Operating an LLC

You’ve formed your LLC and are ready to reap the many tax, limited liability, and asset protection benefits afforded by the organization. What are the things to look for and look out for in order to properly run your LLC? How should it be run? Where should you start? Because of the flexibility in management styles and tax status treatment available to LLCs, there are important choices to make that bear careful consideration. It is important that your company is established and operated properly so that you can take advantage of the asset protection, lawsuit protection and tax benefits that are the advantageous features of an LLC.

There is much written about these benefits and of the LLC as a business form for the small to medium-size business owner. LLCs can indeed be a beneficial business formation because the varied options with respect to how the company is operated and taxed can fit a number of different types of businesses. One must tread carefully, however, as your choice of operation and taxation treatment can be adversely affected by the manner in which your company is run and this is primarily how the courts and/or the IRS will examine how to treat your company in the event of litigation or taxation questions.

Operating your LLC as an S Corporation

Many times members elect to have their LLC taxed and operated like an S corporation because unlike a standard “C” corporation with its double taxation issue, and the exposure to liability of a partnership, in an LLC profits and losses can pass directly through to the owner’s personal income tax return while the owner’s personal assets are shielded from liability. These are benefits that were once unique individually to either a corporation, or a partnership, but never before combined under one model. This protection, however, is not limitless--if the LLC is improperly structured or the operating agreement is poorly written with inadequate protections or language, LLC members may find themselves facing lawsuits without the personal protections, or they may find themselves being treated as a non-separate entity or alter-ego by the IRS with the commensurate tax pitfalls. It is critically important that the LLC be run in accordance with the formalities of an S corporation if it is in fact to be treated that way.

Corporation shareholders have occasionally been subject to the doctrine of “piercing the corporate veil” for things such as not adhering to the corporate formalities. The owners, in those instances, have been faced with the prospect of having their personal assets subject to an adverse judgment if a court deems that the corporate form has been disregarded or misused by its shareholders, officers, and directors. LLC members can occasionally fall prey to the same doctrine. Courts are, at times, applying the same doctrine to LLCs in what could be named the “piercing the LLC veil” doctrine. The premise of the doctrine is that no business entity should rely and utilize the entity’s financial shelters or taxation status as a tool to defraud or perpetuate a wrong against an outside entity or agency. If a business entity is deemed to have been used in such a manner, or if the owners or members of the LLC have been shown to act as if the assets and funds of the business were interchangeable with their own (co-mingling of funds such as paying one’s personal light bill with company funds), then they may lose the asset protection afforded by the former separate legal entity treatment.

Piercing an LLC veil would require the plaintiff to show that the owners or members exercised complete domination of the LLC with respect to the subject transaction or offense; and that such domination was used to commit a fraud or injustice which resulted in an injury to an outside party. In order to determine whether an LLC is “dominated” by its owners, courts will consider a number of factors, including:

• 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 their 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.

Operating your LLC as a C Corporation

While not the most common election, especially so if there are multiple members, a single-member LLC can be operated, and treated for taxation purpose, as a standard or “C” corporation. Electing this method, however, will deny the pass-through benefits of the LLC and therefore negates many of the advantages of organizing your business as an LLC. Your business will be required to adhere to the corporate formalities, relinquishing the simpler LLC nature, and may be subject to increased scrutiny as a result. Some states require that a single-member LLC be treated as a C corporation, but that is not the case in every state. Tread carefully when electing to have your LLC treated as a C corporation.

Managing Risk

Members of an LLC can manage the risks involved by ensuring that they have a complete and proper management plan in place in the form of a well written and articulate operating agreement. They should ensure that personal business and financial affairs are maintained separate from the LLC, that personal assets and funds be maintained separate from the LLC, and that there is always adequate capitalization in order to ensure the proper operation of the business.

Each member’s ownership percentage should be clearly delineated in the operating agreement, along with any enhanced ownership rights or authorities granted to any one owner. Profit and bonus distribution should also be properly outlined in the operating agreement, along with the members’ annual draw or salary. If there are non-member employees of the LLC, their duties, rights, and responsibilities should also be a part of the operating agreement and properly listed within.

Operating your LLC following the basic guidelines outlined above, and using good business and common sense, will ensure that your LLC functions and is treated as it was intended to.