BY ERIC C. BELANGER, ESQ.
The organization of a limited liability company (LLC) is a complex matter and should be taken seriously. The following information is intended to make you aware of certain steps that must be taken, decisions that must be made and the legislative requirements of organizing and maintaining a LLC in the Commonwealth of Massachusetts.
THE FOLLOWING INFORMATION IS AN OVERVIEW OF THE LLC ORGANIZATION PROCESS IN MASSACHUSETTS ONLY; YOU SHOULD CONTACT AN ATTORNEY EXPERIENCED IN THIS PROCESS TO ASSIST YOU IN ORGANIZING YOUR LIMITED LIABILITY COMPANY.
Determining Whether to Organize a Limited Liability Company
Prior to deciding to organize a LLC, alternatives such as organizing a corporation should be considered. It is not necessary to form a limited liability company or incorporate to start a business, but it makes good business sense to do so as the business owner’s personal assets will be protected from law suits and the liabilities of the business. There are both advantages and disadvantages to organizing a limited liability company. A business attorney and an accountant should be consulted regarding the legal and tax obligations of electing to organize a limited liability company and the consequences of choosing to operate a business under the umbrella of a LLC.
Once a LLC is organized, continuing statutorily mandated obligations exist regarding the maintenance of the LLC. Maintenance obligations may also arise out of the provisions of the LLC operating agreement. The LLC will be responsible for submitting records, information and fees to various governmental agencies on a regular basis.
Secretary of the Commonwealth of Massachusetts. A limited liability company comes into existence when its Certificate of Organization is filed with the Secretary of the Commonwealth of Massachusetts Corporations Division. A LLC must also file an Annual Report with the Secretary of the Commonwealth on or prior to each anniversary of its organization.
Massachusetts Department of Revenue. If a LLC is classified as a corporation for Federal income taxation purposes, such LLC must pay corporate taxes to the Massachusetts Department of Revenue. The LLC should be in contact with its accountant to ensure that these taxes are paid. Certain businesses must obtain a sales tax number from the Massachusetts Department of Revenue prior to commencing operations. All state tax-related questions should be directed to either an accountant or the Massachusetts Department of Revenue.
Organizing a Limited Liability Company
Step One: Preparing and Filing the Certificate of Organization. Once it has been determined that organizing a limited liability company is in the best interest of the business venture, certain information must be gathered and certain documents prepared. The document that must be filed with the Secretary of the Commonwealth of Massachusetts, the Certificate of Organization of the LLC, must include:
The name of the LLC, which should include the words “Limited Liability Company” or the abbreviation “LLC” and not be substantially similar to the name of any other venture conducting business in the Commonwealth of Massachusetts;
The principal business address of the LLC in the Commonwealth of Massachusetts;
The name and address of the limited liability company’s registered agent for the service of process;
The date of dissolution of the LLC (if any);
The names and addresses of the managers of the LLC (if any) and the person other than managers authorized to execute documents to be filed with the Secretary of the Commonwealth;
The general nature of the business of the LLC;
The names of persons authorized to execute recordable documents affecting interests in real estate; and
Any other information deemed appropriate by the person(s) organizing the limited liability company.
In addition to the foregoing, a LLC organized for the purpose of rendering a professional service in the Commonwealth of Massachusetts (such as the services of a physician, accountant, attorney, veterinarian, etc.) must indicate in its Certificate of Organization the specific professional services which it intends to render. A professional services LLC must include as part of the filing of its Certificate of Organization, a certificate of the professional services regulating board indicating members’ compliance with professional eligibility standards.
Step Two: Preparing the Limited Liability Company Operating Agreement. In addition to the Certificate of Organization, the members of the LLC should enter into an agreement governing the terms, operation and lifecycle of the LLC. Such agreements are commonly referred to as “LLC operating agreements.”
The following is an overview of provisions commonly included in a typical LLC operating agreement. Certain types of businesses require a more comprehensive agreement while other enterprises require fewer protective and operating provisions to govern the enterprise.
