provide the client with the greatest flexibility in deploying and redeploying business assets?
• Choosing the right federal income tax regimen for Social Security Tax purposes. The third is choice of federal income tax regimen for Social Security Tax purposes. The relevant regimens are those listed above, but the relevant issues are entirely different from federal income tax issues. In addition, you won’t find the key authority in this field in the Internal Revenue Code or even in a final regulation—it’s a little-known but remarkably powerful IRS proposed regulation designated Prop. Reg. § 1.1402(a)-2.

Understanding these three types of analyses in detail takes a lot of study and experience; but the best place to start in understanding them is with the Big Picture. The Big Picture is in the three bullet points above.

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By John Cunningham, April 29, 2010 4:48 pm

On April 27, 2010, I taught a 90-minute national teleconference CLE-credit seminar for National Business Institute on the basics of LLC taxation.  In my experience, for most single-member LLCs whose members are individuals, the two federal income tax regimens that are likely to be useful are sole proprietorship taxation and Subchapter S; and for almost all multi-member LLCs, the relevant federal income tax regimens are Subchapter K (partnership taxation) and Subchapter S.  My seminar was based in part on tables I’ve prepared comparing the above regimens.  If tax choice of entity is a topic that interests you, you can access the table comparing sole proprietorship taxation and Subchapter S, click here; and you can access the table comparing Subchapter K and Subchapter S by clicking here.

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By John Cunningham, April 26, 2010 9:10 am

In my April 13, 2010 post in this blog, I expressed the view that even though, by definition, the members of single-member LLCs completely dominate their LLCs, written operating agreements can nevertheless provide three valuable benefits to these members—(i) these agreements can trump default rules of the governing LLC act that are adverse to single-member LLCs but that would otherwise govern them; (ii) they can serve as users’ manuals for the members concerning the nature and operation of their LLCs; and (iii) they can provide valuable documentation to potential lenders, tax authorities and other third parties about who is authorized to sign LLC contracts and about other significant LLC legal and tax issues.

In a response to a related post, attorney Thomas Beckett has suggested a fourth important benefit that an operating agreement can provide to the member of a single-member LLC—namely, that it can help to support the member’s position that the member and the member’s LLC are separate and distinct legal persons that exist independently of one another.  This, in turn, can reduce the risk that, on alter ego grounds, a court will pierce the veil of the single-member LLC and hold the member personally liable for claims against the LLC.

I could not agree more with attorney Beckett, and I’m quite grateful for his comment.  I confess that I’m also a bit embarrassed by it.  As he himself points out, the potential value of operating agreements in helping the members of single-member LLCs resist veil-piercing claims is one that I myself have made in my Aspen LLC formbook and practice manual.  I should have mentioned attorney Beckett’s point in the above post.  But I want to at least make three follow-up points that I believe will support Mr. Beckett’s excellent comment:

1)     A few years ago, Professor Robert B. Thompson of Vanderbilt Law School reported in a law journal article extensive case law research showing that the shareholders of single-shareholder corporations are far more at risk of veil-piercing that the shareholders of corporations with two or more shareholders.  The same principle undoubtedly applies to the members of single-member LLCs.  Thus, even more than the members of multi-member LLCs, these members and their lawyers should do all they reasonably can to protect themselves from the risk of veil-piercing.

2)     I know of no case specifically supporting, either directly or by analogy, an argument that the existence of an operating agreement can help the members of single-member LLCs resist veil-piercing.  However, such an agreement certainly can’t hurt.  And it’s one more consideration, even if not a compelling one, for the members of single-member LLCs to pay the modest legal fees that LLC lawyers are likely to charge for a well-designed operating agreement.

3)     I believe the above argument may have particular force in the case of single-member LLCs whose members are entities.  In a forthcoming post, I’ll explain in some detail why I think so.  However, briefly, the reason is that if these entities clearly define in operating agreements the nature of their duties toward their single-member LLCs and if they comply with these duties, I can’t help thinking that a court will give at least some degree of weight to this compliance in a veil-piercing case—notwithstanding that the court and everyone else knows that the member could amend the agreement and terminate these duties in the blink of an eye.