Often, I’m asked what is needed to organize a limited liability company (LLC), how much it will cost, and whether an attorney is really needed to do so. With the hundreds of incorporation companies advertised online, legal self-help sites like LegalZoom, and various how to guides online, many people have the notion, for better or worse, that they can save time and expense by setting up an LLC on their own. When making the decision to organize your business as an LLC, it is important to thoughtfully consider: (1) whether an LLC is the correct entity type for your business; (2) the specific circumstances, goals, and requirements of your business; (3) the process involved in properly organizing an LLC; (4) the risks and potential liabilities involved with setting up an LLC on your own; and (5) an honest assessment of your own capabilities to decide whether an attorney should be retained.
While it is often tempting to save a little bit of money upfront in setting up an LLC on your own, it is very important to understand that there are often significant risks, including personal liability, in doing so. This post is not intended to scare people into hiring attorneys such as myself, rather, the intent is to help entrepreneurs understand the risks, process, and decisions which should be considered when they’ve decided to set up an LLC. I have chosen to focus on LLCs in this posting, however, please note that many of the ideas and commentary below are equally applicable to other entity types such as corporations.
Is an LLC the Right Choice?
The threshold questions, that entrepreneurs commonly overlook is whether an LLC is the appropriate entity for their business. The popularity of LLCs, along with their often incorrectly perceived simplicity, commonly leads to poor decisions in choosing the correct entity. Doing so is a great disservice to your business. While an LLC is often the right choice when setting up a business entity, there are many considerations that need to be understood, and an attorney experienced in these matters is typically the best person to help you ensure the best decision is being made for your company. For example, for some closely-held small businesses, an S-corporation is more advantageous from a tax perspective. For a basic overview of the different types of entities, please see my post entitled “Choosing the Best Entity Type for Your Texas Business.” Many of these issues are complicated, and very difficult for an entrepreneur to understand without the guidance of an attorney, particularly when they lack lack experience and an understanding of the nuances involved in making the best choice of entity decision.
Understand the Specific Circumstances, Goals, and Requirements of Your Business
No type of entity, be it a corporation, LLC, partnership, or otherwise, is “one size fits all.” The specific circumstances, goals, and requirements of your business will dictate what type of entity your business is best organized as. Once the best entity type has been determined, with or without the assistance of an attorney, it is important to organize that entity, whether its an LLC or otherwise, to fit those specific circumstances, goals, and requirements of your business. One of the biggest problems in using self-help to set up your business is that the specifics of your business are typically not contemplated by the organizational documents used to set up your business. Template documents downloaded online or recycled from other businesses, are almost always either (a) drafted too broadly to address the specifics of your business, or (b) drafted with the specifics of another business in mind that often do not fit the terms needed by your business. This is where a good attorney is often most important, as they are experienced in analyzing the specific circumstances, goals, and requirements of your business to tailor the organizational documents specifically to your business. An additional consideration is what state you should incorporate your business in. While it is often the state in which you will be based, there are sometimes considerations that make doing so in another state advantageous – please see my post, “Which State Should I Incorporate In?” for a discussion of these issues. The importance of properly addressing the specific needs and requirements of your business cannot be emphasized enough, as failing to do so can have disastrous consequences down the road.
The Basic Process for Setting Up an LLC
The basic process for setting up an LLC involves the following: (a) filing a Certificate of Formation (or analogous document, depending on the state) with the Secretary of State of the state you have chosen to incorporate in; (b) drafting an Operating Agreement (known in TX as a “Company Agreement” instead) tailored to meet the needs of your company; (c) obtaining an employer identification number (EIN) from the IRS; (d) preparing an organizational written consent; and (e) drafting any other documents and agreements required by the specific needs of your business (e.g., a buy-sell agreement).
The Certificate of Formation
Filing a Certificate of Formation (or analogous document) is typically fairly straightforward, however, there are a few important issues that need to be considered, including (a) name availability, (b) the registered agent, (c) choice of type of governing authority, and (d) inclusion of any special provisions.
First, you need to select a name that is available for use in the state you chose to incorporate in. You can typically check name availability online, using the name search function on the website of the Secretary of State for the state you are incorporating in. However, it is important to note that even if the Secretary of State allows you to file using a certain name, if that name is too similar (usually using a potential for confusion type standard), another company can sometimes prevent such use. It is important to carefully consider your business name, to ensure that you follow all rules and regulations involved with name availability.
Second, you need to determine who will serve as the registered agent – this will be the person or entity in the state of incorporation that will accept service of process (i.e., lawsuits) on behalf of the LLC. This can be anybody residing within that state. Typically there are some basic requirements, such as the registered agent being at least 18 years old, however, most residents should qualify. If you’re LLC is incorporated in a state where none of its owners reside, you can use a commercial registered agent service instead, which typically costs between $50 and $100 per year.
