Mistakes to Avoid When Forming a Limited Liability Company (LLC), Part 1: Operating Agreement

October 12, 2011

This two part series will cover the most common mistakes people make when trying to form a Limited Liability Company (LLC) themselves. The first part of this series will address the importance of an operating agreement. The second part of this series will address potential problems when filling out a Certificate of Organization.

I work with a lot of new businesses and I understand saving money is important to a business. Cutting costs ultimately adds to the bottom line, which is extremely important for new business owners, so I can understand why people would want to try to form their LLC on their own. As an attorney I try to provide the maximum value to each client. While some people might feel that it’s significantly more cost effective to form an LLC on their own, my clients know that I will work diligently to identify and correct issues that may cause unforeseen problems. The value of retaining an experienced lawyer is that I have seen firsthand the types of things that can go wrong. I am able to bring that experience to my clients who are new business owners and ask questions that may have significant implications to how they should structure an LLC.

Due to the perceived ease of forming of an LLC, some business owners may decide to print an operating agreement off a website and use it, and then file their own Certificate of Organization. For a single member LLC this may work, although it is certainly not recommended. For multiple member LLCs, this can be laying the groundwork for future disagreements that are costly in terms of time and money to resolve. Many future disputes can be prevented or quickly resolved by spending more time and money up front to write a thorough operating agreement tailored to the needs of the business.

Here are a couple of questions I routinely ask two or more people looking to start a new business:

  1. How do you plan on resolving disputes if there are an even number of members and you’re split down the middle?
  2. How are you going to value a member’s interest when he or she decides to retire or becomes incapacitated? How are you going to pay it out when one of those events happens?
  3. How are you going to distribute a salary and profits? Depending on what type of business you’re in, you might want to use a formula.
  4. Is the LLC going to pay a member’s legal fees if he is sued, or is the member personally responsible for paying his own fees? If he pays his own fees will the LLC reimburse him?
  5. Are you going to be taxed as a partnership or will you elect S. Corp. status?
  6. Under what circumstances can a member transfer his or her interest to someone else or use it as collateral for a loan?

The answers to these types of questions are either not addressed in a form operating agreement, or may be addressed in a way that doesn’t work for your business. These questions tend to arise when members are fighting or when something occurs and the members don’t know the answer, such as when a member dies or becomes incapacitated and a spouse or estate is looking for the LLC to pay them for the member’s interest. A well-planned operating agreement can provide the answer and quickly resolve the dispute.

It’s hard work to get a new business up and running. Small business owners are responsible for many aspects of their business such as accounting/finance, management, operations, marketing, human relations and so on. I believe it is my job to alleviate some of that burden by preventing problems before they occur. As with many agreements, an ounce of prevention is worth a pound of cure. Putting some time and thought into your operating agreement will save time and money later, and will also cause you to think about issues you may not have considered until it is too late.

Derek Dissinger is an attorney at Russell, Krafft & Gruber, LLP in Lancaster, Pennsylvania. He received his law degree from Duquesne University School of Law and practices in a variety of areas including Business Law

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