How to Form an LLC or Corporation
Corporations and limited liability companies (LLCs) are legal entities governed by state law. You form these entities by filing articles of organization that met the state's requirements and by paying fees to the appropriate state agencies. These documents describe the entity, identify its owners and provide for a registered agent.
The LLC and the corporation are creations of state law. As such, each state imposes a number of legal requirements must be satisfied to formally establish your business entity. Of course, with each of these filings comes a state fee. These fees vary by state and by company size/structure.
All states require the filing of articles of organization that lay out the specific formal structure of the business. This "blueprint" of the company is filed with the state in which your business will be formed.
If you plan on doing business in a state, but formed your organization in a different state, you may need to file a foreign registration certificate.
To give the state jurisdiction over your business and operations, you will need to name an agent for service of process (usually called the "registered agent.") The initial designation of the registered agent is often part of the articles of organization.
The registered agent is the company's point person in dealing with that state's legal matters. You will need to name a resident for each state in which you do business. There are several businesses that, for a fee, will act as your agent in every state.
While required by law only for a corporation, an operating agreement among the business's owners is highly recommended for all business forms. It clearly spells out the division of ownership, labor and profits, and often heads off disputes among the owners.
Taken together, all of these filings and requirements make up the legal, formal structure of your new business entity.
Anything not addressed in these documents will be covered by a set of default statutory laws instituted by the state.
Before drafting articles of organization or an operating agreement, you should read the state statute that will govern the entity. State statutes can differ significantly. Remember that the statute for the state in which the entity will be formed will govern the entity's internal affairs.
Professional guidance is always recommended. Unfortunately, many small business owners seek legal guidance only after they have created an entity through the filing of articles of organization, perhaps at a point where they are considering an operating agreement. However, certain provisions must be created in the articles of organization, as opposed to the operating agreement (e.g., waiver of a board of directors in a statutory close corporation).
Thus, legal guidance should be sought before the articles of organization are drafted, unless the small business owner has read the applicable state statute and is absolutely sure that he or she has incorporated any necessary or desirable provisions into the articles.
A defectively formed LLC or corporation will be deemed a sole proprietorship if there is one owner, or a general partnership if there are two or more owners.
In either case, the owner or owners will lose limited liability and will have unlimited, personal liability for all of the entity's debts and for the acts of the business's employees.
Because of the possibility of severe consequences, professional guidance is always a good idea when forming a business entity.
Registration Required When Doing Business in Foreign State
Before an LLC or a corporation can do business on a regular basis in a state other than the one in which it was formed (referred to as foreign state), the entity must file a foreign registration certificate with the other state and pay the required fee.
Typically, an entity needn't register in another state if it will be conducting only a few isolated transactions in the state. The foreign registration fee may be the same as, or more than, the fee the state charges to form an entity of that type in the state.
A failure to register as a foreign entity usually does not invalidate the entity or the entity's contracts in that state. However, in a few states, the entity or its contracts may be deemed invalid. And, there are frequently other consequences, such as civil penalties or being unable to institute legal proceedings. Distinguishing states in this respect shouldn't be necessary, as the issue can be avoided simply by registering the entity as a foreign entity in every other state in which it will be doing business.
File Articles of Organization To Create Entity
If you want to do business as an LLC or corporation, you must file articles of organization with the state in which you have decided to form the business. Remember, you are free to form the entity in any state, and not merely in the state in which you live or will be doing most of your business. Delaware and, to a lesser extent, Nevada have emerged as popular sites for business formation.
When a corporation is being formed, a statutory close corporation usually will be a better choice than a conventional corporation. The statutory close corporation must be formed by way of specialized articles of organization.
These specialized articles specifically use the language required by the particular state's close corporation statute. Not all states permit the formation of a statutory close corporation.
When forming an LLC, a formal document known as the "Articles of Organization" must be filed with the state. In the case of the corporation, the required document is usually termed "Articles of Incorporation."
