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Chapter Two

Entity Formation

Case Numbers 1 & 2 – John and Liz; Mary and Gary

John and Liz are ready to form J & L Consulting, LLC. Mary and Gary are likewise ready to form M & G Holdings, LP. How do they proceed?

Limited Liability Company

With an LLC, Articles of Organization are filed with the secretary of state’s office of the state in which you wish to operate. Before the Articles are filed the organizers must determine if they are to be member-managed or manager-managed and who the managers will be. A resident agent (an individual or corporate entity that will agree to accept service of legal documents on your behalf) must be identified and accept the appointment. In some states a resident agent is known as a registered agent. An Operating Agreement is then prepared which further details the rights and responsibilities of the managers and members and outlines the operating procedures for the entity.

Limited Partnership

With a Limited Partnership, a Certificate of Limited Partnership (LP-1) is filed with the secretary of state. Likewise, before the LP-1 is filed the partners must determine who is going to serve as the general partner and a resident agent must be identified.

A Limited Partnership Agreement is then drafted which, as in the LLC Operating Agreement, details important entity issues. It should be noted here that a discussion of how to draft Operating and Partnership Agreements far exceeds the scope of this book, and is indeed a book unto itself. For now, we shall discuss what points and strategies should be contained in these agreements so that you and your professional advisor can come up with the document that is right for you.

Which State to Use?

A common formation issue for LLCs and LPs is which state to utilize for filing. To answer this question the following must be considered:

1. In what state – or states – will the company operate?

2. Is the company willing to pay extra to file in a more favorable state?

Case Number 1 – John and Liz

John and Liz know that J & L Consulting, LLC will operate in a number of states right away. They already have clients lined up in California, Nevada, Texas and Florida. They have been advised by their accountant that by going into Florida, for example, they will need to have their company qualified to do business in Florida. This entails filing as a foreign (or out of state) LLC with the Florida secretary of state’s office.

The decision then for John and Liz is which state to use for the original formation. While Wyoming offers excellent protections at a lower cost, the two have clients in Nevada, which means they will have to register in Nevada anyway. With their professional advisor they review the LLC statutes for the states in question. They decide on Nevada because it offers the advantage of greater protections for managers. After filing originally in Nevada they then go ahead and qualify as a foreign LLC doing business in California, Texas and Florida (already being aware of the special state tax issues associated with California LLCs, as addressed in one of the last questions in Chapter Four). They realize that they will have to pay annual fees in each state as well as, where applicable, file an annual tax return to each state. However, John and Liz know that these are the costs of doing business and they sleep better at night knowing they are following the rules. In addition, they know that if they have not registered they could be prohibited from bringing a lawsuit or transacting any future business in the state(s) in question.

Case Number 2 – Mary and Gary

Mary and Gary live in California and the first asset they seek to protect is a four-plex apartment building they are purchasing in California. Mary and Gary have learned that LPs (and LLCs) are effective asset protection entities, in part because of the charging order procedure. (Refer to Chapter Seven for details on what a charging order is and how it works). However, they have also learned that in California the charging order is not always enforced. In two cases California courts have ignored the charging order procedure and allowed partnership interests to be reached by a creditor. We shall further discuss California issues ahead.

This disturbs Mary and Gary. They want to protect their assets, not expose them. After reviewing the situation with their professional advisors they decide to use a Nevada or Wyoming LP to hold the apartment building – and then qualify that entity to do business in California.

Of course, this means that they have to spend more money than is ordinarily required. If California law had been favorable they could have originally filed in California and be done. But they want to assert that Nevada law, which has never overturned or ignored the charging order remedy and has legislatively made it the exclusive remedy for creditors, will apply. (Later we will review the benefits of Nevada and Wyoming law.) While there is no guarantee that a California court hearing such a case will apply Nevada law, at least Mary and Gary, by creating a Nevada LP and qualifying it in California, can make the Nevada argument. We will discuss this issue later in the book.

And so Mary and Gary find themselves in the position of paying extra to be in a more favorable state. For them it is worth another several hundred dollars per year to use a Nevada LP.

