This may come as a surprise to many LLC members and managers:  Keeping records for your LLC is required under the New York LLC laws.  You have an obligation to keep proper records under §1102 of the New York Limited Liability Company Laws.

What Records must be kept in an LLC

Specifically, you must maintain the following records:

  • if your LLC has managers, a list of the full names of all managers and their mailing addresses;
  • a list of all members and their mailing addresses together with each member’s contribution to the LLC and his or her share of profits and losses;
  • a copy of the articles of organization and all amendments;
  • a copy of the operating agreement;
  • a copy of the LLC’s federal, state, and local income tax returns for the three most recent years;

If you are in charge of managing the LLC books, you are well-advised to adhere to these rules so that nobody can blame you for being negligent in the management of the LLC.

Where do I have to keep the records of the LLC?

The law does not specify where.  But the law does allow you to keep the records other than in paper form, which includes in electronic format, as long as you can produce everything in written form in a reasonable time (aka print it).  §1102(d).

Who can demand access to the Books and Records of the LLC?

Any member of the LLC.

Any member of the LLC has a right to demand access to such records and any financial statements maintained by the limited liability company for the three most recent fiscal years and any other information regarding the limited liability company’s affairs as is just and reasonable.  From that, it follows that you should also keep accurate records regarding the financials of the LLC and all resolutions or similar LLC documents relating to the LLC.

While I have you thinking about keeping records, it wouldn’t hurt to peruse this IRS publication:  Starting a Business and Keeping Records.

Call me if you have any questions about this topic.

Also, see “Access to LLC Books and Records.”

“Should I sue my business partner?” you are asking yourself. You are fuming right now about what your business partner is doing to you and/or the business, and you are wondering if you should sue your business partner. Before pulling the trigger, understand what lies ahead:

Is there a way to negotiate yourself out of this before suing your business partner?

Going to court should always be the last resort. Court actions are costly and time-consuming (years, not months) and can destroy what is left of your business and your sanity. While your attorneys will do most of the heavy lifting, you will have to spend a lot of time cooperating with them and gathering relevant evidence. So try your best to come to the table with your partners to negotiate a good outcome before going to court. Give a little, take a little.  And even if you are already well into a lawsuit, consider settling before trial.

What do the Agreements say?

Your decision to sue your business partner or settle begins with your business agreement. You, or preferably your attorney, should check whether you have a written agreement with your partners and what it might say about your dispute. If your business is a corporation, there may be bylaws, a certificate of incorporation, and a shareholder agreement. If it is a limited liability company, there may be an operating agreement. Each of these documents, and others, may have relevant provisions.

Even if you have no formal documents, other writings could act as agreements between you and your partners. Do you recall all the promises made in email correspondence or phone texts – or on cocktail napkins? Any document showing some sort of consent may be helpful.

If you do not have anything in writing (like many small businesses, unfortunately), you need to look to the New York laws dealing with your specific entity: for LLCs, the New York Limited Liability Company Law (NYLLC), and for corporations, the New York Business Corporation Law (BCL). These laws also apply if you have a written agreement that says nothing about the issues behind your dispute.

What are my Remedies if I sue my business partner?

Your next step is to consider what you might get in court or through negotiation. Obviously, the cure depends on the problem.  But certain remedies often come up in partnership disputes.

Access to Books and Records

You can demand to see the books and records of the business.  If needed, an expedited legal proceeding (meaning it takes months, not years) can enforce this right.  The governing law is set forth in BCL 624 and  NYLLC 1102.  Inspection rights of members and business owners are not absolute, but any legitimate purpose will likely satisfy the court.  In any event, a demand can signal to your partners that you mean business and may force them to choose good faith negotiation over digging in their heels.

Claim against Partners who damaged you or the Business

You may have a claim against fellow business owners for misbehaving toward you or the business.  Managers and managing members of New York LLCs owe fiduciary duties to the other members (while non-managing members of manager-managed LLCs do not).   Officers and directors of a corporation owe fiduciary duties to the corporation and the shareholders.  Shareholders do not owe fiduciary duties to each other – except in very small corporations or where the shareholders are essentially managing the corporation.

A fiduciary duty is an obligation to act in good faith, to treat co-owners fairly and in accordance with the deal struck, to act in the best interest of the business and its owners, and to refrain from fraud, taking assets for one’s own benefit, wasting assets, competing with the business or diverting clients away from it. If your partner violates this duty, you may be able to sue the partner directly or on behalf of the LLC or corporation.

If there is a breach of those duties, you may be able to sue the person committing the breach directly or, if the breach was more towards the business, you could sue on behalf of the LLC or corporation, a so-called “derivative” action.

Forced Break-Up of the Business

Under certain circumstances, you may be able to take your dysfunctional business family to court and have a judge dissolve the business and order it to liquidate its assets.  You will first need to ask yourself if this drastic step is really the best outcome. The value of a business lies in its operations and goodwill as a going concern. But sometimes, it can be a good idea to bring such a lawsuit anyway because it may force your partners to consider a buyout – and the court may even order one.