Commonly required information. While each filing is unique to itself, there are a number of common elements that, at a minimum, make up standard articles of organization:
- name, principal location and purpose of the business
- agent for service of process
- classes of ownership interests
- initial managers and owners
Standard forms for the articles of organization (for an LLC, statutory close corporation or conventional corporation) are available from each state. The business owner can fill in the necessary information on the form. Ideally, however, the articles of organization for an LLC or a corporation will be tailored to the business owner's specific requirements. No two situations are identical.
The entity legally comes into existence when the Articles are accepted by the state. Thus, it is important to be able to prove, if necessary, that the Articles were filed. The state will return a stamped copy of the articles. The stamp will note the effective date of the formation of the entity. For an additional fee, the state will return a certified copy of the articles.
A Records Kit can be purchased with pre-printed ownership certificates. One copy of the stamped (or certified) articles should be kept in the entity's Records Kit. Another copy of the articles should be kept in a separate secure location. The entity should issue ownership certificates to the owners and record the issuance, including the consideration received in return, in its Records Kit and its accounting records.
Entity Name Must Meet Legal Requirements
Nearly all states require that the legal name of a limited liability company use the initials "LLC," or some derivation thereof, as prescribed in the state's LLC statute. Similarly, the legal name of a corporation must include the abbreviation "Inc.," or a similar term, as prescribed by the state's corporation statute.
If there is the possibility that another entity in the area may be using an identical or similar name, the owner can, for a small fee, have the state's corporations office conduct a name search. A name also can be reserved for a limited period.
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Assumed Name. An LLC or a corporation may operate under a different name, which is termed a "fictitious" or "assumed" name. States also have rules that govern the selection of assumed names.
Usually, states prohibit the use of certain terms in an assumed name. For example, usually the terms "LLC" or "Inc.," which are required in the legal name, cannot be used in the assumed name. The use of terms that refer to a financial institution (such as "bank") usually are prohibited (unless, of course, the entity is a separately licensed financial institution).
The laws in each state are unique in this regard. For this reason, the business owner should always check the statutes in the state in which the entity will be formed and the states in which it will be doing business.
Typically, the business owner must register the assumed name with the state or with the county recording office in which the entity will be doing business. States charge a separate fee for the registration of an assumed name.
Trade Name as Intellectual Property. The business owner who is sure that the legal and assumed names selected are unique may want to simply use the selected names in the articles of organization and the assumed name registration. However, the name of a business entity, which is termed a trade name, is protected as a type of intellectual property.
You Must State Principal Location and Business Purpose
The principal place of business is, of course, the primary city and state in which the business will conduct its operations. However, after registering this location, nothing prevents the entity from conducting operations elsewhere.
A detailed description of the purpose of the business usually is not required. In fact, the articles of organization forms in some states have pre-printed language that covers every situation. For example, the form might state that the business will be conducted "for any lawful purpose."
When a more detailed description is used, the generic or catchall phrase "any other lawful purpose" should be used in addition to the detailed description.
Designating Registered Agent Is Critical
Every state requires that a corporation or LLC formed or doing business in the state designate a "registered agent." The registered agent serves as the company's point person in legal matters regarding the state and for service of process on your business. (Service of process refers to the delivery of a summons and complaint, which is the required way of initiating a lawsuit.)
Generally, a state will have personal jurisdiction over a party only if the party is served with the summons and complaint within the geographical boundaries of the state.) Having a representative of your company physically located in the state allows the state to seal its jurisdiction over your business and its operations.
By naming a resident agent in the state, the entity is, in effect, consenting, in advance, to the state's assertion of personal jurisdiction over the entity, in the event of a lawsuit in that state. To sue the entity in the state, a plaintiff merely has the summons and complaint served on the resident agent, who then mails a copy to the entity.
The registered agent must be a resident of that state, but can be an individual or an entity. The agent must be named in the articles of organization. If you are a resident of the state, the entity can simply name you as the agent for service of process.
