Sunday, July 17, 2011

Economic Empowerment: How to Form Your Own LLC (In Plain English)

The Notorious B.I.G. said it best: "Either you slang crack rock or you got a wicked jump shot."  The profoundness of this lyric has become increasingly apparent during these hard economic times where millions of people have worked so hard making other people rich only to find themselves unemployed in return.  Far too often we hear our conservative brethren tell us that in order to make it in America we need to pull ourselves up by our bootstraps.  Although that proposition mistakenly assumes that any of us are born with boots in the first place, the underlying point is not far off from the point made by Biggie: the only way for any of us to become wealthy is if we take matters into our own hands.  In other words, you have to start your own business because you're never going to be financially sound working for somebody else.  Especially in this economy.

Realizing that you need to start your own business is the easy part.  That's the "pull yourself up" assumption of the bootstraps mantra.  Understanding HOW to go about starting your own business, on the other hand, is the hard part.  Nobody ever talks about that part of the mantra.  That is, until today.  In this post I will discuss the 411 on forming your own Limited Liability Company (LLC), which can help make the journey of starting your own business a whole lot easier.

Before we begin I have to give a disclaimer up front: I am a corporate law attorney but, with all due appreciation to you for taking the time to read this post, I am not YOUR PERSONAL corporate law attorney. In other words, nothing I am about to say here should be mistaken as legal advice that would create an attorney-client relationship between us.  This post is purely for educational purposes only.  OK?   I know, I know - to most of you this may seem as obvious as understanding that you're not really going to win a Harrier II fighter jet just because a TV commercial says you can get one by turning in a few million Pepsi points, but you'd be surprised to see what people sue about these days.

Now that we've gotten that out of the way let's get down to business, shall we? 

What the heck is an LLC and why do you need one to start your own business?
An LLC is a relatively new type of business entity.  It's similar to a Partnership or a Corporation but with a lot fewer rules and complications which is why it has become increasingly popular over the past two decades.  An LLC can either have multiple "members" if you want to go into business with some friends, or it can be a "Single Member LLC" if you simply want to go into business by yourself.  As the name implies, it "limits" your liability as a business owner in the event that your company ever runs into any legal or financial trouble. For example, if you open a bakery and somebody happens to choke on one of your cupcakes and successfully sues you in court, the judgment will only attach to your company's bank account and assets.  Your personal bank account and belongings, on the other hand, will be shielded from the judgment (provided the court finds no reason to "pierce the corporate veil" - we'll define this later).  Other common scenarios in the business world include situations where your company takes on a financial obligation that, for reasons beyond your control, it simply can't repay or signs a business deal that turns out to be sour. In either scenario, the liability of your business is limited to the company's pockets only and not yours.  Given the million and one things that can go wrong with a business, you can probably see how this type of a set up might come in handy.

Despite how beneficial an LLC is for a business, the fact of the matter is that you actually don't need an LLC (or any business entity for that matter) to start your own business.  You could walk outside of your house or apartment right now and hang up a sign that says "Psychiatric Help 5 Cents" and start making money today, Jack.  In the legal world we call this a "sole proprietorship."  Again, you could do business this way, but the question is should you?  In today's business world, that would literally be like going to a casino and placing all of your chips on red at the roulette table.  In a sole proprietorship, one bad business deal could not only clean out your business's bank accounts but it could also clean out your own personal bank account and possibly everything you own.  When you consider that forming an LLC can cost as little as a few hundred bucks in most states, it begs the question why anybody would gamble with going the sole proprietorship route.

Another important aspect of the LLC is that an LLC can actually tell the IRS how it wants to be taxed (no I'm not joking). It can be taxed like a sole proprietorship or a partnership where the profits of each member are only taxed once (known as "pass-through taxation" because the tax "passes through" the LLC and goes directly to the member(s)), or it can choose to be taxed as a corporation where the profits are taxed twice, once at the LLC level on any revenue the business itself received and once at the individual membership level on any profits the members received.

Lastly, if you should ever want to turn your business into a corporation at any time in the future, it is much easier to go from an LLC to a corporation than it is to go from a corporation to an LLC.  Trust me.

Is the Limited Liability absolute?
No.  It is not absolute.  Most people don't realize this and after they've formed their LLC they put their paperwork in a drawer somewhere and think that they're fully shielded from any bad business decisions they might make in the future.  It doesn't work like that.  It is possible to make a few bad decisions that will allow a court of law to do what is known as "pierce the corporate veil," meaning the court can reach through the shield of your LLC and empty your pockets.  Very quickly, a few examples are:
  • Mixing your own money with your company's money in the same bank account.  Don't do this.
  • Making company by-laws and then not following them whenever it's inconvenient for you.
  • Your company defaults on a loan it received from a bank where you signed a personal guaranty for the loan.
  • Signing a contract using ONLY your name and forgetting to put "Member of ABC LLC" after your name.
  • Failing to pay taxes to the IRS.
  • Using the LLC to commit fraud.
Do any of those things and a court may have grounds to come after you personally, limited liability be damned.

