Category: Single-member LLCs

WHAT SHOULD BE YOUR GOALS IN DRAFTING THE OPERATING AGREEMENT OF A “SUBSIDIARY SINGLE-MEMBER LLC”?

By , December 22, 2010 9:13 am

In the last post in this blog, dated November 27, 2010, I discussed the potential business asset protection value for many privately owned companies that presently hold their assets and conduct their business through a single entity of adopting a new two-entity parent/subsidiary structure. In this restructuring, the subsidiary should be a single-member LLC taxable as a “disregarded entity.”

In implementing this restructuring, what should be your goals in drafting the operating agreement between the parent and the single-member LLC? I suggest you should have the two main goals summarized below:

1. You should draft the operating agreement so as to provide the parent company and its owners and relevant employees with a clear and comprehensive statement of the legal and tax structure of the single-member LLC, including, especially, its financial and management structures. This statement will be indispensable to the single-member LLC’s managers in administrating and operating the LLC. It may also be indispensable in dealing with third parties that deal with the single-member LLC, such as federal and state tax auditors and potential lenders.

2. To minimize the risk of veil-piercing, you should make clear in the operating agreement the essential separateness of the parent and the single-member LLC. The operating agreement can do much to accomplish this goal—e.g., by documenting the compliance of the LLC with the anti-veil-piercing “adequate capitalization” requirement and by providing in its management provisions that all day-to-day decisions of the single-member LLC will be made by its own internal managers and not by the parent.

However, it may be also be useful for this anti-veil-piercing purpose to formalize, in the operating agreement or in separate intercompany agreements, all other arrangements between the parent and the single-member LLC—e.g., arrangements, if any, for centralized accounting and marketing.

USING SINGLE-MEMBER LLCs TO CREATE PARENT/SUBSIDIARY STRUCTURES

By , November 27, 2010 4:17 pm

Protecting business assets through parent/subsidiary structures—overview. As a general rule, business entities that own valuable business assets and conduct business operations that could lead to third-party claims should not conduct these operations directly.

Rather, unless there are significant considerations to the contrary, it should hold these assets directly but should conduct its operations through a wholly owned subsidiary entity, and it should lease, lend or license its assets to this subsidiary. Under a properly structured parent/subsidiary structure of this kind, if the subsidiary’s operations give rise to a third-party claim, the parent, if it has not participated in the subsidiary’s operations, should not be subject to the claim and its assets should not be at risk for the claim.

Companies that decide to create parent/subsidiary structures must choose between two types of entities as their subsidiaries—namely, single-member LLCs and single-shareholder corporations. In most cases, the better choice is single-member LLCs. These entities, like single-shareholder corporations, can provide their parents with a strong statutory liability shield. However, because single-member LLCs are subject to no significant statutory formalities, they are simpler to manage than single-shareholder corporations (which are subject to numerous such formalities) and they face a lesser risk of veil-piercing than single-shareholder corporations.

In addition, under applicable default statutory rules, the very simple management structures that can be provided for in the operating agreements of single-member LLCs owned by entities is generally much more user-friendly than the default statutory management structure of single-shareholder corporations.
Illustration. To illustrate the parent/subsidiary structure outlined above:

XYZ, Inc. manufactures and sells widgets. Its annual gross sales receipts are $20 million. It owns tools, vehicles and equipment (its “Hard Assets”) worth $5 million; it owns valuable patents, trademarks, copyrights and trade secrets (its “Intellectual Property”); it has average receivables during its fiscal year of about $ 1million; and it maintains in its bank account about $1 million as operating capital.

As long as XYZ’s board is willing to accept the modest additional complexities involved in operating through a subsidiary rather than through XYZ as a single unitary entity, XYZ should restructure itself as follows:

• It should create a single-member LLC (“XYZ Operations”—
which I’ll refer to here simply as “Operations”) to conduct
all of its product design, manufacturing and sales
operations.

• It should lease its hard assets to Operations.

• It should license its Intellectual property to Operations.

• It should lend to Operations the operating cash that
Operations needs.

Finally, in order to document its separateness from Operations and thus to minimize the risk of claims from business activities of Operations, XYZ should formalize all of its significant relations with Operations in written agreements that contain arm’s-length terms. These agreements should include a lease agreement; a licensing agreement; a loan and security agreement; a licensing agreement; and, last but not least, an operating agreement governing the relationship between XYZ as the parent of Operations and Operations as its subsidiary.

The operating agreements of single-member LLCs owned by entities. What should be the goals of the operating agreement between XYZ and XYZ Operations? I will address this question in my next post in this blog.