If the entity is formed or does business outside of your home home state, you will have to locate a resident agent.
Numerous organizations exist that provide this service. Many companies that provide incorporation services also serve as agents for purposes of service of process. The fees charged vary, but should be substantially less than $300 a year.
Attorneys who form corporations may also act as agents for service of process. Attorneys might tend to charge a somewhat lower fee for serving as registered agent because of the likelihood that they will get the business if process papers are served that require legal action. In some states (e.g., New York), the owner can name the secretary of state's office as the resident agent.
Articles of Organization Must State Ownership Interests
If you are forming a corporation, the articles of incorporation must indicate the classes of shares that exist, and the number of shares within each class that are authorized. In addition, the articles must state whether the stock has a par value.
If you intend to make an S corporation election, then you must make sure that you do not provide for multiple classes of stock in you your articles of organization. While voting/non-voting distinctions are permitted, an S corporation can have only one class of stock.
Par value. Par value is an arbitrary amount per share representing the minimum the corporation can receive in return when it issues the stock. The amount paid in for par value stock represents what is termed the corporation's minimum or legal capital.
A corporation cannot legally make a distribution to the owners based on their ownership interests (i.e., a dividend, or redemption of shares) that impairs this minimum or legal capital. Distributions can be made to the owners in ways not subject to this restriction. The most common example is a salary paid to the owners for services rendered on behalf of the entity.
Corporations are not required to issue par value common stock. They can issue "no par value" stock. In this case, the entire amount paid in for the shares represents the minimum or legal capital, unless the corporation sets aside a portion of the proceeds within a certain period (e.g., 60 days).
Bear in mind that many states impose a franchise tax that is based on the number of shares of stock authorized by the corporation. In the case of "no par value" stock, these states set a value for taxation purposes, which ranges from a few pennies to over five dollars.
Whether you assign a par value to the shares or issue "no par" stock, you must be able to prove that the corporation was adequately capitalized. Undercapitalization can form the basis for piercing of the veil of limited liability. For this reason, in most cases, no amount is set aside from legal capital when no par common stock is issued.
Par value has no relationship to fair market value. Fair market value represents the true value of the shares, which is based on the value of all of the entity's assets, less its liabilities. Par value, as described above, is an arbitrary amount per share selected by the owners. Its only significance relates to the concept of minimum or legal capital.
LLCs Need Not State Classes of Members
Generally, there is no requirement that an LLC describe different types of ownership interests in its articles of organization. Instead, consistent with the theme of simplicity that governs LLCs, this is accomplished in the LLC's operating agreement.
In addition, the concept of par value does not exist in the LLC, although there are similar restrictions on distributions to owners of an LLC based on their ownership interests. These restrictions also can be avoided through the payment of salary to the owners.
Generally, the LLC is a simpler business form, as compared to the corporation. Thus, many arrangements, including the designation of nonvoting interests, in the LLC can be controlled by way of the operating agreement, rather than the articles of organization.
This especially simplifies the operation of the LLC because the operating agreement is not filed with the state. Thus, a modification of the operating agreement also does not have to be filed with the state. So if you wish to restructure your business by using nonvoting ownership interests, which are desirable for estate planning purposes, the LLC form allows you to make this change more simply and easily.
While not required, it may be desirable to designate classes of ownership interests in the articles of organization for an LLC, as a form of constructive notice. Because the articles are filed with the state and constitute a public document, their contents will be presumed to be public knowledge.
This same practice also can be followed with other matters not required by LLC statutes to be designated in the articles of organization. Of course, any advantage here must be weighed against the fact that changes to the articles of organization (but not the operating agreement) will require a filing with, and payment of a fee to, the state.
Identification of Initial Managers, Owners Required
Articles of organization for a corporation usually require that the business owner list the initial management structure (that is, the names and addresses of the initial officers and directors), in addition to the initial owners.
