My response is if, as the owner of the company, it is important to you to decide how or who runs your company rather than the state legislators then it is critical for you to create an operating agreement.  Registering the LLC simply puts the public on notice that you intend to do business as LLC and it does not tell the world what rules and procedures you intended for running your company or resolving any disputes.  Even though there is no requirement that you must create an operating agreement.  However, creating one allows the owner the freedom to choose a method for running his/her company rather than legislators dictating the choice.  If there is no operating agreement in place, the courts will apply the default rules meaning the rules that the state legislators selected when they enacted the LLC statute.  Although avoiding application of default rules ought to be important, there are other reasons for creating operating agreement as well such as understandings variations between different entities and clarifying terms between parties.

For example, LLC interests can and do differ in management, capital, profits and losses. Whereas, the law for business corporations mandates that shares of capital stock of the same class or series convey identical rights and preferences. If an investor A pays cash for 1000 units in an LLC but investor B contributes only sweat and equity for 100 units, investor A would receive his cash investment plus preferred return on that capital investment before the profits can be shared on the basis of the number of units each investor/member owns at the time of sale. Thus, unless differences between economic interests are defined in an operating agreement, the members may not realize or have intended the consequences from lack of knowledge and/or understanding.

There are various other reasons for creating operating agreement, which are as follows:
• Whether tax distributions should be made on the basis of the allocation of the LLC’s taxable income or economic sharing percentages?
• What happens when the LLC does not have enough cash flow from operations to make the required distributions?
• What happens if one of the members is foreign citizen? (Of course this list is not meant to be exhaustive)

Harsharn K. Makkar practices Corporate Law in the Atlanta area. She can be reached at 404-200-4072 or hersh@makkarlaw.com.

There are various ways in which a corporate liability can occur. Although there is no one form that protects from all types of corporate liability, some business forms at least limit the liability. For example, if a business owner forms a corporation, the owner can limit his losses from the above mentioned examples to amount invested in the corporation.  In other words, the business owner can protect the personal assets.

State Law

Basic entity types and pros and cons:

1. Sole proprietorship: A kid who sets up lemonade stand to make profit by selling lemonade to his friends and neighbors without taking any formal steps to form a company is a sole proprietor. The pros of this structure are that it is easy to form, it does not require state filings, and there are no documentation requirements such as bylaws or an operating agreement. Thus, the maintenance is simpler than other forms of structures. However, the cons are that this structure does not provide any liability or asset protection. For example, if someone sues, the sole proprietor’s personal assets are at risk. For this very reason this structure should be avoided. Having said that no entity type protects a professional from his or her own professional liability, i.e., an attorney or a physician.

2. Partnership: When two or more persons who associate to carry on as co-owners of a business, they are operating as a partnership. There are several different types of partnerships and the liability and asset protection in each depends on the type of partnership. For example, general partners are jointly and severally liable for all obligations of the partnership, which means if one of the partner files bankruptcy, the other partner is responsible for the bankrupt partner’s share of liability even if the source of those funds is personal assets of the other partner. But limited partners, on the other hand, are only liable to the extent of their share invested in the partnership. In other words, limited partnership shields the personal assets of the partners in a limited partnership. The pros of this structure are that a general partnership is easy to form, it does not require state filings, and there are no documentation requirements. However, the cons are this structure does not offer the best liability and asset protection as articulated above. In addition, if partners do not take the time to decide at the inception of partnership the management, withdrawal, and termination issues, it can complicate dissolution of the partnership.

3. Corporation: A corporation is an entity distinct and separate from its owner. An “S-corporation” is not a separate type of entity rather it is a different method of taxation. In order to form an S-corporation, one must form C-corporation and then select the tax treatment as an S-corporation. A corporation provides an excellent liability and asset protection, which means that a shareholder is not personally liable for the debts/obligations of the corporation, which includes liability stemming from the actions of co-shareholders. In other words, the liability of shareholder is limited to the corporation’s assets not the shareholder’s personal assets. The cons of forming a corporation is that it is one of the most complex entities to form and operate because it requires filing the articles of incorporation with the state’s Secretary of State’s office. It has documentation requirements such as bylaws in addition to annual reports and both directors and shareholder meetings. In other words, it requires high maintenance to preserve this status.

4. Limited Liability Company (LLC): This structure combines the features of a partnership and a corporation, which means that a member of an LLC has liability and asset protection like a shareholder of a corporation without the tax liability that a shareholder suffers. This feature is an excellent reason alone for forming an LLC. In addition, LLC is easier to maintain than a corporation since there is no requirement of maintaining annual meetings, etc. However, the cons of forming an LLC are that it requires state filings, it has documentation requirements such as an operating agreement, and there are annual fees. In addition, an LLC must be managed and controlled according to the operating agreement. If there is no operating agreement in place or the LLC is not managed according to the operating agreement, a plaintiff might be successful in piercing the LLC’s veil, which means the LLC member’s personal assets might be at risk. Finally, it is the newest form of business structure.

Although it may appear that forming an entity is not that complex, it would be a mistake to form an entity without consulting an attorney and an accountant because selecting the right entity that provides you the most liability and asset protection can be complex as well as it could result in you paying more taxes than necessary.