Forced Dissolution of a Corporation

If you (alone or together with other owners willing to go into battle with you) own 50% of the shares in a corporation, you can have a judge order dissolution by showing that management is hopelessly deadlocked (Section 1104 of the BCL).

If you own at least 20%, you can have a judge order dissolution by showing that management is guilty of illegal, fraudulent, or oppressive actions toward the complaining shareholders or that the corporation’s assets are being looted, wasted, or diverted for non-business purposes by the directors or officers or others in control.  In deciding over such a case, a judge has some options under the law and could conclude that liquidation of the corporation is too harsh a remedy and that there less painful means, such as a buyout, to give you what you are owed and protect your rights (Section 1104-a).

So a shareholder with 50% or more has two options, under 1104 and 1104-a.  But the choice needs to be carefully considered since 1104-a petitioners can be forced to accept a buyout. 1118 BCL gives your opponents the option to buy you out for the fair value of your ownership share. What is fair value? Unless you agree on an amount, a battle will commence between experts who follow complicated rules and methods established over time.

Forced Dissolution of a Limited Liability Company

Many LLC owners are surprised to learn that their break-up rights and remedies are much less defined than in a corporation.  Dissolution of an LLC is codified in Section 702 of the New York Limited Liability Law.   Under 702, you need to show that management is not willing or is unable to pursue the stated purpose of the LLC, or that continuing the entity is financially unfeasible.   Easy in theory but difficult in practice.  That management may be hopelessly deadlocked or guilty of misconduct is not always enough to justify a dissolution under Section 702.

Equitable Buyout

In connection with this proceeding or standing on its own, a court may decide to grant an “equitable buyout,” meaning it is not provided for in the written law, but the court thinks it is a good idea to protect the business owners.  An equitable buyout consists of one member being forced to sell his/her ownership interest to the other member.  But don’t rely on this since this equitable remedy is very new and the requirements a little murky.  It seems that a prerequisite for the equitable buyout is that you can show that you also have a good case for dissolution under Section 702 and that a buyout is really the “most equitable method of liquidation.”  So it all depends on the individual facts.

Do you need legal action immediately?

Many people are anxious to bring injunctive relief as soon as the dispute hits the fan.  Injunctive relief means that a court will relatively quickly stop the rogue business owner’s shenanigans without waiting for a trial, which can take years.  Injunctive relief requires that you can show a high likelihood that you would win after trial, and there would be irreparable injury without this expedited relief.  An example would be any action that significantly affects the control and management of the LLC or corporation.  Courts have held that such misconduct can have irreparable consequences.  Anything that can be fixed with money damages is less likely to be a candidate for injunctive relief.   However, bringing an action for injunctive relief rather than waiting for the wheels of justice to turn can make or break your litigation strategy.  Even if you have a good case, a lost injunctive relief petition may shift the balance in favor of your opponent.

Call me if you have any questions about the above topic.  And also see “Business Partnerships Gone Bad.”

Picture this: You’ve been happily doing business with your fellow LLC members for some time now.  But now, trouble is brewing on the horizon.  The other two members are ganging up on you and exclude you from any further business dealings.  When you ask to see the LLC’s books, records, bank accounts, tax returns, or other financial records, they tell you that you don’t have any right to see such documents.

The majority ousted LLC member often lacks access to information about what is going on in that LLC business.  While such a member often suspects wrongdoing, he cannot look at the LLC’s bank accounts, accounting, and other records, because the other members refuse to show it to him.  What is he or she supposed to do?

Access to LLC Books and Records

Luckily, the New York LLC law gives the ousted (or any) LLC member an explicit right to ask for the LLC’s books and records.  The law provides in Section of 1102 of the New York LLC law that:

“Any member may, subject to reasonable standards as may be set forth in, or pursuant to, the operating agreement, inspect and copy at his or her own expense, for any purpose reasonably related to the member’s interest as a member, the records referred to in subdivision (a) of this section, any financial statements maintained by the limited liability company for the three most recent fiscal years and other information regarding the affairs of the limited liability company as is just and reasonable.”

The records mentioned in subdivision (a) are:

“(1) if the limited liability company is managed by a manager or managers, a current list of the full name set forth in alphabetical order and last known mailing address of each such manager;

(2) a current list of the full name set forth in alphabetical order and last known mailing address of each member together with the contribution and the share of profits and losses of each member or information from which such share can be readily derived;

(3) a copy of the articles of organization and all amendments thereto or restatements thereof, together with executed copies of any powers of attorney pursuant to which any certificate or amendment has been executed;

(4) a copy of the operating agreement, any amendments thereto, and any amended and restated operating agreement; and

(5) a copy of the limited liability company’s federal, state, and local income tax or information returns and reports, if any, for the three most recent fiscal years.”

