LLC Formalities

Limited Liability Company Operating Formalities

Limited Liability Companies are becoming more and more popular as an excellent company organizational vehicle for conducting business, with very good reason. They offer untoward flexibility with respect to management and operation, excellent protection from liability, and they offer profound taxation benefits in the form of their pass-through taxation. There almost seems to be a scramble by some states to lure corporations in general, and LLC’s in particular, to them in the form of very business-friendly acts and legislative moves. Even so, there are certain operational and organizational steps, sometimes known as “LLC formalities,” that must be taken and adhered to in order for the members to enjoy all of the limited liability and taxation benefits afforded the LLC.

Piercing the LLC Veil

"Piercing the corporate veil" is the equitable remedy courts use to disregard the corporate structure, and this can translate into a piercing of the “LLC veil.” If a corporation is found not to be operating in observance of the formalities, an owner is exercising excess control, funds are being grossly misappropriated for the benefit of an owner, or if the corporation is deemed to be operated in such a manner as to cause harm to another entity, the courts can pierce the corporate veil and make the owner(s) personally liable for any debts or obligations of the company. The same can be true, although admittedly to a lesser extent, of an LLC. If a member exercises excess control over the entity, if the member in control engages in improper conduct in the exercise of control over the entity; and this improper conduct causes another entity to be denied adequate remedy in a lawsuit or business transaction proceeding, some courts may “pierce the LLC veil” and make the members or managing member directly responsible for the debt or obligation.

Traditionally, courts have looked at numerous factors to determine whether a controlling member/shareholder engaged in improper conduct. Chief among these factors would be the lack of an operating agreement, or a poorly written one. Too, a failure to maintain adequate records of acquisitions, business transactions, and in some states, minutes of meetings could lead a court to disregard the entity and hold the controlling member personally liable.

While the rules for observing the corporate formalities are not as stringent for an LLC, there are obviously still some semblance of formalities that must be observed. Having a well-written operating agreement in place should be obvious by now, but there are a couple others. The important ones (but by no means the only formalities) are listed below.

LLC Formalities

• Having a well written Operating Agreement in place, with well defined roles for members, well outlined distribution guidelines, and operational and taxation rules.
• Adequate records for all transactions and business engagements, as well as properly written minutes of meetings (at least one state, Tennessee, requires an annual meeting of the members). List of members, past and present, articles of organization, tax returns for the past three years, bank statements, resolutions authorizing activities that, either by law or under the terms of the operating agreement, require a vote of the members, etc. Are all examples of the types of records and written agreements that should be properly maintained by the LLC
• Adequate capitalization for the company and maintaining proper operating capital

These are but a few, though vital, suggestions of formalities that should be observed. Other actions, or lack thereof, that could lead to the piercing of the LLC veil include:

• Actions not covered in the Operating Agreement of an LLC--this is tantamount to disregarding the LLC formalities. Although an LLC is technically not required to observe formalities in the same manner that a corporation is, its actions should be completely guided by the operating agreement, and this agreement is taken into consideration by the courts and tax authorities when a determination is made as to the operation of the LLC.
• Deficient or inadequate capitalization is another important deficiency that a court or tax regulator will examine when determining the intent of the LLC and its member’s and will usually factor heavily in their decision to pierce the veil. It is important that an LLC be properly capitalized and funded, and that the members manage the funds properly in order to run business properly. Siphoning too many assets or capital and leaving too little in the coffers to satisfy creditors or company operations may lead to a veil-piercing determination.
• Co-mingling of funds is a bad idea in any form of corporation or LLC. Any sense of co-mingling of funds or accounts will almost certainly lead to an “alter-ego” determination by the courts or a tax regulatory board and will lead once again to veil piercing--thereby risking personal assets and stripping members of the liability and asset protection. It is a best-practices act to make certain that separate accounts are maintained and monitored.
• The amount of discretion shown by the members should be metered to ensure that all actions are deemed to be in the best interest of the LLC or the business. Personal agenda’s should come secondary to the LLC as a whole, lest it be determined that it was formed for an express personal agenda and not a business goal.
• The LLC should never be treated as an extended personal account of its owners or members. The courts and tax regulatory boards regularly examine the financial dealings and workings of an LLC to determine whether it is a working business or an independent profit center for its owners or members. If it is deemed an independent profit center, the veil could be pierced and there can be tax penalties and liabilities against the owner or members personally.

An LLC should pay and guarantee its own debts, unless specifically outlined in the operating agreement for specific requirements for such things as the rental or leasing of real property, etc. At times, if an owner or member regularly guarantees or pays debts, he will have been shown to act as an alter ego of the LLC and hence will cause that LLC to lose its separate entity status. Owners should not pay or guarantee the debts of their own LLC unless it is specifically outlined in the operating agreement for specified purposes.

So while a “formal” set of rules is not a requirement outlined by any state for an LLC, the concerned and astute business man or LLC member will understand that there are LLC formalities to be followed and adhered to in order to fully enjoy the benefits afforded by the LLC.