The Massachusetts Limited Liability Company Act provides persons organizing a LLC with considerable flexibility regarding the creation and issuance of membership interests in a limited liability company. A LLC membership interest is similar to a shareholder interest in a corporation and is considered a security under Federal securities laws.
Unless a LLC so elects, it need not comply with the restrictions imposed on Subchapter S corporations, as such a LLC may create greater than one class of ownership interest. Membership interests of various rights, privileges, obligations and values may be authorized and issued to both persons and entities such as trusts, corporations and other LLCs.
Beyond the creation of numerous classes of membership interests, organizers of a LLC may impose conditions of good standing on members of the LLC and impose penalties for non-compliance such as fines and forfeiture of ownership rights. The membership provisions of the LLC operating agreement can also impose restrictions on the admission of additional members or the creation of additional classes of membership interests. Conversely, the LLC operating agreement can permit such additions to be completed with ease.
The membership provisions of a LLC agreement also commonly grant and limit the authority of members of the LLC to act on behalf of the LLC. A typical provision provides that one class of member controls the business of the LLC while other classes remain passive investors and may not act on behalf of or bind the LLC to any business arrangement.
Other common provisions in the membership articles of a LLC operating agreement include compensation of members for services rendered, permissibility of, and restrictions on, member withdrawal from the LLC, and non-competition agreements.
All LLC operating agreements must contain provisions outlining how members’ LLC capital accounts will be maintained. A capital account is an account on a LLC’s balance sheet which represents a member’s share of LLC capital. Internal Revenue Service (IRS) regulations provide specific requirements for the maintenance of capital accounts for LLC allocations of profit and loss to be respected for Federal income taxation purposes.
Allocations of Profit and Loss
The allocation provisions of the LLC operating agreement determine how allocations of profit and loss and distributions of such profit and loss are made among the members of the LLC. As with the maintenance of LLC capital accounts, the IRS provides specific requirements regarding allocations made under these provisions in order for the same to be respected for Federal income taxation purposes. Taxation attorneys and/or accountants often review and sign off on these sections of the LLC operating agreement prior to the agreement being executed and put into effect by the organizers.
LLC operating agreements may contain extensive management provisions providing for (a) managers or management committees, (b) officers, (c) annual and special meetings of management and members, and (d) notices of, and rules regarding, the conduct of such meetings. The organizers of the LLC may alternatively elect to put fewer and less formal rules regarding such topics in place in the LLC operating agreement.
Massachusetts law provides the organizers of a LLC with much greater flexibility when it comes to these items than it does with respect to corporate operations. The organizers may be inclined to eliminate detailed rules in the LLC operating agreement if it is possible that the managers and/or members of the LLC will not be inclined to follow the letter of the agreement and instead choose to run the business venture in a less formal fashion. If detailed regulations are included in the LLC operating agreement and are not adhered to by management, it is possible that the judicial doctrine of “piercing the corporate veil” might be invoked in a law suit relieving the members of the LLC of limited liability protections.
While LLC organizers may elect not to include detailed management guidelines in the LLC operating agreement, it is imperative that rules and guidelines regarding management approval of business operations be included. For example, “The president and treasurer shall have exclusive authority to execute contracts on behalf of the LLC.” The organizers may also wish to include language limiting management’s ability to act with respect to certain LLC business affairs without first gaining the approval of the ownership of the LLC. For example, “Management may not sell substantially all of the assets of the LLC without first obtaining the unanimous approval of the members of the LLC, which approval shall be in writing and included in the books and records of the LLC.”
Transfers of Limited Liability Company Ownership Interests.
All LLC operating agreements, other than those for single member limited liability companies, should contain provisions regarding the transferability of LLC interests. If a LLC operating agreement does not contain such restrictions, members of a LLC might find themselves in business with someone they never intended to work with, or worse yet, with someone they find impossible to work or interact with.
Restrictions on the transferability of LLC interests often come in the form of (a) the required written consent to the transfer of the LLC interest by the non-transferring members; and (b) the LLC interest proposed to be transferred first being offered to the LLC or to existing LLC members.