Third, you need to determine whether the governing authority of the LLC should be member-managed or manager-managed. A manager-managed LLC uses one or more managers, who may be different than the members, and depending on how you set things up, can roughly mirror a corporation’s board of directors. In contrast, a member-managed LLC uses its members to directly serve as the governing authority – this option is typically better for LLCs with few members. To properly prepare a Certificate of Formation, you must clearly understand the differences and nuances involved in selecting the appropriate governing authority.
Fourth, in certain cases, the specific circumstances, goals and requirements of your LLC, may necessitate the inclusion of special provisions on the Certificate of Formation. For example, if you want certain provisions relating to expanding or limiting indemnification obligations, it is often prudent to include such special provisions directly in the Certificate of Formation. If these types of provisions are to be included directly on the Certificate of Formation, please take great care in doing so, as it can be more difficult to amend the Certificate of Formation at a later date.
While drafting and filing a Certificate of Formation (or analogous filing) can certainly be done without the guidance of an attorney, they can sometimes present complex issues not readily understood by non-attorneys, and have significant consequences if prepared and filed incorrectly – unless you are very familiar with the process, using an attorney to file a Certificate of Formation on behalf of your company is typically the best course to take.
The Operating Agreement
Although I sometimes encounter LLCs operating without an Operating Agreement (known as a “Company Agreement” in TX), if the LLC has more than one member (owner), doing so is practically insane, and many states actually require one by law. Described generally, an Operating Agreement is an agreement among the members of the LLC which establishes most of the rights and obligations of the members among each other and in relation to the LLC. They can be quite extensive, covering things such as: management, ownership transfer restrictions, capital structure, taxes, how profits are distributed, dissolution of the LLC, and a host of other issues which are vital to the LLC and its members. An Operating Agreement is almost always the most important organizational document for an LLC, and can be quite complicated, particularly in terms of tax considerations. Unfortunately, it is also the place where entrepreneurs most commonly make a vital mistake in organizing their LLC. It is somewhat common to come across Operating Agreements which have been downloaded as a template online or recycled from another company, which can have potentially disastrous effects. This is probably the most complicated, difficult, and important step in properly forming an LLC, and I cannot stress enough how important it is to get a quality Operating Agreement specifically drafted by an attorney to fit the needs of your LLC.
Obtaining an EIN for Your Business
The process for obtaining an employer identification number, or EIN, is one of the easier steps involved in setting up an LLC, however, failing to correctly do so has consequences. Currently, the easiest way to obtain an EIN from the IRS is to file for one using their online application system, however, you may still elect to file a hard copy Form SS-4, and in some cases the IRS will require you to do so. An EIN will be necessary for the operation of your company (e.g., you typically need an EIN to open a bank account), and you one should typically be obtained as quickly as possible after the Secretary of State has accepted the LLC’s Certificate of Formation.
The Organizational Written Consent & Other Documents
This document, often known as something similar to a “Written Consent by the Members in Lieu of the Organizational Meeting of the Members” (depending on the type of LLC), is a set of resolutions to complete the internal organizational formalities for the LLC. Some of types of things covered in this document would include: election of officers, opening of a bank account, issuance of membership interests, appointment of managers, establishing an office location, and other corporate formalities which must be addressed. Its typically not a complicated document, however, its best for an attorney to draft to ensure that everything to address everything that needs to be.
Though not always required, the specific circumstances, goals, and requirements of your business may require documents other than those described above, including documents such as buy-sell agreements, employment agreements, conveyances, and others that may be required to ensure that your LLC is properly organized. An attorney can help you determine whether or not there are additional agreements and documents that your specific business will require, and help to get them prepared.
Risks Involved With Self Help
While each of the documents and filings described above can conceivably be prepared using a self-help service such as LegalZoom, more often than not, doing so can and will lead to significant problems down the line. Many aspects of organizing an LLC can be quite complicated, particularly from a tax perspective, and as such, one needs a strong understanding of the process and different issues involved in properly organizing an LLC to meet its specific needs. Put simply, few non-attorneys have a sufficient depth of understanding to adequately address these issues. The typical cost involved in using an attorney to organize your business is not that great, however, the potential costs of incorrectly doing so on your own can often be quite high. Incorporation costs typically vary with the level of complexity involved, depending on the number of members, number of different classes of equity, type of management, securities issues, taxes, and a long list of different considerations.
The Eastman Law Firm understands that entrepreneurs often have concerns with mounting legal fees, and as a result it offers flat fees for most incorporation services. Most attorneys, The Eastman Law Firm, will offer a free consultation to give you an idea on the specific requirements, costs, and issues relating to organizing your business as an LLC or other entity type. Even if you’re fairly certain that you’re going to attempt to organize an LLC on your own, I highly suggest contacting an attorney if only to get a better idea on how to proceed.`