State corporation statutes differ as to the number of directors and officers required. The modern view allows the owner to use one director, or waive the board of directors altogether in a small corporation, and to designate such officers, if any, as desired by the owner. Delaware and Nevada follow the modern view.
States following the more traditional view sometimes require a minimum number of directors, even in a small corporation. This number usually is equal to the number of shareholders, but typically no more than three directors are required. These states also require a minimum of two officers (a president and a secretary). In some of these states, the two officer positions must be held by two separate individuals. In others, one individual may assume both roles. If you are forming a corporation in a state other than Delaware or Nevada, check with the state's corporations office before deciding on the management structure for the corporation.
Statutory Close Corporations. The statutory close corporation can waive the requirement for management by a board of directors and instead assign the duties normally performed by the board to the voting shareholders (or some other group). This is desirable because it simplifies the management structure of the corporation. Note that this must be accomplished in the articles of incorporation, although the operating agreement will reinforce this arrangement.
The state's usual rules regarding corporate officers (see above) apply to the statutory close corporation. In addition, a statutory close corporation can forego the requirement for a board of directors, but the waiver must be included in the articles of incorporation.
Moreover, in most states that permit statutory close corporations, the articles of incorporation must:
- restrict ownership of the entity to a limited number of shareholders (30 or 50, depending on the state)
- subject the ownership interests to a buy-sell agreement
- prevent the corporation from making a public offering of its stock
The Secretary of State's website usually contains sample forms, including those necessary to create a statutory close corporation. The forms include these required provisions.
LLCs Must Disclose Initial Owners
Articles of organization for a limited liability company (LLC) usually only require the listing of the names and addresses of the initial owners of the business. Some states also require that the articles of organization for an LLC indicate its management structure (i.e., whether the LLC will be member-managed or manager-managed). In the latter case, the names and addresses of the initial managers usually must be listed. A manager-managed LLC can facilitate the use of the LLC as an estate planning device.
Governance Varies Between LLCs and Corporations
In a corporation, the owners are called shareholders. A conventional corporation is managed by a board of directors and officers. The officers are hired by the board of directors and make all of the day-to-day management decisions.
The board sets the compensation of the officers and oversees the officers as they perform their duties. The board also makes all of the larger financial decisions, such as whether to issue additional common stock or declare a dividend. Directors usually serve for one-year terms in a small corporation.
Initial directors (and officers) usually are named in the articles of organization. Subsequently, directors are elected by the shareholders.
Directors and officers also differ in another important respect. Officers are individual agents of the corporation, while directors must act as a group, through majority vote, at a duly constituted meeting or through a unanimously signed written waiver (see below).
In the statutory close corporation, usually there is no board of directors, and the voting shareholders assume the role of the board.
LLCs Can be Member-Managed or Manager-Managed. In contrast, in an LLC, the owners are termed "members." If no election is made in the articles of organization to make the LLC manager-managed, the presumption is that the LLC is member-managed. In this case, every owner, or member, is deemed a manager, and thus an individual agent of the LLC. In this respect, the member-managed LLC resembles a general partnership.
In a manager-managed LLC, a select group of members are designated as managers. (Managers do not need to be members.) A manager-managed LLC is often desirable for estate planning purposes or where certain members will be passive investors.
In a manager-managed LLC, the members who are not managers have no management authority. However, provided that they hold voting member interests, the non-manager members still can vote on a limited number of issues, including selection of the managers, amendments to the articles and operating agreement, dissolution of the LLC, etc.
Usually, the LLC can assign its managers titles traditionally associated with officers in a corporation (i.e., president, vice-president, secretary and treasurer). One manager also can be designated a representative for tax matters, as permitted under the Internal Revenue Code. All of these designations are accomplished in the operating agreement.
Formation Requirements and Impact of State Law
Other legal issues related to entity formation must be considered. In particular, the owner should determine whether he needs a license to conduct the business, whether the business can be operated at its intended location under local planning and zoning laws (especially important if it is a home-based business), and whether contracts with consumers must take a particular written form.