Additional LLC Information

But the LLC member is not necessarily limited to asking only for these records.  The law also gives access to “other information regarding the affairs of the limited liability company as is just and reasonable.”  This can open the door to asking for more detailed records, such as proof of expenses, revenue, bank accounts, or other documents underlying the LLC’s business accounting.   The judge ultimately had discretion on how much access will be granted.

Claim for an Accounting

While it is not mentioned in the law, the courts have also given LLC members the right to ask for an accounting of the LLC business.   In other words, you may ask for a full picture and explanation of the LLCs financial affairs.  This is a different claim than the one for books and records since it asks for much more than just the opportunity to review financial information.  You may be entitled to ask for explanations underlying the financial information to get a full picture of what went on.  You cannot demand this on a whim or what your adversary would call a “fishing expedition.”  There have to be some allegations of concrete wrongdoing by the LLC members in charge.  The LLC members in charge cannot counter that they already gave you access to the books and records under 1102 because this is a much broader demand.

Majority Member Defenses

Is there something that the remaining members can do to prevent you from getting the desired access to the LLC’s books and records?

Yes, if the other members can plausibly show that any information sought is in the nature of trade secrets or their disclosure is not in the best interest of the LLC, they may be able to restrict such material.  But this is not easy to show and they have to have those rights under the operating agreement or show special circumstances in order to succeed.  Plus, you can offer to sign a confidentiality agreement to protect such information from third parties.

Pre Lawsuit Demand

In both claims described above, the claim for access to books and records and the claim for accounting, you have to make a formal written demand before bringing a lawsuit.  You can do it yourself or have your attorney do it so that the secretive LLC members get the message that you are serious.

Operating Agreement

Finally your operating agreement may contain special provisions about access to books and records.  So make sure to read the operating agreement to see whether it mentions any particular requirements to access the LLC’s books and records.

Ok, I’ll make this quick and dirty.  LLC, C-corp or S-corp for your small business you ask?  I think most small businesses still go with the LLC for the flexibility and to take advantage of the flow through taxation.   Below is a rundown of the main differences.  But be mindful that the recent tax changes pose a whole different set of issues that MUST be discussed with your trusted accountant.  For an explanation of the new tax considerations, see here.

Formation

LLC

C-corp

S-corp

For $200 file articles of organization with Department of State

For about $1300, arrange for publication of LLC and file certificate of publication

For $125 file certificate of incorporation with Department of StateSame as c-corp.  But State and Federal s-corporation tax election required
Draft and execute an operating agreementDraft and execute bylaws, shareholder agreement and issue sharesSame as c-corp

Ownership and Transfer

 One or more membersOne or more shareholdersOne to 100 shareholders, only US residents or citizens
Full membership is not transferrable unless allowed under operating agreement; otherwise only economic transfer permittedShares are transferable unless restricted by shareholder agreement.

There may be registration requirements under securities laws

Same as c-corp
Multiple classes of membership with different rights allowedMultiple classes of shares allowed (common shares/preferred shares)Only one class of shares allowed

Liability

Members are not liable for obligations of LLC

The ten members with the most ownership are liable for unpaid wages of the LLC’s employees

Shareholders are not liable for obligations of the corporation

The ten shareholders with the most ownership are liable for unpaid wages of the LLC’s employees

Same as c-corp

Management

Managed by members unless the formation docs specify management by managersManaged by a board of directors and officerssame as c-corp

Taxes

Flow through entity; the members are directly taxed on the profits and losses allocated to themThe corporation is taxed as a separate entity and the shareholders are taxed again when they receive dividends (aka double taxation)Flow through entity

Formalities

Few if any, biannual statement, no annual meetings requiredregular shareholder meetings; owner payroll taxessame as c-corp

In closing, forming any of the entities above is pretty easy and there is no reason why the small business owner couldn’t do it on his/her own.  However, if you are in business with another person(s), don’t try to save money by drafting your own shareholder agreement or operating agreement, or maybe worse, not have one at all.

 

 

  • What is a New York Limited Liability Company (“LLC”)?
  • Who can form an LLC?  How do I form an LLC?
  • How much does it cost to form an LLC?
  • What ongoing requirements are there for maintaining an LLC?
  • How does an LLC pay taxes?  Is an LLC a good choice for my new business?

Read on for answers to  such common questions about  New York LLCs.

What is a New York Limited Liability Company (LLC)?

An LLC is a business entity created by the New York Limited Liability Company Law (“NY LLC”).   Often people say that an LLC is a hybrid between a corporation and a partnership; an LLC offers its owners (called members) protection from business liabilities like  a corporation would, but functions more like a partnership:  it is not considered a separate corporate entity and its membership interests are not freely transferable.  While LLCs do offer limited liability, it is not a shield from personal wrong doing.

Limited liability companies are one of the most created business entities in New York.

