Five Questions to Ask Before Forming an LLC

The decisions you make when forming a limited liability company (LLC) can have long term consequences. When forming an LLC, there are five things in particular that you should think about before you file any official documents. This article assumes that you have already chosen an LLC as your preferred entity type (instead of a corporation, partnership, sole proprietorship, and the like), based on a variety of factors that are relevant to your particular situation. For further information on how to pick the corporate entity type that is best for you, see Choosing the Best Ownership Structure for Your Business.

In What State Should I Form My LLC?

A variety of factors can determine the state in which you decide to form your LLC. The most obvious choice is usually the state where you are physically located and expecting to conduct your business. Some states (Florida, for example) offer added incentive because they have user-friendly online services that allow you to file and access corporate documents and information on the Internet. Other states (Delaware, for example) offer no online filing services and disclose very limited company information on the Internet, but are preferable to those persons seeking to limit public access to confidential company information.

Some new business owners prefer to form their LLCs in states like Delaware because of its favorable tax treatment and more fine-tuned corporate legal system. Also, the corporate case law in Delaware is more well-developed, which reduces uncertainty for how your business can be conducted legally. However, remember that if you end up conducting business in states other than your state of formation, you will likely be required to file (and maintain) authorizations to transact business as a foreign LLC in such states (see 50-State Guide to Qualifying Your LLC to Do Business in Another State).

What Will I Name My Company?

If you aren't under pressure to form your LLC right away, you can potentially save yourself future aggravation by carefully choosing the exact name you want for your LLC. Be sure to check the LLC statute in your state of formation to make sure your preferred LLC name satisfies all legal requirements. You will also need to make sure that the name you want is available in your state. See 50-State Guide to Forming an LLC.

The good news is that you can always change the legal name of your LLC if you need to. Every state has a different process for changing the name of a company, some more complicated than others. Furthermore, if you want to conduct business under another name, you can avoid changing the legal name of the company by filing a fictitious name (also known as a doing-business-as or assumed name in different states) in the states or localities where you want to conduct business under such name. See How to Register Your Business Name. Fictitious names can be very useful if you want to vary your business' name by geographic location, or assign different names to separate divisions within the company. This allows you to avoid having to formally create new subsidiaries.

Do I Have Investors?

Starting a business with your own money typically makes things a lot less complicated. Having investors who expect to make returns on their investment can add complexity to your LLC in many ways. For example, if there is only one investor, then that person may want to be fully repaid before any other owners (called members) receive distributions on their ownership interests (called membership interests). Multiple investors will likely want to have the LLC repay them on identical timelines, with repayments made proportionally based on their respective membership interests. Sometimes the investors will agree that they don't need their money returned until the LLC is sold or liquidated, in which case no other members will get a penny until the investors have been repaid in full.

The negotiation of these terms will depend on the relationships and relative bargaining power among the parties. In any case, the financial understanding between you and any investors should be fully memorialized in an operating agreement (referred to as an LLC Agreement in some states) signed by you, the investors, and the other members at the time you form the LLC. See The LLC Operating Agreement. The operating agreement will also include any other rights demanded by the investors regarding control of the company's management, selling the company, preventing other members from transferring their membership interests, and other matters.

Who Will Own and Manage the Company?

Initial ownership of the Company is typically based on what capital, talent, or other assets people are bringing to the business. Because membership interests in a company are its most valued assets from a control and profit perspective, you will typically want to relinquish as little ownership interest in your LLC as possible. For example, instead of giving away membership interests, you can instead offer alternative compensation arrangements (for example, commissions, wages, salary, or profits interests) to persons you need to operate your business. However, note that it is standard for investors to be members because they're putting up the money and have the most financial risk. The number of membership interests given to each member will usually be based on such member's proportional contribution to the LLC. After the members negotiate their ownership amounts, each member's membership interests should be reflected in the operating agreement.

Management of the LLC can take many different forms, particularly if there are multiple members are investors. Generally, management of an LLC will fall into one of the following categories:

• You are the sole member, with no investor, and you fully manage the company.
• The LLC has multiple members (possibly including an investor), but all the members agree that one person manages the company.
• The LLC has multiple members (possibly including an investor), all the members agree that one person manages the company, but that person needs their consent before taking certain actions that are outside the ordinary course of business (for example, borrowing money, selling the company, declaring bankruptcy, and the like).
• The LLC has multiple members (possibly including an investor), and all the members agree to manage the company together, perhaps by forming a board of managers (which is similar to the board of directors of a corporation).

Again, after you and the other members negotiate the final management arrangement, the terms should be specifically reflected in the operating agreement so that everyone is clear of their rights.

Do I Have an Accountant or Tax Lawyer?

One of the attractive characteristics of an LLC is the potential pass-through tax treatment. Having an accountant or tax attorney advise you during and after the LLC formation process will allow you to best take advantage of this benefit. Among other things, your tax adviser can inform you how to get your company's tax identification number and use it to open up a bank account. Your tax adviser can also give you a tutorial on what you can write off as business expenses for tax purposes and suggest how you should retain receipts and maintain your internal financial records. Your tax adviser can also guide you on how to make and record periodic cash distributions to members, if applicable.