State laws vary widely in these respects. The state's consumer protection department or a professional organization (e.g., a contractors' association) usually can provide information on any special requirements that must be met for consumer contracts.
IRS Employer Identification Number. After establishing the business entity, you must apply to the Internal Revenue Service for an employer identification number (EIN). This is the identification number the business will use on all of its bank accounts, as well as on all of its income and employment tax filings. In addition, in each state in which the entity will be doing business, you will have to apply to the state's tax department for a sales tax identification number and register with the state's labor department.
Develop a business plan. It is essential to develop a sound business plan. The business can be adequately and carefully funded only if projections are made of the required resources. These types of projections also are essential if the entity is to avoid an accusation that asset transfers from the business to the owners were fraudulent. Similarly, these projections are important in defeating allegations that the entity was fraudulently capitalized.
State Law Varies Regarding Authority to Act on Entity's Behalf
The law is not always clear when it comes to division of authority within an entity. Some issues must be decided by the owners (i.e., shareholders or members), while other issues are within the control only of the entity's managers.
It is not uncommon for an action to be authorized by the wrong group, thus making it unauthorized. Creditors can capitalize on improper authorizations in two ways. Creditors may be able to invalidate a particular action, such as the withdrawal of funds from the entity by the owners. In addition, improper authorizations can be used to pierce the veil of limited liability.
In some states, absent a provision to the contrary in the operating agreement for manager-managed LLC, members who are not managers are still deemed to be agents of the LLC, with the power to bind the LLC to contracts.
It is therefore wise to provide in the operating agreement that non-manager members are not agents of the LLC. This, of course, is one example of why an operating agreement is desirable.
In a member-managed LLC, every member (i.e., owner) also is a manager. Thus, if all members sign an authorization, its validity cannot be challenged on the grounds that the authorization had to be signed by the managers. The members and managers are one single group.
However, it often is desirable to form a manager-managed LLC and have the LLC issue nonvoting member interests to the non-managers. The voting members should be designated as the managers. In this way, once again, there is a single group (i.e., the voting members/managers). Thus, an authorization unanimously signed by this group is beyond challenge on the grounds that it was authorized by the wrong group.
The articles of organization should note that the LLC is to be manager-managed. The operating agreement then reinforces this fact and divides member interests into two classes: voting and nonvoting. Therefore, to prevent confusion, it is important in a manager-managed LLC that any non-managers hold nonvoting member interests.
If the non-managers hold voting member interests, confusion may arise because the voting members will have rights to vote on all issues, except management issues.
The dividing line between management issues and non-management issues is not always clear under state LLC statutes. If the owners do decide to issue voting member interests to non-managers, it is especially imperative that the state statute be scrutinized to determine the proper lines of authority between the two groups (i.e., the members and the managers).
Similarly, in a statutory close corporation, the articles of incorporation can create two types of common stock, voting and nonvoting, waive a board of directors and assign management duties to the voting shareholders. In this way, there is only one group, and the issue of improper authorization should not exist when that one group unanimously signs an authorization.
Understanding Default Statutory Rules Affecting Entity Choice
When forming an LLC or corporation, care must be taken by all owners to consider all aspects of the business and put agreements in writing. In certain cases, absent contrary provisions in the articles of organization or the operating agreement, state statutes apply default rules. These default rules are not always desirable.
Management authority. By default, an LLC is member-managed, and a statutory close corporation is managed by a board of directors. In addition, the presumption for both entity types is that all of the owners hold voting interests and divide profits and losses according to their relative ownership interests. It is often desirable to modify each of these default rules and incorporate them into your articles of organization or operating agreement.
In many cases, the state statute simply will provide no rule whatsoever. This invites disputes among the owners and slip shod management of the entity, which could lead to piercing of the veil of limited liability. For example, state LLC statutes do not cover an extremely important issue--disposition of ownership interests. It usually is desirable to prevent an owner from selling his interest to an outsider.