Who can form an
LLC?

Any individual (including a non-resident alien, i.e. a foreigner), a corporation, a partnership or another LLC can form an LLC alone or together with other members.

How do I form an LLC? 

1. Choose a name.

The name must contain the words “Limited Liability Company” or the abbreviation “L.L.C.” or “LLC”.  For more name requirements, look up Section 204 NY LLC.

2. File Articles of Organization

You have to file so called “articles of organization” with the New York Department of State division of corporations (Sections 203 & 209 NY LLC).  The Department of State now offers online filing and a step by step guide; choose “Articles of Organization for a domestic limited liability company”.

3. Publication of LLC Formation

Within 120 days after the articles of organization have been filed, you have to publish the fact of the LLC’s formation “once in each week for six successive weeks, in two newspapers of the county in  which  the office of the limited liability company is located, one newspaper to be printed weekly and one newspaper to be printed  daily”  (Section 206  NY LLC).   The newspapers are designated by the county clerk.  In New York County, you actually have to call  the county clerk’s office and a real person will tell you where to publish.  After publication, the newspapers will send you an “affidavit of publication” which you will have to file with the Department of State together with your certificate of publication (sample form from the Department of State).

Pro tip:  Don’t do the newspaper publication on your own, use a service that specializes in doing them and gets special rates from newspapers, such as Interstate Filings.

Many starting LLC businesses used to forgo the required newspaper publication due to its high cost (about $1200 in New York County, see below).  Be warned, though; what used to be relatively inconsequential under the law  now has serious consequences due to a recent change in the publication law.  If you fail to publish the formation of your LLC, your LLC’s authority to “carry on, conduct or transact any business” in New York may be suspended.  Still this not as dire as it sounds, see consequences of failure to publish here.

4. Adopt Operating Agreement

Finally, at the latest within 90 days of formation of your LLC, you have to adopt an operating agreement for your LLC (Section 417 NY LLC).   The operating agreement sets forth the rights and obligations of the members, management of the LLC, distribution of profits and losses, dissolution of the LLC, and so forth.  For the love of god or anybody you believe in, if your LLC has more than one member (i.e. you), get yourself to a lawyer and have a proper operating agreement drafted.

While many one member LLCs neglect to adopt an operating agreement (and nobody really knows what the consequences of such neglect are), it is highly advisable to adopt a well prepared operating agreement in cases where there are more than one member.  What goes into an operating agreement: See here.

How much does it cost to form an LLC?

Filing fee for the articles of organization: $200;
Filing fee for certificate of publication: $50
Fee for a certified copy of your filed articles of organization: $10 (you will probably need this to open bank accounts)
Fee to newspapers for publishing notices (for a New York County LLC): about $1299

What ongoing requirements are there for maintaining an LLC?

LLCs  must file a biennial statement every two years with the Department of State setting forth the address to which the Secretary of State shall mail a copy of any process accepted on its behalf (Section 301(e) NY LLC).  Since your LLC is on record with the Department of State, the Department will automatically send you a form for a biennial statement once the time to file has come.  But you can also take care of the biennial filing online.

LLC are not required to hold annual member meetings.  However, in order to preserve the limited liability protection of an LLC, it is a good idea to pass written resolutions documenting member meetings and decisions  and keep personal and LLC business strictly separate.

How is an LLC taxed? 

An LLC normally does not pay federal taxes, instead income received by the LCC is allocated to the members and taxed at their individual rates.

Similarly, an LLC normally does not pay New York State income taxes, rather the members pay taxes on their allocated share of LLC profits.

Is an LLC a good choice for my new business?

It might well be.  However, choice of entity is a complicated issue which is highly dependent on your situation.  Nonetheless, some benefits of LLCs over other entities are:

1. You only pay one level of tax.  If your business were a corporation, the corporation would have to pay corporate tax; in addition,  upon distribution of profits to you, you would have to pay another level of tax on the distribution.

2. LLCs are very flexible when it comes to capitalization (the process of funding the LLC).  An LLC can issue any type of equity or debt to its members.

3.  You can “pass through” losses of the LLC to yourself (and the other members); these losses can be used as a deduction on your (and the other member’s) non LLC related income.

4. You can convert an LLC to a corporation at a later time with relatively minor consequences, whereas a conversion from a corporation to an LLC can raise ugly tax liabilities.

 

 

Updated October 10, 2018

 

The LLC Operating Agreement

The LLC Operating Agreement is a key document for a business organized as a New York Limited Liability Company, especially if that business has more than one owner (the owners are “Members” in LLC terminology). If an LLC business was like a marriage, the LLC Operating Agreement would be like a prenup, parenting agreement and divorce settlement all in one.