HOW TO CHOOSE THE RIGHT MANAGEMENT STRUCTURE FOR A SINGLE-MEMBER LLC OWNED BY AN INDIVIDUAL

By , November 20, 2010 10:54 am

In my experience, there are three—and only three—management structures likely to be useful to individuals who form single-member LLCs. These are (i) management by the individual; (ii) management by the individual together with one or more assistant managers; and (iii) management by a third party. (Needless to say, if you have a different view about this issue, I would be grateful to hear from you in a comment on this post.)

In forming a single-member LLC for an individual, how should you, as an LLC lawyer, choose among these three management structures? The choice will generally be an easy one.

• Single-member LLC whose only manager is its member. If, under your client’s articles of organization or other statutory formation document and under the governing operating agreement, you form your client’s LLC as a “member-managed” single-member LLC, this arguably means as a matter of LLC statutory law that only the member may sign contracts and take other management actions on behalf of the LLC. This, in turn, may mean as a matter of law that if, because of death, illness or other causes, the member is unable to act as the LLC’s manager, no one can so act. In other words, it may mean that the LLC completely lacks continuity of management; and more particular, in the case of the death of an individual who is the member of single-member LLC, it may mean that the LLC may be managed only under the direction of a probate court. .

• Single-member LLC with a member-manager and a non-member assistant manager. Thus, to provide for continuity of management in a single-member LLC whose member is an individual, (i) you should provide in the governing articles of organization or equivalent document (if you are required to state the LLC’s management structure in this document) that the LLC is manager-managed; and (ii) in the LLC’s operating agreement, while appointing the member as the LLC’s member-manager, you should also appoint a third party trusted by the member (who will often be the member’s spouse) as a non-member assistant manager. And you should make clear in the operating agreement the precise circumstances in which this assistant manager will have authority to manage.

• Single-member LLC whose only manager is a non-member manager. However, it may sometimes happen that an individual who is the member of a single-member LLC does not want to manage the LLC. This may occur, for example, if the member holds real property in the LLC and does not want property management responsibilities or liabilities.

In this situation, you should provide in the articles of formation (i) that the LLC is manager-managed; (ii) that the member is a non-manager member; and (iii) that the only manager of the LLC is a specified third- party non-member manager. (But you should also normally provide that the member may replace this manager at will.)

LLC CHARGING ORDER PROTECTIONS–JUNE 29, 2010 SEMINAR

By , 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.

TAX CHOICE-OF-ENTITY TABLES

By , 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.

SINGLE-MEMBER LLC OPERATING AGREEMENTS AND THE ISSUE OF VEIL-PIERCING

By , 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.

WHY SINGLE-MEMBER LLCs NEED OPERATING AGREEMENTS

By , April 13, 2010 3:57 pm

In my last post, I summarized a number of arguments sometimes made by lawyers and legal scholars and even by clients for the proposition that single-member LLCs don’t need operating agreements.

All of those arguments are plausible.  However, for most single-member LLCs, the arguments for the opposite position are stronger.  In this post, I’ll briefly state these arguments as applicable to single-member LLCs whose members are individuals; but essentially the same arguments apply to single-member LLCs whose members are entities.

1)     The need for written operating agreements to trump LLC statutory provisions that are inappropriate for single-member LLCs whose members are individuals.  LLC acts are written primarily for multi-member LLCs, and many of their mandatory and default provisions are inappropriate for single-member LLCs whose members are individuals.  These include, for example, the mandatory provision in almost all LLC acts that LLCs cannot exist as legal persons unless they have at least one member; the default provision in almost all acts that LLCs are managed by their members; and the default provisions in most or all acts that members shall be dissociated (i.e., their memberships shall terminate) if they become bankrupt or incompetent or if they assign their entire LLC interest to other persons.

In subsequent posts, I will explain why these and other typical LLC statutory provisions can do fatal damage to single-member LLCs whose members are individuals.  For now, suffice it to say that the only fail-safe means to avoid this damage is through written operating agreements.

2)     The need for written operating agreements as users’ manuals.  Operating agreements for single-member LLCs whose members are individuals can, if they are comprehensive, well-organized and written in plain English, serve as invaluable “users’ manuals” providing these members with a clear idea of the nature of their LLCs before they form them and with practical operating instructions once they have launched them.  In my experience, clients don’t like to have to think of their LLCs as black boxes; they want to understand them and they want to know how to administrate them.  For this, they need well-designed written operating agreements.

3)     The need for written LLCs in dealings with third parties.  Operating agreements can greatly facilitate relations between, on the one hand, an LLC and the individual who is its member; and, on the other, third parties such as banks, parties to business transactions with the LLC and tax authorities.  All of these third parties are likely from time to time to ask individuals who are members of single-member LLCs for legally valid documentation concerning, for example, the identities of persons with authority to bind their LLCs and concerning the tax and financial structures of these LLCs.  Written operating agreements provide this documentation.

