Why A Limited Liability Company (LLC) Might Be The Right Fit For Your Start-Up Internet Business

Updated January 2009

By Ethan Watts

When starting an internet based business (or any business), one of the important issues you will face is whether to form a business entity and, if so, what sort of business entity to form. This article explores the advantages and disadvantages of forming a limited liability company ("LLC") in California, and why an LLC may be the right choice for your start-up internet based business.

Protection from personal liability for business debts is of course one of the main reasons to form a business entity such as an LLC. Generally, only the LLC (which is considered a separate legal entity (see Corp. Code § 17701.04(a))) can be held responsible for the entity's debts. Thus, like corporate shareholders, LLC members are generally not personally liable for the LLC's liabilities. Corp. Code § 17703.04(a).

An LLC also has characteristics of a partnership in that it is given the “pass-through” tax treatment of a partnership. Although an LLC is taxed like a partnership, it need have only one member (i.e. owner). Corp. Code § 17704.01(a). LLC owners do not have to be U.S. citizens or permanent residents.

An LLC enjoys perpetual existence. Corp. Code § 17701.04(c) Even if an LLC owner dies or leaves the business, the LLC persists. An LLC may be dissolved by the vote of 50% or more of the voting interests of the members of the limited liability company, or as otherwise provided in the articles of organization or a written operating agreement. Corp. Code § 17707.01 (see also Corp. Code §§ 17707.01 - 17707.09 for other circumstances in which an LLC may be dissolved).

An LLC member's capital contribution to the LLC may consist of "tangible or intangible property or other benefit to a limited liability company, including money, services performed, promissory notes, other agreements to contribute money or property, and contracts for services to be performed." Corp. Code § 17704.02. This is in part different from the issuance of corporate shares in that an “obligation” to contribute property (unless adequately secured by collateral other than the shares acquired or unless permitted by Corp. Code § 408)or future services is not lawful consideration for the issuance of corporate shares. Corp. Code § 409(a)(1). Indeed, a person may become a member of an LLC "without acquiring a transferable interest and without making or being obligated to make a contribution to the limited liability company." Corp. Code § 17704.01(d)

By default under the Corporations Code, LLC profits and losses (or money or property) are allocated in proportion to each member's capital contribution to the LLC. However, such profits and losses may be allocated differently as provided in the operating agreement. Corp. Code § 17704.04(a).

In order to form an LLC, articles of organization must be filed with the Secretary of State. Corp. Code § 17702.01. The person or persons who execute the articles need not be members of the LLC. Id. To validly form an LLC, the members must also enter into an operating agreement either before or after filing the articles. Although not recommended, the operating agreement may be oral. Corp. Code § 17701.02(s). A Statement of Information must also be filed within 90 days of the filing date of the Articles. Corp. Code § 17702.09. Depending on whether the LLC is member-managed or manager-managed, the LLC, unless it qualifies for an exemption, may need to comply with state and federal securities registration requirements.

Regarding managing the LLC, the LLC requires fewer formalities than a corporation. LLCs need not hold annual meetings or record meeting minutes (although not necessarily recommended). Each member has the right to vote in proportion to such member's interest in the current profits of the LLC, unless the articles of organization or operating agreement provides otherwise. Corp. Code § 17704.07(r). Generally (with a few exceptions – e.g. to amend the articles of organization or operating agreement), the vote of a majority in interest suffices in determining the actions of the LLC. Corp. Code §§ 17704.07(b)(3), 17704.07(c)(5), 17704.07(r)(3), 17704.07(s). Management of the LLC is vested in all its members unless the articles of organization provide otherwise. E.g. Corp. Code §§ 17703.01(a), 17702.01(b)(5). If an LLC is managed by all its members, each member is deemed an agent of the LLC in dealings with third persons and can bind the LLC. Corp. Code § 17703.01(a).

An LLC may also be managed by one or more designated managers (“centralized management”), if the articles of organization so provide. Corp. Code § 17702.01(b). By default, LLC managers (and members in a member-managed LLC) owe fiduciary duties of care and loyalty to the LLC and the LLC’s members. Corp. Code § 17704.09. Generally, LLC managers and members are not personally liable for any LLC debt, obligation or liability (Corp. Code §17703.04(a)), but a member may agree to personal liability "as long as the agreement to be so obligated is set forth in the articles of organization or in a written operating agreement that specifically references [Corp. Code § 17703.04(e)]." Corp. Code § 17703.04(e) However, similar to a corporate officer, an LLC manager will likely be liable for his or her own torts.

Under the California Revised Uniform Limited Liability Company Act, a member of an LLC is free to transfer all or a portion of the member's interest in the company to any other person at any time. However, LLC operating agreements typically have provisions restricting the transfer of membership interests, such as requiring a majority of other members to consent to the transfer.

In summary, a limited liability company, because of its relative flexibility and the members’ ability to manage it with as little formality as desired, may be the right fit for a start-up internet business seeking limited liability protection.

 

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The above discussion is intended to be a general commentary on legal issues. Each situation is different and this article is not intended as legal advice. Further, nothing in this article is intended to create an attorney-client relationship.

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