How do you form an LLC?
There are about a thousand and one Legal Zoom-type companies out there that will be glad to take your hard-earned money for their "Delux" LLC-formation packages which are full of a bunch of unnecessary crap, and many people buy them not knowing that they only need the following 5 or 6 items that we're about to go over.  All the rest of the stuff you see on these websites - such as your very own "LLC Kit," expedited shipping, newsletter subscriptions, member certificates, or "member transfer ledgers" - are COMPLETELY unnecessary, although these websites do a very good job of making it seem like you need everything they're offering.  As a general rule of thumb, pretty much any so-called "delux" or "complete" LLC formation package is going to be a waste of your money.   You should opt for the "standard" or "basic" LLC formation package instead and add the items below as needed. Once you've picked out a name for your company (arguably the first and most important step in the process) these are the only things that you actually need in order to form your own LLC:

1. Run a company name search in your state.
You can't pick a name that's already being used and also some states have restrictions on words that are not allowed in the title of your business such as "underwriter" or "lawyer."  Each state varies so you should look at the Department of State website for the state you live in to be sure.   If you use a business filing company to form your LLC, this service is typically included.

2. File the "Articles of Formation/Organization" with your State Department.
The "Articles of Organization" is simply a 1 or 2-page document that tells the State Department in your state the basic info of your LLC, such as its name and who is a member.  You can view an example of what it looks like in New York HERE.  Most states charge a filing fee for accepting this document (of course), so check with your state's Department of State for the costs where you live.  If you use a business filing company to form your LLC, they will add the filing fee on top of whatever they charge you for their services.

3. Apply for a Federal Tax ID (EIN) Number.
An Employer Identification Number (EIN) is a 9-digit number that allows the IRS to identify your business for tax purposes.  You will also need it in order for your LLC to be able to open a bank account or take on any employees.  The IRS, of course, charges a small fee for this application. For more info see the IRS website HERE.  If you use a business filing company to form your LLC, they may add the application fee on top of whatever they charge you for their services.

4. Establish a Registered Agent in your State.
A "Registered Agent" is simply a fancy way of saying "the guy who will accept official notices for your business during business hours."  And when I say "official notices" I'm talking about accepting service of process if your company ever gets sued or accepting tax documents from the IRS.  You have to have one because every state requires you to have one.  Technically, you could be your own Registered Agent but most states require the Registered Agent to be available during business hours every day during the work week, so most companies simply pay another company that specializes in this sort of thing to act as their official Registered Agent.  You shouldn't pay much more than $100 bucks a year for this service.  If any business filing company tries to charge you more than that then they are trying to get over on you.

5. Draft an Operating Agreement.
An Operating Agreement is basically the constitution or "by-laws" of your company.  It spells out things such as the purpose of your LLC, the ownership interest of each member, how profits will be split, etc.  You can see a sample HERE.  Unlike the Articles of Formation, you don't have to file this document with the state (or with the feds).  You simply draft it, get all members to sign it (or sign it yourself if you have a Single Member LLC) and then keep it in a safe place.  If your LLC ever goes to a bank for a loan, the bank will likely ask to see a copy of your Operating Agreement.  If you use a business filing company to form your LLC, this may or may not be an item that they will draft for you depending on the company.  You do not need a lawyer to draft it, but it is probably in your best interest to have one do it for you, especially if you are not using a business filing company to draft one.

6. Comply with the Publication Requirement of your State (if there is one).
Some states, like my beloved money-grubbing state of New York, have an additional step in the LLC formation process that requires you to actually publicize the formation of your LLC in a few newspapers for a particular amount of time before the state will allow your LLC to do business in the state.  I know right?  If your state has such a requirement - and not all of them do - this step can be quite costly, ranging anywhere from a few hundred to a few thousand dollars.  It all depends on how much advertising costs are for the given newspapers in your area.  After you complete this requirement, the newspapers will provide you with an affidavit saying that you paid them their blood money completed this state requirement and you can then file those documents with the state (for a small filing fee of course).   If you choose to use a business filing company on this item beware: most companies do not - repeat - do not pay for the actual cost of the newspaper publication.  What they charge you for is the service of talking with the newspapers on your behalf in order to set up the advertisement, but they do not pay for the advertisement itself.  They leave that cost to you.  So if you are using a business filing company to form your LLC and you see an option to pay for the "publication requirement" just know that the fee that you see does not include the actual cost of the advertisement.  When in doubt, check with your state's Department of State to see which newspapers are acceptable and then speak with the newspapers directly to see what they charge.

So that's it.  Whether you decide to use an LLC formation service or whether you decide to do it yourself, those are the 5 (possibly 6) steps that you need to do in order to form your own LLC to protect your business and protect yourself.  Forming your own LLC may cost you a few hundred bucks early in the beginning, but it can save you thousands (possibly millions) of dollars later on.  Hopefully this info has helped you get one step closer to taking your financial future into your own hands.

Good luck!
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