As they proceeded both Mary and Gary and John and Liz learn it is also important to consider the specific issues associated with each document, as outlined next:

Limited Liability Companies

As mentioned, the first step in organizing an LLC is to prepare and file the Articles of Organization. While each state has different rules, there are common requirements:

Articles of Organization

LLC Name: Check for name availability with your state’s secretary of state. Consider separately trademarking and protecting the name within your state through your local secretary of state or within the country through the United States Trademark Office. (Visit www.uspto.gov for the government’s trademark search service. Our free guide “Winning with Trademarks” is available at www.corporatedirect.com/asset-protection/winning-with-trademarks.) Know that using a name like ‘bank’ or ‘finance’ in your entity name may require a license from the state. Other name restrictions may exist. For example, use of the words “Olympic” and “Olympiad” are restricted in Utah.

Purposes and Powers: You must make a statement about what kind of business your entity will engage in. Many states allow a broad, unlimited purpose and power to be stated, essentially saying that your entity has all rights available to engage in any and all legal businesses within that state.

Name and Address of Resident Agent: To provide claimants with an office in the state upon which to serve lawsuits, a resident agent must be obtained and a registered address listed. Please note that, as with LPs and Corporations, if you live in your state of organization you can serve as your own resident agent, although you may not want to do so. (First of all, you have just put your home address out on the internet. As you can imagine we have a number of horror stories associated with this lack of privacy.) Some states require the registered agent to be open during business hours. If you use your home address you may not meet this requirement. Your option is to use a private service. Most corporate entities (such as our firm) that act as resident agents charge a small yearly fee for this service.

Manager Managed or Member Managed: Unlike an LP or Corporation, either all of the members or a manager may run the LLC. Usually, this decision must be stated in the Articles of Organization.

Operating Agreement

Like the bylaws of a corporation, the Operating Agreement provides the rules for operation of the LLC. Common provisions likely to be found are:

Managers: The number of managers, the term, election and removal of managers will all be set out.

Restrictions on Transfer of Interests: Unlike shares of a corporation, the transfer of LLC membership interests is more complicated. The rules are set out in the Operating Agreement.

Distributions to Members: Profits and Losses: Profit distributions and loss allocations are governed by partnership law, which is different from the laws governing payment of dividends in a corporation. The rules for partnership law are more complex and are set out in the Operating Agreement.

Meetings: Many states leave the whole need for meetings up to the members. We suggest that annual meetings be held to satisfy entity formality issues. Any requirements should be set out in the Operating Agreement.

Charging Order: Although many states require creditors to follow the charging order procedure as a matter of state law, it is a good idea to include it in the Operating Agreement.

Other Requirements: You should also be aware of any requirements that your own state’s statute may have regarding Operating Agreements. In some cases, if you don’t provide for an issue you default to the state’s position on it. For example, Nevada law (Nevada Revised Statutes (NRS) 86.286) provides:

“A limited liability company may, but is not required to, adopt an operating agreement. An operating agreement may be adopted only by the unanimous vote or unanimous written consent of the members, and the operating agreement must be in writing. Unless otherwise provided in the operating agreement, amendments to the agreement may be adopted only by the unanimous vote or unanimous written consent of the persons who are members at the time of amendment.”

If you don’t provide otherwise, amendments must be approved by 100% of the members. If you don’t like the state’s default position you’ll have to draft the Operating Agreement to allow for a less than unanimous vote.

Limited Partnerships

To organize an LP, most states require that a certificate of Limited Partnership (LP-1) be filed with the secretary of state. As mentioned with LLCs, while each state may have unique requirements, the following are common requirements:

Certificate of Limited Partnership

Limited Partnership Name: As with the other entities, check on name availability with the secretary of state and remember that there are separate trademark requirements.

General Character of Business: “General character” is another way of saying “business purpose.” You need not be too specific in most states (i.e., you can describe the general character of the partnership as “to conduct any legal form of business in that state”).

Name and Address of Resident Agent: As discussed throughout the book, it is important to list a registered agent that will be in business next year.