Deposition of interests. Absent a buy-sell agreement, an LLC owner is free to dispose of his interest as he sees fit. While the transferee of an LLC interest cannot become a full-fledged owner with voting rights without the other owners' consent, a transfer to an outsider can still disrupt the entity's operations.
In the statutory close corporation, the transferee becomes a full-fledged owner without the consent of the other owners. While the statutory close corporation is compelled by state statute to adopt a buy-sell agreement, the actual agreement can take different forms. The owners of the entity control how this is actually executed.
Dispute resolution. In addition, absent a provision in the operating agreement to the contrary, the parties are free to resolve disputes among themselves by way of a court proceeding.
Mediation and arbitration usually are better alternatives to a court proceeding because they are much less expensive and less time consuming. However, mediation and arbitration are consensual. In other words, the parties to the dispute must agree to use mediation and arbitration, in lieu of a court proceeding. The best place to do this is in the operating agreement, which is executed before disputes arise.
Indemnification. Also, state statutes generally allow an LLC or a corporation to indemnify the entity's managers for losses that they incur while carrying out the entity's business. Indemnification is an important adjunct to the use of insurance. The statutes merely authorize the entity to include an indemnification provision in its operating agreement. The operating agreement (or bylaws in a conventional corporation) must take advantage of this opportunity and actually provide for indemnification.
Other governance issues. Other issues may be adequately addressed in state statutes, but often it is advantageous to repeat the statutory language in the operating agreement. So, if a state statute is later amended, but the previous statute is written into the agreement, the owners do not have to be concerned that a new, and perhaps unknown, rule now governs the business's affairs. The existing rule in the operating agreement would remain valid.
For example, default rules usually mandate that a conventional corporation hold, at a minimum, annual meetings of shareholders and directors. A waiver of a board of directors in the statutory close corporation, of course, eliminates the need for annual meetings of the board of directors.
LLC statutes are more informal, mandating that certain actions need to be approved by the voting members, and that management decisions be approved by the voting members or the voting managers in a manager-managed LLC. However, usually LLC statutes are silent on the issue as to how frequently either group must meet.
Both the LLC and statutory close corporation (as well as a conventional corporation) can, according to state statutes, take action without formal meetings. Any action that would have been taken at a formal meeting may, instead, be accomplished through the execution of a written document, which is unanimously signed by the particular group that had authority over the issue (e.g., the shareholders or members). The notice requirement for meetings also is automatically waived, simply by way of execution of the document.
Though this type of waiver is authorized by state statutes, the language from the particular state's statute should be incorporated into the entity's operating agreement. This should eliminate problems that might arise should the statute be amended. The owners of an entity certainly don't want to discover, in the midst of a financial crisis for example, that they were operating under older statutory provisions that had been replaced.
In addition, the incorporation of statutory provisions into an operating agreement gives the owners firm guidance on the rules that govern the entity. As questions arise, the owners are far more likely to refer to the operating agreement, as opposed to the state statute.
Paying State Organizational Fees
Each state charges a fee for creating an LLC or corporation in the state. Each state also charges a fee when a foreign entity registers to do business in the state (see our discussion about choosing a state).
Each state has a minimum fee that it charges for the formation of a corporation. Most states now charge a flat but, but in some states the fee still is based on the number of shares the corporation is authorized to issue. In those states, a business owner who wants to pay the minimum fee to form a corporation must select the corresponding number of authorized shares.
With an LLC, the state formation fees are not based on the number of ownership interests. Instead, states usually charge a flat fee. This flat fee typically is lower than the minimum fee that states charge to form a corporation.
A registered agent for service of process is necessary when a business entity is formed. While the initial fees is usually "bundled into" the initial formation fees, there is usually an ongoing annual fee that averages about $75.
LLCs. A few states (New York, Nebraska and Arizona) require that the articles of organization (or a foreign registration) for an LLC be published in a newspaper. New York, for example, requires that the articles, or foreign registration, be filed each week, for six weeks, in two different newspapers.
