Category: Entity formation tasks

IF YOUR CLIENT’S NEW LLC WILL OPERATE IN TWO STATES, IN WHICH OF THESE STATES SHOULD YOU FORM IT AND IN WHICH SHOULD YOU REGISTER IT AS A FOREIGN LLC?

By , December 31, 2010 12:05 pm

If your LLC formation practice is like mine, you probably find yourself from time to time having to assist clients in the creation of LLCs that will operate regularly in two different jurisdictions. In this situation, a key threshold question is this: Under which of the two relevant state LLC acts should the LLC be formed; and under which should it be registered as a foreign LLC?

Because I am licensed to practice law both in Massachusetts and in New Hampshire and because my law firm has offices in both states, I regularly address the above question under the Massachusetts and New Hampshire LLC Acts, and I recently published an article in the New Hampshire Bar News comparing the two acts from an LLC formation viewpoint. I realize for many readers of this blog, these two acts won’t be relevant. However, I feel confident that the general guidelines presented in the article may be useful not only to Massachusetts and New Hampshire lawyers but also to readers in other states. You can access the article here.

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.

WHAT LLC BUSINESS ORGANIZATION LAW DO YOU NEED TO KNOW IN ORDER TO BE COMPETENT TO FORM LLCs?

By , 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?

WHAT SHOULD BE THE PURPOSE OF LLC MODEL OPERATING AGREEMENTS?

By , 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.

LLCs AND CHOICE OF ENTITY—THE BIG PICTURE

By , 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.

ATUL GAWANDE, CHECKLISTS AND LLC FORMATION PRACTICE

By , February 25, 2010 8:03 am

Atul Gawande

Several years ago I began developing what I intended to be a comprehensive business entity formation checklist. The list is now included as Exhibit 2-2 in Drafting Delaware LLC Agreements and as Exhibit 5-2 in Drafting Limited Liability Company Operating Agreements. It is the master checklist in these books. You can access it by clicking here.

When I first wrote my checklist, it identified just 10 professional tasks. Now the list is up to 23. I have no doubt that as time goes by, it will continue to grow.

Recently, I read The Checklist Manifesto—How to Get Things Right, a terrific book about checklists by Atul Gawande. As you may know, Gawande is a Boston surgeon who also teaches at Harvard Medical School, is a staff writer for the New Yorker magazine, publishes a best seller every year or so, has a wife and three children, appears on Jon Stewart’s “The Daily Show,” and, apparently, doesn’t need to sleep. Gawande’s photo is on the right. Here are the key ideas in his book:

  • Technical knowledge has become so extensive and complex in most contemporary professions that, when professionals are performing their work, it’s very difficult for them to avoid overlooking critical tasks.
  • However, there’s a remarkably easy and inexpensive way to avoid professional errors: Use checklists!
  • There is overwhelming empirical evidence of the efficacy of professional checklists—above all in the field of surgery and in the prevention of hospital infections, but also in flying airplanes, building skyscrapers, selecting venture capital investments and in many other fields.
  • Despite this evidence, surveys show that surgeons tend to resist the use of checklists in their operating rooms because they don’t think they need them and because they view them as mindlessly mechanical. But although only 80% of surgeons have been willing to use the checklist that Gawande and the World Health Organization developed to ensure safe surgery, 95% of them say that if they were the ones going under the knife, they’d want their surgeons to use it!

I read The Checklist Manifesto with tremendous interest because I found that all of the above ideas and most of the other ideas in the book can be applied in direct and powerful ways to LLC formation practice. In my experience, good checklists are all but indispensable in these formations if you want to avoid important omissions.

But for people like me, who write books about their specializations (and thus also for my readers), I’ve found there’s another huge benefit to checklists: If, once you feel you’ve mastered the topic you’re writing about—e.g., the topic of how to form LLCs or, more narrowly, how to do non-tax choice of entity—you try to reduce your ideas to one or more practice checklists, this will not only enhance the value of your ideas for fellow professionals; it will also almost always force you to expand and improve your ideas.

The proof: If you read my entity formation checklist, I suspect you’ll think of at least one professional task it fails to address. If you do, please send a comment to this blog. LLC checklists need to be social—they need to be the products of LLC lawyer dialogue.