Name and Address of General Partner: Some states also require the names and addresses of all limited partners.

Amounts of Contributions: Not all states require this and for good reason. Not many investors want it on the public record that they put $10 million into Wild Oats, LP. That kind of information is better kept within the company.

Duration: Some states limit a Limited Partnership to only 30 years’ duration. You must specify a termination date.

Events of Termination/Dissolution: Some states require the certificate of Limited Partnership to state what triggers dissolution or termination.

Limited Partnership Agreement

The Limited Partnership Agreement, like the LLC’s Operating Agreement and a Corporation’s bylaws, sets out the road map for operations. Common provisions include:

Management by General Partner: The agreement will set out the duties of the general partner. Unless limited by the Partnership Agreement, the general partner(s) will have broad authority to obligate and operate the partnership. It is important to consider these issues when drafting the agreement. You may want to limit the authority of the general partner(s).

Limited Partners’ Role: The rights, powers and voting rights of the limiteds will be set out in the Partnership Agreement. Again, you may draft the agreement according to your own strategy and procedure, subject to the overall foundational requirement that limiteds do not get involved with management. Nevertheless, flexibility is allowed, as evidenced by Nevada’s law that:

“The partnership agreement may grant to all or certain identified general partners the right to vote on a per capita or any other basis, separately or with all or any class of the limited partners, on any matter.” (NRS 88.465) and

“… the partnership agreement may grant to all or a specified group of the limited partners the right to vote on a per-capita or other basis upon any matter.” (NRS 88.425)

Restrictions on Transfers/Distributions to Partners: As is true for LLCs, partnerships can be fairly complex with regard to these issues. Oftentimes partners are restricted from selling their interests to an outside third party. These issues should be dealt with in great detail in the Partnership Agreement.

Events of Termination/Dissolution: Because Limited Partnerships generally have a fixed duration (e.g. 30 or 99 years) the provisions for termination and dissolution should be detailed.

Charging Order: As with LLCs, you may want to provide that a charging order is a creditor’s exclusive remedy. Again, this is the most effective way to keep LP assets out of the reach of would-be creditors.

Frequently Asked Questions

What are some of the issues to be considered when forming an LLC or an LP?

The following issues should be reviewed when forming any entity:

• Business Continuity.

• Formation Costs.

• Time for Formation.

• Federal Taxation.

• State Taxation.

• Tax Consequences of Formation.

• Tax Consequences Upon Sale or Transfer.

• Management and Control.

• Liability of Owners.

• Transferability of Interest.

• Ability to Raise Capital.

• Estate Planning Opportunities.

When does the LLC/LP come into existence?

In most states existence for an LP or LLC occurs upon filing of the Certificate of Limited Partnership or Articles of Organization, respectively. Most states also provide that a certified copy of such documents from the secretary of state’s office is conclusive evidence of formation.

What are the consequences of a rejected filing?

The secretary of state’s office may reject a filing of articles or a certificate for a number of reasons. These include a failure to pay the filing fee, entity name already in use and failure to provide a resident agent. Generally, the state will send back the paperwork and identify the problem.

The consequence of this is that until those documents are properly prepared and filed the members or partners are personally liable for all business debts. As such, it is best to have your accepted and certified paperwork from the state in hand before you begin obligating the business, or yourself.

Is an LLC required to have an Operating Agreement or an LP to have a Partnership Agreement?

These agreements are not required in some states and may be oral in others. New York requires written agreements. Follow their lead. The better practice is to have a written agreement defining the operation of the entity.

Are all of the members/partners of an LLC/LP required to sign the Operating/Partnership Agreement?

Some states require that all members/partners adopt the agreement. However, in states where this is not required, those members/partners who do not sign the agreement may not be bound by its terms. It is far better practice to have each member/partner sign the agreement and consent to be bound by it.

How are Articles of Organization or Certificates of Limited Partnership amended?

Most states provide that these documents may be amended at any time. In some cases, such as a change of name or duration, they must be amended. The procedure involves an authorized person(s) filing a certificate of amendment with the secretary of state’s office.