Why you should have an LLC Operating Agreement

While the New York limited liability company law provides for some default rules applicable to LLC businesses that do not have an LLC operating agreement in place, the members of the business are well advised to craft their own rules by way of an LLC Operating Agreement (which is actually required by law in New York, Section 417).  The members of the LLC business are given great flexibility to regulate their rights and responsibilities with respect to the LLC, management of the LLC and pretty much everything else that concerns the LLC and the LLC Members. Only very few rules in the NY LLC law cannot be modified by an Operating Agreement.

The LLC Operating Agreement sets forth the rules that apply to the members of the LLC and the management of the LLC.   It should give answers to the following questions:

  • Who owns what of the LLC business?
  • Who contributes what to the business of the LLC?
  • Who gets how much of the business profits of the LLC?
  • When are LLC business profits to be distributed?
  • How are the members to manage the day to day affairs of the LLC business?
  • Are there specially appointed Managers to manage the LLC business, rather than management by the LLC members?
  • Who can vote on non day to day, monumental business decisions affecting the LLC business?
  • Who has which responsibilities regarding the business of the LLC?
  • What other obligations do the LLC members have to the business and to the other LLC members?
  • What happens if an LLC member wants to leave the LLC Business or sell his or her membership interest?
  • How can new LLC members join the club?
  • Should the LLC members be allowed to force someone to leave the LLC Business?
  • How can the LLC be dissolved?
  • What happens upon dissolution of the LLC and how are the assets to be distributed?

All these and more are questions to be addressed in an LLC Operating Agreement.  Ideally, you should hire a business attorney who specializes in startup matters and LLC operating agreements to draft your LLC operating agreement.  However, an educated client is the best client and knowledge of the key issues in an LLC Operating Agreement is key for efficient cooperation with a business attorney.

Management Provisions in an LLC Operating Agreement

Management provisions in the LLC Operating Agreement deal with the management of the LLC business, which basically means decision making for the LLC business. There are ordinary business decisions (think: buying copy paper at Staples, landing another customer, paying employees….) and extraordinary business decisions, such as obtaining financing for the LLC business, selling major equipment, taking in a new owner, i.e. a new LLC member, merging with another business, and so forth.

Default NY LLC law Rules: Management by Members

As per NY LLC Law, by default, the LLC is managed by its Members (Section 401) and each Member has authority to make ordinary business decision for the LLC and bind the LLC (i.e. enter into contracts in the name of the LLC) in connection with such ordinary type decisions. Extraordinary business decisions, however, require a formal authorization by the LLC Members (Section 412). The formal authorization can be by majority vote of the LLC Members in a meeting or by written consent.

Management by Managers

If you set forth in the LLC’s Articles of Organization (the document that was filed with the Secretary of State in Albany in connection with the formation of the LLC), that the LLC shall be managed by Managers, New York law has a second set of default rules applicable to the management of the LLC. In that case, the Manager(s) have the authority to make ordinary business decision for the LLC and bind the LLC (i.e. enter into contracts in the name of the LLC) in connection with such ordinary type decisions. Extraordinary business d ecisions require a formal authorization by the Manager(s). If there is more than one Manager, a majority vote or written consent constitutes such formal authorization.  In that case, the LLC Members do not have any authorization to manage the day to day business affairs of the Company.

However, some extraordinary business decisions still require the consent by the LLC Members. The law has a list of such extraordinary events (admit a person as a Member, dissolve the LLC, and so forth, look in Section 402 (c) and (d)).

Drafting your own Rules

When you read the NY LLC law, it almost always states “except as provided in the Operating Agreement…). This is your ticket to draft your own rules with respect to the management of your LLC.

Here are common matters written into LLC Operating Agreements with respect to the management of the LLC business:

No required Annual Meetings

By default, under NY LLC Law, meetings of LLC Members must be held annually. In order to keep administration of the LLC lean and mean, many LLC founders decide to NOT require annual meetings of the LLC members and state as much in the LLC Operating Agreement.

Board of Managers

LLCs with many Members or Members who are not involved in the day-to-day management of the LLC can provide for a Board of Managers, similar to the structure in corporations.

LLCs can establish committees with responsibilities designated by the Board of Managers, Officers with special titles, such as President, Vice President and others.

In that context, you can provide how many people should be on the Board of Managers and who are the initial persons to serve on the Board of Managers.

You can provide for special veto rights by certain people, how Managers are to be elected, how they should be replaced or fired, if necessary.

In LLCs with only a few involved LLC Members and no Managers, you would also set forth who of the Members has authority to decide about day-to-day LLC business decisions and bind the LLC in contracts and agreements.  You could also provide for certain areas of responsibilities assigned to each managing LLC Member, like Joe is responsible for the LLC’s marketing and Jack for sales and distribution of the LLC.

Retained Voting Rights of LLC Members

You can set forth a list of LLC business decisions that are so important to your LLC that they always require a vote by the LLC Members, despite management of the LLC by Managers or a few select Members.  In that respect, you would also provide the level of consent that is required (majority, super majority, or unanimous consent) for such decisions.