Real, Personal and Intellectual Property Rights
Contributed Property. LLC operating agreements should contain provisions as to who will own the property used in conducting the business of the LLC. Often one or more LLC members will contribute real and/or personal property to the LLC in lieu of a cash contribution upon “start-up.” In other instances, the members will lease their property to the LLC rather than contributing the property to the LLC outright. The answer to property ownership in the latter situation is straight forward, but what about in the former? What happens when the contributed property is sold by the LLC? How is the profit from such sale shared? Do the members of the LLC share these profits equally or does the contributing member receive a greater share of the profits from the sale? Proper consideration and drafting of the LLC operating agreement answers these and other questions in advance thereby avoiding business disputes and accounting and taxation nightmares.
Property Generated or Created By the Business of the LLC. Some limited liability companies will generate or create their own property. The LLC operating agreement of such a LLC should include language as to how members will share in the value of this property during the life and upon dissolution of the LLC. For example, if the property created by the LLC is to be furniture, the organizers need to determine whether the profits from the sale of furniture should be distributed to the members equally or based upon each member’s furniture production. The organizers must also determine how remaining inventory will be divided among the members upon dissolution in the event the property can not be sold at a price agreeable to the members.
Determinations such as these must be incorporated into the LLC operating agreement so that each member knows his or her rights and obligations regarding LLC real and personal property from the “get go” of the business venture. Lack of planning regarding this subject matter can cause many headaches down the road.
Intellectual Property Rights. Certain limited liability companies engage in business that generates intellectual property, such as copyrightable and patentable ideas, concepts and materials. The operating agreements of limited liability companies engaging in this type of business should contain provisions for the ownership of intellectual property rights and the licensing of the same to appropriate parties. Examples of appropriate licensees include the LLC (if the LLC is not to be the owner of the intellectual property), members, consultants and independent contractors retained to work with the LLC, and third parties making use of the intellectual property pursuant to a purchase of a license.
Relationships with Independent Contractors
As small and start-up ventures’ business grows, it is often necessary to increase the LLC workforce to accommodate the needs of the developing enterprise. However, such companies often do not have the capital resources to retain full-time employees when expansion is needed. At the same time, members may not wish to offer the additional workforce ownership interests and a percentage of the LLC’s profits in exchange for their services to the LLC. The answer to this dilemma is often the independent contractor. It is smart business practice to contemplate the need for independent contractors during the preparation of the LLC operating agreement and provide in the agreement at a minimum (a) a manager or member who is responsible for selecting independent contractors, (b) member approval of additional workforce, (c) provisions regarding the termination of independent contractor services, and (d) management, business attorney or member approval of the terms of service agreements between the LLC and independent contractors.
Books, Records and Taxation
All LLC operating agreements should include paragraphs regarding the maintenance of the books and records of the LLC, selection of an accounting method, provisions for quarterly and annual accounting, member inspection and audit rights, control of LLC bank accounts, selection of tax and fiscal year, and the IRS mandated election of a Tax Matters Partner.
The LLC operating agreement should include provisions for indemnification of members, managers and officers in the event the actions of such individuals on behalf of the LLC result in a law suit by the LLC or any third party. These indemnification rights are commonly limited to unintentional acts or acts of simple negligence and do not extend to intentional misconduct by members, managers and/or officers.
Dissolution and Termination
All LLC operating agreements should address the method of winding down the affairs of the LLC in the event of a variety of events such as death or disability of members, irreconcilable differences between the managers and/or members and any other event the organizers of the LLC deem appropriate. These provisions also set forth the hierarchy of the distribution of LLC assets and profit and loss upon dissolution and termination of the LLC.
The LLC operating agreement of a new business venture may become obsolete as the business and/or ownership of the LLC grows and evolves. The amendment provisions of the LLC operating agreement take this into consideration. The members may wish to create new types of membership interests, put a more complex management structure in place, and/or adopt additional formulas and mechanisms for compensation and profit sharing.
Paragraphs regarding the amendment of a LLC operating agreement should provide for a certain percentage of the ownership of the LLC to approve changes to the LLC operating agreement. A majority vote is typically included for limited liability companies with many members; while a unanimous vote is commonly found in the operating agreements of limited liability companies with three or fewer members. As with most provisions of the LLC operating agreement, these decisions are best left for the organizers to determine in light of the facts and circumstances of each particular business venture.