In short, drafting written operating agreements for your single-member LLC clients isn’t just good business for you as an LLC lawyer; these agreements can also provide invaluable legal and tax tools to your clients.

DO SINGLE-MEMBER LLCs NEED OPERATING AGREEMENTS?

By , April 5, 2010 11:38 am

There are currently about 9 million U.S. LLCs in good standing.  IRS filing statistics suggest that about 3 million of them are single-member LLCs.  Perhaps 95% of these single-member LLCs are owned by individuals and 5% by entities.

Do these LLCs need operating agreements?  Indeed, does the concept of operating agreements for single-member LLCs even make sense?

These questions are important, since, among other considerations, if single-member LLC operating agreements really are legally meaningful and of practical utility to clients, they should constitute a legitimate and profitable little line of business for LLC lawyers.  In my view, it’s legitimate for lawyers to charge between $500 and $1,000 for drafting operating agreements for single-member LLCs owned by individuals and significantly more for those owned by entities.  But obviously, if single-member LLCs aren’t legally meaningful, then charging clients for drafting them would be unethical.

It’s often argued by reputable LLC lawyers and scholars that operating agreements for single-member LLCs don’t make sense.  This is because, by definition, the members of single-member LLCs totally dominate their LLCs.  Thus, arguably, there can be no meaningful offer and acceptance between a single-member LLC and its member and thus no legally meaningful contract between them.

Furthermore, even assuming that single-member LLC operating agreements can somehow be legally valid, what possible purpose can they serve?  Stated otherwise:  Who ever heard of a shareholder agreement between a single-shareholder LLC and its owner?  So why might single-member LLCs need operating agreements?

I believe that the above arguments, though plausible, are wrong, and I believe that most single-member LLCs need operating agreements.  In my next post, I’ll explain why.

WHAT LLC FORMS DO YOU NEED FOR SINGLE-MEMBER LLCs WHOSE MEMBERS ARE INDIVIDUALS?

By , February 25, 2010 12:42 pm

WHAT LLC FORMS DO YOU NEED FOR SINGLE-MEMBER LLCs WHOSE MEMBERS ARE INDIVIDUALS?

IRS statistics indicate that about one-third of all U.S. LLCs consist of single-member LLCs whose members are individuals.

This statistic is not surprising. People love being their own bosses.

That is why there are over 25 million U.S. single-owner businesses owned by individuals. Most of these businesses are, from a business organization law viewpoint, state-law sole proprietorships. But many as 3 million are single-member LLCs. And since the owners of single-owner business that have third-party employees need liability shields, millions of single-owner businesses owned by individuals that operate as sole proprietorships ought to operate as single-member LLCs.

So there’s a lot of potential business out there for LLC lawyers who are properly equipped to form single-member LLCs.

If you’re an LLC lawyer, what model operating agreements (“forms”) do you need in order to be fully equipped to form these LLCs?

I would answer this as follows:

  • All operating agreements for single-member LLCs whose members are individuals contain numerous provisions that are essentially identical from one single-member LLC to another. These include, for example, introductory provisions concerning the name, taxable year and method of accounting of the LLC and provisions about contributions, allocations and distributions.
  • However, these LLCs differ from one another with respect to two critical LLC structures—their management structure and their federal tax structure.
  • Single-member LLCs whose members are individuals can have any of three main management structures—(i) a structure in which the member is also the manager; (ii) a structure in which the member is the manager but in which there is also a non-member assistant manager who can manage the LLC if the member is unable to do so because of death, injury or otherwise; and (iii) a structure in which the member doesn’t want to manage the LLC, but rather, appoints a non-member to manage it.
  • In theory, single-member LLCs whose members are individuals can also have any of three main federal tax structures—(i) a sole proprietorship structure; (ii) taxation under Internal Revenue Code (“IRC”) Subchapter C; and (iii) taxation under IRC Subchapter S. However, because Subchapter C is a double-tax regimen, it almost never makes sense as the federal tax structure for a single-member LLC whose member is an individual. Thus, in practice, single-member LLCs whose members are individuals should normally be taxable only as sole proprietorships or as S corporations.
  • The bottom line: In order to be fully equipped to form single-member LLCs for individuals, you need forms for LLCs with any of three possible management structures and two possible federal tax structures. Since three times two is six, this means you need six forms. For a table identifying these forms, here.

Does my reasoning about the forms you need in order to form single-member LLCs for individuals make sense to you? Am I missing anything?