Voting Requirements

How many votes does each LLC Member or Manager have when it comes time to take a vote? The default rule for member managed LLCs under NY LLC Law: The Members vote in proportion to each Member’s share of profits.  Example: Joe gave $10,000 as startup capital to the LLC and Jack gave $90,000.  Joe gets 10% of all the profits of the LLC and Jack gets 90%.  Joe gets 10% of the votes and Jack gets 90%, i.e. in matters requiring majority consent, Jack would always have the last word.

You can change voting requirements for the LLC in numerous ways.  There can be special groups of LLC Members who have voting rights different from other LLC Members and independent of their economic interest in the Company.  There can even be LLC Members who have no voting rights at all.

Ownership, Contributions and Distributions of Profit in an LLC Operating Agreement

The LLC Operating Agreement will have provisions stating what the LLC members have contributed upon formation of the LLC.  Contributions can be in the form of money, property or services.  While not a contribution per se, the Operating Agreement can also provide that the LLC members may have the right to grant loans to the LLC.

Read more about Capital Contributions in Funding the Company.

The LLC Operating Agreement further has to address the economic ownership rights of its LLC members.  (Economic ownership rights are usually distinguished from the voting and management rights of the LLC members.)

There is equity ownership in the LLC which represents the LLC member’s right to share in what is left over of the company upon its dissolution or if it were to be sold as a whole to another person or entity.

Then there is the right to receive distributions of the LLC’s profits as it goes along and makes money.  LLC members have a right to receive their share of profits, i.e. money left over from the revenues of the LLC’s business after expenses.

In the most common scenario, LLC members share equity ownership and profit distribution rights equally.  For example, if A and B each own 50% of the LLC and nothing else is stated in the Operating Agreement, A and B would each have a right to 50% of the equity ownership and the profit distribution rights.

But it is the beauty of the LLC, that the Operating Agreement can provide otherwise.  For example, if A contributed $50,000 to the starting capital of the LLC and B nothing, they could agree that they both own 50% of the equity ownership of the LLC, but that A will initially receive ALL the profit distributions of the LLC until he has received back his initial capital investment.

LLC Member Obligations in an LLC Operating Agreement

These days, LLCs are often founded around a brilliant idea which requires a lot of development, creation and “sweat equity.”  As a consequence, it is a good idea to include certain obligations of the LLC members in the LLC Operating Agreement.

Confidentiality

Each member should be obliged to keep all LLC business confidential.

Non- Competition

Members should be restricted from competing with the business of the LLC or soliciting employees, vendors or customers away from the LLC to another business venture.  Note though, that restrictive covenants like non compete provisions and non solicitation provisions have to be reasonable to be enforceable in court.

Intellectual Property

If the LLC members are creating intellectual property on behalf of the LLC (software, designs, innovative methods of doing anything), the LLC Operating Agreement must set forth that all such intellectual property has to be immediately assigned to the LLC and is not and will not be the property of the individual LLC members.

Participation in the LLC Business

The LLC Operating Agreement could  set forth that certain members have distinct responsibilities with respect to the operation of the LLC.  For example, it could provide that A is responsible for research and development and B for sales and marketing.  If the agreement was silent, you could potentially have the situation that A works 24 hours a day to make things happen and B sits around and does nothing.  Without obligations in the LLC Operating Agreement, A could do nothing about B’s inactivity.

Buy Sell Provisions in an LLC Operating Agreement

While many LLC Operating Agreements are silent on this point, it is a good idea to include so called Buy Sell provisions in the LLC Operating Agreement.

Buy Sell provisions set forth what is going to happen when an LLC Member wants to leave the LLC, dies, is unable to continue his or here duties, declares bankruptcy,  wants to sell his or her interest to an outsider, or when the LLC members are hopelessly deadlocked in the management of the LLC.  All of these scenarios could seriously harm the LLC or the remaining members.

The most common buy sell provision is probably the so called right of first refusal, which would provide that an owner can sell his LLC membership interest to an outsider if he or she has first offered it to the LLC or the remaining LLC members and such members declined.

Then there could be provisions forcing a buy out of an LLC member if such member has committed a serious breach of his obligations against the LLC.  Or, in case of a professional LLC, if any member has lost his license to practice the profession of the LLC.In each buy-out situation it is important to have terms that provide the exact mechanism of a sale and exit of an LLC member as well as the method of determining a price for the LLC membership interest.
It is also common to limit the price being paid for an LLC membership interest under certain circumstances.  For example, if a member decides to leave before the expiration of a certain period after formation of the company, he may not be able to get much if anything for his interest, since he or she hasn’t put in enough effort to have earned it.

As many of you undoubtedly know, after filing for a New York LLC, you have to fulfill the expensive and wholly unnecessary publication requirement. This means you have to arrange for a notice of the formation in two New York newspapers for six weeks each.  People have tried fighting this requirement in court and lost.  It is still alive and well.  I wrote more about how to actually effect the publication here.

