New kid on the block, The

LLC: New kid on the block, The

Kleinman, Randall

Is a limited liability corporation the right structure for your agency?

(Agents’ Legal Issues provides a brief, general overview of a complex area of law, and neither the author nor Rough Notes intends it to be taken as legal advice for any specific legal problem. For a specific legal problem, consult legal counsel that understands the law of insurance and insurance agencies, and provide all the details.)

There’s a new group of kids on the block these dayscocky young kids who think they can solve all your problems when you want to start a new business enterprise. Who are these new guys? They’re called limited liability corporations, or LLCs for short. But are these kids good guys or bad guys? To find out, we have to look at them in comparison with the old regulars on the block.

Sole proprietorships

When you establish a new business, you have to decide what legal form it will have. Several types vie for your attention. First is the sole proprietorship, in which you simply conduct your business without choosing any particular form (the word “sole” means there’s only one boss, although there can be several employees). In the old days, you could just open up shop and start selling in this manner. And today, in fact, if you don’t use one of the other business structures, a court might find that you are a sole proprietor, because the law has to assign some legal structure to you in case of a dispute. Even as a sole proprietor these days, you’ll probably have to pay fees to get city and county business licenses; and if you’re a professional, such as an insurance agent, you’ll also need to pay licensing fees to a state agency or two. So if you have to pony up money in any case, it’s worth your while to consider what business structure makes the most sense for you.

I remember reading several years ago about a real estate developer who had started as a sole proprietor and had built up an organization of a couple of hundred employees, while still operating in the same form, without incorporating or forming any other type of legal structure to operate his company. So, potentially, a company can become quite large in the sole proprietorship form.

Corporations

The second form of business is the good old corporation, which was invented hundreds of years ago. In the early days, consumers often were surprised to learn that a group of businesspeople could go out of business holding consumer money and yet not be liable for failing to deliver goods-but that’s the corporation, a form of business in which, technically, only the corporation is liable and not the individual owners. Operating as a corporation these days, however. can have considerable drawbacks. First- courts have developed many ways to “pierce the veil” of the corporation (to use legal jargon), and to find individual shareholders or officers liable. It doesn’t always happen, but you can’t assume you’re shielded from individual liability just because you’re associated with a corporation. Second, a corporation has a very rigid power structure-somebody has to be chairman of the board, and somebody has to be president, while other investors or managers have lesser titles and lesser power. Third, in some states it’s quite expensive to set up a new corporation. In California, for instance, once you pay the legal fees to a typical business lawyer, and once you pay state fees, setting up even a small corporation might cost you between $1,000 and $2,000. For a large start-up, or for a successful corporation based in another state that wants to start operations in a new state, it can be more expensive. And that’s just one additional state-if you want to operate in 50 states and internationally, you have to comply with legal procedures and pay fees in each state and country, which can be quite expensive. Most large entities choose to operate as corporations; more and more large companies, however, are using other operating structures.

Partnerships

The third kind of business structure is partnership. Most people don’t realize that if they get together with a couple of buddies to start a company and they don’t form a corporation, the law will probably treat them as partners. These people also don’t realize that the law in each state has all sorts of provisions that describe how a partnership is supposed to operate if the partners haven’t written up a detailed partnership agreement. That’s because so many partners fail to have a lawyer draw up a formal agreement that state lawmakers decided it was prudent to put provisions in the law in the absence of a formal agreement. As a partner, however, you’re better off having an agreement to avoid problems down the line. You might as well have an agreement where you know the obligations and rights, instead of finding out later that you’re bound by a law you don’t know about!

The basic partnership, however, has a severe drawback: it offers no limited liability. Sure, you can buy insurance to deal with certain kinds of problems, but it’s nice to have a limitation of liability written into the law. That’s why most new partnerships consider whether they want to be limited partnerships or limited liability corporations. In a limited partnership (not the same thing as an LLC), there’s usually one “general partner” who has much more power than the “limited partners”; so for limited partners there’s a tradeoff, where you have much less liability, but also much less power. I remember reading about a limited partner in a major league baseball team who said he hadn’t realized when he bought into the team that he had not only limited liability, but also limited power! The general partner made most of the decisions, and this limited partner just watched.

Another kind of partnership is the joint venture, in which two big corporations join together to form a partnership, usually on a temporary basis. If one corporation is in telecommunications and the other is in software, they might form a joint venture to make telecommunications software. Sometimes a joint venture is like a trial marriage, and if it works out well, the two companies may merge into one in the future. Some states have special laws regarding the operation of joint ventures, which may be somewhat different from the usual partnership laws.

LLCs: new kids on the block

As noted earlier, the new kids on the block are limited liability corporations. The concept isn’t totally new, although it was only during the 1990s that most states got on the legislative bandwagon regarding LLCs. Although some foreign countries (notably Germany and France) have had something like the LLC for many decades, in the United States the first state to allow LLCs was Wyoming in 1977. Other states slowly followed; but when only a few states had LLC laws, it was dicey to start up a company as an LLC if you wanted to operate nationwide, because you didn’t know what kind of reception you’d get in states that didn’t have LLC laws. The laws of Wyoming and Delaware served as the models for other states that were considering the adoption of LLC laws. There’s also the Uniform Limited Liability Company Act, which was drawn up by a conference of experts in 1995 to serve as a model for states seeking to conform their laws to approved provisions.