Other Considerations Regarding Organizations
Federal Employer Identification Number. A LLC which has more than one member must apply for an employer identification number (commonly referred to as the EIN or Federal Identification Number). The EIN is required for federal taxation purposes and is also used as a reference number for filings with the Secretary of the Commonwealth. Limited liability companies apply for an EIN by completing IRS Form SS-4 and filing such form with the Internal Revenue Service. Unless it elects to be taxed as a corporation, a single member LLC is disregarded by the IRS for income taxation purposes, however a single member limited liability company should consult an accountant regarding the propriety of applying for an EIN as certain business and accounting purposes may justify such application.
Licenses and Permits. Prior to commencing business operations, certain business ventures are required to obtain licenses and permits from state, county and municipal authorities in order to begin operations. For example, prior to opening for business, new owners of bars and restaurants serving alcoholic beverages and providing entertainment to customers on premises must either obtain, or complete transfers of, licenses to sell alcohol at the state and municipal levels and receive municipal licensing of the type of entertainment the restaurant wishes to provide.
Workers’ Compensation. The limited liability company may be required to maintain insurance coverage under Workers’ Compensation laws. The company the LLC selects for its payroll processing will walk the organizers through this process. The organizers may also ask the limited liability company’s attorney or accountant to recommend an insurance provider.
Maintenance of the LLC. Each year a limited liability company must:
File an Annual Report with the Secretary of the Commonwealth. The Annual Report must be filed by the anniversary of the filing of the Certificate of Organization of the LLC.
File a Corporate Excise Tax Return with the Massachusetts Department of Revenue if the LLC elects to be treated as a corporation for Federal income taxation purposes.
File a Federal Income Tax Return. Unless it elects to be taxed as a corporation, the LLC is a “flow-through” entity for Federal income taxation purposes; however, it must file an income tax return with the IRS. The members of the LLC then take the profits and losses of the LLC into account on their own income tax returns.
File changes in the Limited Liability Company. Once the LLC has been organized it may be necessary to make certain changes to the original Certificate of Organization. For instance, the LLC might move its operations and, therefore, change its principal place of business; or change its business name. Changes such as these do not take legal effect until properly filed with the Secretary of the Commonwealth of Massachusetts.
Penalties for Non-Compliance. These statutory responsibilities must not be taken lightly. Managers and active members of a LLC are responsible for ensuring that the LLC fulfills its legal duties. Massachusetts law provides that penalties may be assessed against limited liability companies that fail to comply with legal requirements. For example, failure to file the Annual Report with the Secretary of the Commonwealth can result in the involuntary dissolution of the LLC.
Not Every Lawyer is Experienced in Limited Liability Company Law
Many attorneys are not familiar with limited liability company law and simply file a standard “form” with the Secretary of the Commonwealth without taking into consideration the specific needs of a particular business venture. Similarly, these attorneys often neglect to prepare a LLC operating agreement tailored to the particular needs of a specific business venture. The failure to put an appropriate LLC operating agreement in place can leave the members of the LLC open to personal liability for the acts of the LLC and create unintended obligations and relationships between the members of the LLC.
Avoid Using Online Services to Organize Your LLC
Issues often arise when persons wishing to organize a LLC use an Internet-based company to file their organizational documents and prepare a LLC operating agreement. Online organizations charge a smaller fee by eliminating the thought processes and decision-making that goes into properly documenting the specific needs of a particular business enterprise. Using online services may save the organizers of a LLC money in the short term but create unnecessary liabilities and headaches down the road.
Retain An Experienced Business Lawyer to Organize Your LLC
Everyone organizing a limited liability company should consult attorneys well versed in the LLC organizational process and familiar with the representation of small or start-up business ventures. Experienced business attorneys will make detailed inquiries regarding the proposed business venture and the anticipated ownership structure of the LLC to be organized. They will use this information to prepare a Certificate of Organization and LLC operating agreement tailored to meet the specific needs of the fledgling business enterprise and continue to work with the LLC as its business grows and evolves.