Consequences of Failure to Publish LLC

So you may wonder, what happens if I don’t file the newspaper ads? Is the only issue that I lose the ability to do business in NY?

Yes, if you fail to publish and file the certificate of publication in the required time frame (120 days after formation), the LLC’s authority to carry on, conduct, or transact business in New York will be automatically suspended (see Section 206(a) of the New York Limited Liability Company law).  That sounds scary, but what does it actually mean?

What does suspension mean in practical terms?

It is unclear.  The law was amended in June of 2006 and the part about “carry on, conduct, or transact business” is new.  Would have been a nice gesture by the law makers to leave us some pointers, but no such luck.

At minimum, this follows from failure to publish:

The LLC will not be able to sue in New York State courts (Federal courts in New York don’t seem to care one way or the other), but can still be sued.   But even when non-published LLCs sue, New York courts have allowed them to fulfill the publication requirement and then continue with the law suit.  No harm done.  There is one case where a complaint by an “unpublished” LLC was actually dismissed: Small Step Day Care, LLC v. Broadway Brunswick Builders.

In order to find out whether an LLC is published or not, one has to order a good standing certificate from the Department of State.  You won’t find that information on the online business entity search page.

Failure to Publish does not destroy liability shield of LLC or its ability to actually do business

But, you can be sure of the following:

The members (owners) of the LLC will still be protected by the limited liability shield of the LLC.

Any contract between the LLC and any other party does not become invalid, because the LLC failed to publish.  You can still technically carry on business.

Can I “cure” the failure to publish at a later point in time (when I saved up enough money)?

Once the LLC  takes care of the publication requirement, the law provides that the LLC regains its authority to “carry on, conduct, or transact business in New York.”  The suspension is considered “annulled”.

The first question for every small business owner who decided to form an entity?  LLC or S corp?  Which one is better for me?

Let’s face it, most people would chose the entity that leaves more money in their pocket.  So let’s compare the tax costs and startup costs of these two entities.  This assumes that the business owner is the sole owner of the business.

As a brief recap, an s corporation is a corporation that elected to be taxed as an s corporation.  When you form a corporation, you are a shareholder and the corporation can distribute income to you by way of a salary or profit distributions, aka dividends.  Most importantly, a corporation offers protection from personal liability for debts of the corporation.

A limited liability company offers the same protection from personal liability.  As a member of an LLC, all the profit goes to you directly, you are not paying yourself a salary.

Cost of forming the Entity

LLCScorp
 Articles of Organization: 200 Incorporation: 125
 Expedited Handling 24 hrs: 25 Expedited Handling 24 hrs: 25
 Certified Copy: 10 Certified Copy: 10
 Publication in Albany:  350 Tax on 200 shares: 10
Total:       585Total:         170

 

So it is cheaper to form the s corporation, which is mainly due to the archaic LLC publication requirement, which serves no real purpose other than to put money into the hands of newspapers (I guess they need it) .  And, unfortunately, usually the cost of publication is higher than in Albany County…in New York County it is more like $1200.

Tax Consequences of LLC v. Scorp

What about the tax situation?  Does one entity cause less tax liability than the other?   This is a highly fact specific question and depends on all your sources of income.  But my friend and esteemed CPA Jonathan Medows did an experiment and compared the 2013 tax situation of two small business owners making $75,000 in revenue and each having $15,000 of business expenses.  He came to the conclusion that it didn’t matter much whether they operated their business as an LLC or an S corp.  Each had about the same personal and business tax expenses (LLC: $20,476,  S corp: $20,755).  Please see here for his article on the subject.

So should you run to form the s corporation?  Personally, I would not go with the s corp.  The upkeep of the s corp requires more paperwork and ongoing tax filing responsibilities, because you have to treat yourself as a formal employee of the corporation.

Klick here to Let us form your LLC!

LLCs without an Operating Agreement

Many if not most small business limited liability companies with two or more members do not have an operating agreement.  An operating agreement is the document for an LLC that provides for rules and provisions regarding the management of the LLC and the members’ rights vis a vis the other members and the LLC.   It is highly advisable to have an operating agreement, especially if you are a minority member of an LLC.  But what rules apply to an LLC without an Operating Agreement?

Let’s look at what happens when you do not have an operating agreement.  Maybe that will teach you to invest the money into having a proper operating agreement drawn up.

Default New York LLC Rules

LLCs without an operating agreement are primarily governed by the New York limited liability company law.

Under this law, the following rules would apply to an LLC and its members:

(Let’s assume the LLC has 3 members, Joe, Jane and Jessy)

Entering into Contracts

Either one of Joe, Jane and Jessy can enter into (most) contracts for the LLC and legally bind the LLC without asking the other two members  §401(a) of the LLC Law.  For example, Joe could sign a lease in the name of the LLC and not involve Jane and Jessy in that decision.