The laws of some states may refer to “business trusts” or “statutory trusts” instead of using the term LLC. Keep in mind that the various state laws are not standardized (although they may essentially follow the form of the Wyoming or Delaware laws), so you need to check the laws of your particular state to learn how LLCs based there may operate.

To simplify, an LLC is a formal business entity that has limited liability (somewhat like a corporation), but that basically operates in many ways like a partnership. For the right company, it may combine the features of a corporation the owners want with the features of a partnership they want. But for the wrong company, it may combine bad features of both entities.

States with LLC laws may restrict the kinds of enterprises that may form LLCs. Some states, for example, don’t allow banks or insurance companies to operate as LLCs. The Internal Revenue Service has been a major factor in the growth of LLCs, because it was unclear for many years how LLCs were to be treated under the tax laws. LLCs are now generally treated as partnerships, which can give investors considerable benefits. Of course, businesses formed as so-called “S” corporations can receive similar tax treatment in most cases. The tax issues are important enough that anyone thinking of forming a new company, whether LLC or not, should get competent tax advice as to the benefits and drawbacks of each operating structure.

Documents and fees

A new LLC must file various documents with state authorities and also pay statutory fees. The principal document is the articles of organization, which are similar to articles of incorporation that a corporation files, and which describe some of the basics of the LLC. Before it can conduct business, the newly formed LLC must prepare an operating agreement, the counterpart of a partnership agreement.

The operating agreement encompasses the key facts about an LLC: its name, the location of its main office, the name of the legal agent for service of legal papers, the kinds of business the LLC conducts, who manages the company and how, how one becomes a member, members’ rights and obligations, when formal membership meetings are held, how the LLC will handle disputes, whether various types of insurance are allowed or required, and other provisions involving officers, taxes, accounting, contribution of capital, expenses, withdrawal of members, and dissolution of the LLC.

Although the LLC as a business structure is fairly new in most states, there are some problem areas where litigation has already occurred. A case in Virginia involved an LLC with two members who had a dispute over who had the power to take a certain action. The court ruled that a “majority of members,” as described in the operating agreement, was necessary to take the action in question, and one out of two members was only 50%, not the required 51% that would have been a majority.

Another case, this time in New Jersey, involved the decision of two businesses to join together to form a limited liability corporation, and whether that change in structure would constitute a “change in control” such that regulators would have the right to approve the new LLC and its operations, or whether this was no different than the existing businesses.

In this case, the businesses won out over the state agency that had sued them.

Hot-button issues

Other hot-button issues also affect LLCs. First, like corporations, LLCs may lose protection if they don’t keep up with the required paperwork.

Further, some states may not allow an LLC to have only one member, so if a two-person LLC loses one person, it may no longer qualify to be an LLC.

Issues also have arisen as to who is a “member.” State laws offer a lot of flexibility in this regard, but that flexibility often causes LLCs to be unclear as to when a person becomes a member. Because membership usually involves financial obligations, lawsuits can easily arise if the details of membership are not pinned down.

Questions come up as to who can sue an LLC in the event of financial problems. Where corporations are concerned, a shareholder can usually bring suit “on behalf of the corporation” against the officers and directors when malfeasance is involved, in what the courts call a “derivative action.” The courts are still divided as to whether a member of an LLC can do the same thing.

A related concern is whether a creditor of the LLC has the right to sue the members of the LLC. Normally, creditors of a corporation will not sue shareholders of the corporation who have not been active as officers or directors. In the case of an LLC, if a member has not paid all of his/her capital requirements, he/she usually can be sued by a creditor.

Questions also have arisen as to when an LLC is actually to be considered dissolved, and if it is dissolved, who would be liable if the company continued to operate under another structure.

Another issue concerns how members are to proceed if the manager or a member wrongfully pays out money to someone from the LLC. State laws often provide procedures for members to follow in such a case.

In general, lawyers tend to use legal precedents involving corporate law as a model on which to base their legal arguments involving LLCs, because there are so many precedents involving corporations. Because the LLC operates more like a partnership or perhaps a limited partnership, however, a clever lawyer might be able to score more points by instead basing arguments on partnership law.

The LLC is a great new business structure that every insurance agent needs to understand. But don’t assume that just because it’s newer, an LLC must be better than a corporation or an old-fashioned partnership. Check out the legal, tax, and financial situations before deciding on any business structure. No one structure is perfect in all situations, but for your particular operation, you’ll probably find that one structure is much more suitable than the others!

The author

Randall Kleinman, JD, CPCU, CLU, is a graduate of Stanford Law School whose legal practice involved agents’ legal issues for many years. He is presently vice president of Online Services and corporate counsel for a company that produces insurancerelated software and online services. He is a frequent speaker on topics such as insurance, law, and the Internet. He may be reached via e-mail at Oospensky@msn.com

Copyright Rough Notes Co., Inc. Jan 2000

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