It is important to note that an amendment to a provision that originally required, for example, a 75 percent vote of the members or limiteds, must be approved and amended by at least a 75 percent vote of the members or limiteds. Please also note that some states require a unanimous vote to amend the filings.

How are an Operating Agreement and a Partnership Agreement amended?

Operating Agreements and Partnership Agreements are amended by a vote of the members or partners. Again, some states require a unanimous vote to amend these agreements.

Why would you amend an Operating Agreement or a Partnership Agreement?

There are a number of reasons to amend these agreements. For example, you may want to change the existing procedures for admission of new members/partners or removal of a manager or general partner. You may want to add a new procedure for the review of major acquisition decisions. The key is that if you want to change the agreement, a vote of the members/partners is needed.

What does a registered or resident agent do?

The purpose of a registered or resident agent (they are the same thing) is to accept service of process (lawsuits) in their state of residence. A registered agent, whose office is the registered office and which may be separate from the entity’s business headquarters, is required so that claimants can easily locate and serve corporate, LLC, LP and other entities. If the resident agent or registered office changes the entity must file a notice of such change with the secretary of state’s office.

Be sure to use resident agents that will be in business several years from now. Because they are authorized to receive notices of a lawsuit against your entity you want to be certain they appreciate the importance of this and provide you prompt notice. The last thing you want is to be sued and have a default judgment entered because you never received notice of the claim. Only use a reputable resident agent service. Expect to pay resident agent fees on a yearly basis, which can range from $100 to several hundred dollars per year, depending on the resident agent. Our company, Corporate Direct, Inc., offers yearly resident agent services for $125.00 per year. The service is free the first year with your formation.

Do LLCs/LPs have bylaws?

No, LLCs/LPs do not have bylaws. The Operating Agreement for the LLC and the Partnership Agreement for the LP serve as the bylaws for each entity.

When is an entity considered to be doing business in another state?

Unfortunately, most states do not define what constitutes doing business in their state. Instead, the question must be approached by reviewing what some states consider not doing business in their state. These include:

• Maintaining bank accounts.

• Selling goods through an independent contractor.

• Soliciting or obtaining orders, whether by mail or employees or agents, if the orders require acceptance outside the state before a valid contract is formed.

• Maintaining, defending or settling any lawsuit or other legal proceeding.

• Holding meetings of members or managers or carrying on other activities concerning internal affairs.

• Conducting an isolated transaction that is completed within a short period of time, such as 30 days, and is not a repeated transaction.

That said, California has the broadest definition of what doing business in their state constitutes. (This is so the state can collect their $800 annual fee.) As well, many banks will not open an account unless you are formed or qualified to do business in their state.

When an entity is doing business in another state, how is it registered?

Each state has its own guidelines. Generally, a filing fee and the following information is required:

• Name of the foreign LLC or foreign LP (with “foreign” meaning out-of-state).

• Date of formation.

• Nature of business and purpose.

• State of organization.

• Statement that the foreign entity validly exists in the state of organization.

• Address of the registered office and name of registered agent within the state.

• Address of the office in the state of organization or the principal office.

In some cases certified copies of the LLC Articles or LP-1 along with a Certificate of Good Standing are required. Our company, Corporate Direct, Inc., assists companies to qualify in new states. It is not an overly complicated process, but one that must be done right and on a timely basis for protection to apply.

Can family members be partners in a Limited Partnership?

Yes, but only if one of the following requirements is met:

1. If capital (i.e. investment in machinery, equipment or inventory) is a material factor, a partner must have acquired his or her ownership interest in a bona fide transaction (by gift or purchase) and must actually own or control such interest; or

2. If capital is not a material factor, the partners must have provided some contribution (services or capital) for their interest and come together in good faith to conduct a business.

How is an Operating Agreement or a Partnership Agreement enforceable?

Many states provide that such agreements may be enforced by that state’s courts. Because these agreements are considered contracts by law, when a state’s statute is silent on the issue, state law will apply to enforce binding legal contracts. Nevertheless, as is always the case, an oral agreement may be difficult to enforce.

How to Use Limited Liability Companies & Limited Partnerships

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