Voting and Distribution

Each member’s voting rights and rights to distribution of the LLC profits would be determined on the basis of the value of their contributions to the LLC as stated in the LLC’s records §402(a) LLC Law§ 504.  Assuming again that Joe, Jane and Jessy probably also didn’t keep records of the value of their respective contributions, one would have to determine the value of each member’s contribution.  How much value can you put on that web design contributed by Joe compared to  the cash pumped into the LLC by Jane and Jessy?  This can get messy and a breeding ground for conflict.

But let’s assume it was relatively straight forward and each of Joe, Jane and Jessy contributed $1000 to the LLC.   This would mean that each of Joe, Jane and Jessy have equal voting rights, but any two of them could outvote the other.  Similarly, each of Joe, Jane and Jessy are entitled to equal amounts of distributions from the LLC.

Continuing with the above assumptions,  Joe and Jane could decide to outvote Jessy and welcome Betty as a new member in the LLC without the consent of Jessy  § 402(c)(1).

Joe and Jane could dissolve the LLC without the consent of Jessy § 402(d)(1).

Joe and Jane could decide to sell all of the assets of the LLC without the consent of Jessy § 402(d)(2).

Joe, Jane or Jessy could decide to assign their membership in the LLC to a complete stranger.   § 603(a)(1)  However, the complete stranger would not have any rights to participate in the management and affairs in the LLC, meaning he can’t vote.  But he/she would be entitled to receive distributions from the LLC as the old member would have received.

Joe, Jane or Jessy cannot withdraw from the LLC prior to the dissolution of the LLC   § 606(a).

Adoption of Operating Agreement

Joe and Jane could decide to enter into a binding operating agreement for the LLC without the consent of Jessy. 402(c)(3)

No Expulsion of Members

Now, even with a majority vote, neither member can be involuntarily expelled from the LLC, no matter how egregious the behavior.  Nevertheless, Joe and Jane could adopt an operating agreement without the consent of Jessy and that operating agreement could contain provisions providing for the expulsion of a member for misbehavior.

If the operating agreement of your New York limited liability company is silent on the subject, there is no law in New York that allows you to expel another member, no matter what he or she did to you or the business.  You are stuck with that member.

Thus it may make sense to adopt an operating agreement that has provisions about member expulsion.

In case a member behaves really badly, the LLC can make that member leave, possibly forcing him to accept a buyout, on terms relative to the wrong he or she committed.

Great care is necessary in drafting these provisions.  If misbehavior is drafted too broadly, everybody will walk on eggshells in order to avoid expulsion or a group of members may conspire against another member to make him/her inadvertently break the rules.

First, what are the grounds for expelling someone?  Some of the options are: Failure to provide the services they promised; loss of professional license necessary to be a member of the LLC, such as in a professional LLC; a serious breach of confidentiality or other material rules of the operating agreement.  And so forth….

Second, there has to be a provision that states when the expulsion is triggered: A Vote of the members? What majority is required?  Is the member who is being accused of wrongdoing excluded from voting?

Third, what are the consequences of an expulsion?  The member could be excluded from voting and just remain with an economic interest, which means he/she receives distributions but cannot participate in the management of the business; He/she could be forced to sell his/her full interest, but on what terms and what is the valuation procedure?

 

How do you out-vote or overrule a minority LLC Member?  It is fairly easy, thanks to the LLC laws in effect in New York.  This is assuming, of course, that your LLC operating agreement doesn’t provide something else.  But since so many LLC’s go without operating agreements (against my advice), let’s look at the requirements under the New York LLC laws (Section 407 of the LLC law).

You can out vote a minority LLC member without a formal meeting, without even notice to the minority LLC member, by simply doing the following:

You need a writing that sets forth the decision(s) of the majority LLC members.

The writing has to be signed by all of the members constituting together the majority in interest of the LLC members.

Each member’s signature on the consent has to include the date of such signature.

Within 60 days of the earliest signature date on the written consent, the consent has to be delivered to the office of the limited liability company, its principal place of business or a manager, employee or agent of the LLC having custody of the records of the LLC.  Delivery has to be made by hand or by certified or registered mail, return receipt requested.  If I were involved, I would recommend the certified mail route, so that there is evidence that it was actually sent.

Finally, prompt notice has to be given of the consent to the minority LLC member.  I am not aware of any case law on this, but it is safe to assume that you should send the notice immediately after delivery of the consent as described above.  And make it a certified mail letter with delivery acknowledgement.

The picture is an example of a written consent overruling a minority LLC member.

Now, one question I didn’t address is how to determine the majority members.  All too often, when no operating agreement exists or the situation is otherwise murky, parties fight endlessly over who was actually entitled to make certain decisions or not.  In those cases everything hinges on the question of who has what “ownership percentage interest” in the LLC.  I will explore that in the next post.