Fees for publication can be extreme. In some cases, publication fees can amount to $1,000-$2,000. If you will be forming an entity in one of these states, or registering to do business there, first obtain an estimate on the cost of publication, and consider using a statutory close corporation in lieu of an LLC.
Corporations. Four states, Arizona, Georgia, Nebraska and Pennsylvania have publication requirements for corporations. Thus, in Arizona and Nebraska, articles of incorporation must be published regardless of whether the entity is an LLC or a corporation.
Guidelines for issuing corporate shares. A corporation does not have to issue all of its authorized shares, but you should carefully consider how many to authorize, because any changes require that an amended articles of organization--and a fee--must be submitted to the state. Follow these guidelines, in deciding how many shares to issue.
Don't issue too few shares. Don't issue too few shares (e.g., one share) because this could make the subsequent raising of capital problematic. For example, in a one-owner corporation, one share or 1,000 shares would both represent 100 percent ownership. However, if only one share were issued, and the original owner subsequently sought to raise additional capital from others, he would be forced to purchase some of the additional shares, or perhaps lose control of his corporation.
Don't issue all authorized shares. On the other hand, don't issue all of the authorized shares. Otherwise, if the original owners subsequently sought to raise additional capital from others, he would be forced to draft and file an amendment to the articles of organization with the state of formation, along with a required fee.
Thus, for example, if 5,000 shares were authorized, in a one-owner corporation, an issuance of 1,000 shares to the owner would represent a sound choice. (Note that 1,000 shares may be represented by a single stock certificate).
Dividing Ownership LLC Ownership Interests
In the LLC, while the concept of authorized shares does not exist, a similar strategy can be employed. It is advisable to divide LLC ownership interests into "shares." The original owner could receive, say, 1,000 shares for his investment. Subsequently, to raise capital from others, he could issue additional ownership shares, without significantly diluting his ownership interest.
If you are forming the business entity on your own, contact the state's department of corporations before sending the articles and the formation fee.
States charge various other fees, for things such as recording the articles in the county recording office. In addition, the business owner may want certified copies of the articles or expedited service. States charge additional fees for these services.
Buy-Sell and Operating Agreements Are Highly Useful
Generally, articles of organization are the only documents that are necessary by law to create an LLC or a corporation. However, the small business owner should not be misled into thinking that these are the only documents necessary to form a sound business venture! The small business owner operating an LLC or a statutory close corporation should also have an operating agreement and a buy-sell agreement.
As noted earlier in this discussion, these documents allow the business owner to control such things as voting, management, division of profits and disposition of ownership interests.
In a conventional corporation, bylaws, which serve as the operating agreement, are required to be included with the Articles of Incorporation. In this case, the buy-sell agreement will be a separate document from the bylaws.
In a closely held corporation, a shareholder agreement, which includes a buy-sell agreement, typically is used along with the bylaws.
Many small business owners never adopt an operating agreement, bylaws or a buy-sell agreement. This is a mistake!
Absent an operating agreement, the opportunity to control voting, management structure, profit sharing, etc., is lost. In addition, this may be an even more dangerous mistake from an asset protection perspective.
Impact on statutory close corporation.In the case of a statutory close corporation, a failure to adopt an operating agreement may have the same unfortunate consequences as a failure to adopt bylaws in a conventional corporation.
Moreover, articles of organization for a statutory close corporation must make the ownership interests subject to a buy-sell agreement. This condition usually is satisfied by incorporating a buy-sell agreement into the operating agreement. Thus, a lack of an operating agreement could mean that the statutory close corporation is invalid.
Impact on LLC.The majority of states do not require an LLC to adopt an operating agreement. This is consistent with the informal operating rules that apply to the LLC. Nevertheless, an LLC operating agreement provides the owners with formal guidance on issues such as voting, management and division of profits.
Without this guidance, it is much more likely that disputes among the owners will arise and that piercing of the veil of limited liability will be applied by the courts.