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Nolo's Quick LLC

All You Need to Know About Limited Liability Companies

Limit your liability, simplify taxes with an LLC

Decide if forming an LLC is the right thing to do, and learn the basics of forming your own limited liability company with this unique book. Nolo's Quick LLC provides essential information for business owners in every state, including:

  • LLCs compared to corporations, partnerships and sole proprietorships
  • how to elect corporate tax treatment when (and if) you’re ready
  • the ongoing legal and tax paperwork that’s required

Form your LLC with Nolo's Online LLC.

  • Product Details
  • If you run your own business as a sole proprietorship or partnership, you’ve probably heard of the advantages of limited liability companies—especially the way an LLC can protect personal assets from business debts.

    LLC expert Anthony Mancuso clearly explains how to decide whether an LLC is right for you. Learn:

    • the unique legal features of LLCs, including limited personal liability for owners
    • who should—and who shouldn’t—form an LLC
    • when to choose an LLC instead of a corporation, partnership, or other business form
    • how LLCs are taxed
    • how to manage multiple-owner LLCs, and
    • why an LLC can be the right choice even for a debt-troubled business.

    “[Nolo’s]…material is developed by experienced attorneys who have a knack for making complicated material accessible.”—LIBRARY JOURNAL

    “When it comes to self-help legal stuff, nobody does a better job than Nolo…”—USA TODAY


    Number of Pages
  • About the Author
    • Anthony Mancuso

      Anthony Mancuso is a California corporations and limited liability company expert. A graduate of Hastings College of the Law in San Francisco, Tony is an active member of the California State Bar, writes books in the fields of corporate and LLC law, and has studied advanced business taxation at Golden Gate University in San Francisco. He has also been a consultant for Silicon Valley EDA (Electronic Design Automation) and other technology companies. He is currently employed at Google.

      Tony is the author of many Nolo books on forming and operating corporations (both profit and nonprofit) and limited liability companies. Among his current books are The Corporate Records Handbook, How to Form a Nonprofit Corporation, Form Your Own Limited Liability Company, and LLC or Corporation? His books have shown businesses and organizations how to form a corporation or LLC for decades. Tony is also a licensed helicopter pilot and guitarist.

  • Table of Contents
  • Introduction

    • Should You Consider Forming an LLC?
    • How to Use This Book
    • What This Book Doesn't Do
    • Legal and Tax Experts
    • Other Nolo LLC Resources

    1. An Overview of LLCs

    • Number of Owners (Members)
    • Limited Personal Liability Protection
    • Flexible Capital Structure
    • Flexible Distribution of Profits and Losses
    • Pass-Through Income Taxation of Profits and Losses
    • Flexible Management Structure
    • Exceptions to Owners’ Limited Liability
    • Basics of Forming an LLC

    2. The LLC Compared to Other Business Structures

    • Other Business Structures
    • What Is a Sole Proprietorship?
    • What Is a General Partnership?
    • What Is a Limited Partnership?
    • What Is a C Corporation?
    • What Is an S Corporation?
    • What Is an RLLP?
    • The Series LLC
    • Do-Good LLCs and Corporations
    • Deciding Between an LLC and Another Business Type
    • Business Structures Comparison Table

    3. Members’ Capital and Profits Interests

    • LLC Capital Interests
    • Tax Considerations of Start-Up Capital
    • Converting an Existing Business to an LLC
    • Profit and Loss Interests
    • Special Allocations of Profits and Losses

    4. Taxation of LLC Profits

    • Pass-Through Tax Treatment
    • How LLCs Report and Pay Federal Income Taxes
    • LLC Owners and Self-Employment Taxes
    • An LLC Can Elect to Be Treated as an S Corporation

    5. LLC Management

    • Member Versus Manager Management
    • Legal Authority of LLC Members and Managers
    • Member and Manager Meetings
    • Member and Manager Voting Rights

    6. Starting and Running Your LLC: The Paperwork

    • Paperwork Required to Form an LLC
    • Securities Filings

    7. Getting Legal and Tax Help for Your LLC

    • Getting Legal Help
    • Getting Tax Help


    A. State Information

    • Business Entity Filing Office
    • Tax Office
    • Securities Office

    B. Sample Operating Agreement

    • A.  Preliminary Provisions
    • B.  Membership Provisions
    • C.  Tax and Financial Provisions
    • D.  Capital Provisions
    • E.  Membership Withdrawal and Transfer Provisions
    • F.  Dissolution Provisions
    • G. General Provisions
    • H. Signatures of Members and Spouses of Members

    C. Checklist for Forming an LLC


  • Sample Chapter
  • Chapter 1: An Overview of LLCs

    The LLC is a highly popular alternative to the five traditional ways of doing business: as a sole proprietor, a general partnership, a limited partnership, a C (regular) corporation, and an S corporation. As you’ll see in Chapter 2, most of the LLC’s characteristics are shared by at least some of the other business structures. What makes the LLC unique is that it’s the only business entity with its particular mix of legal and tax attributes—most importantly, limited personal liability for LLC owners (the same legal protection that owners of a corporation enjoy) and pass-through taxation (like sole proprietors or the owners of a partnership).

    Number of Owners (Members)

    You can form an LLC with just one person. While the law doesn’t set a maximum number of owners an LLC can have (legally called “members”), for practical reasons you’ll probably want to keep the group reasonably small. Any business that’s actively owned and operated by more than about five people risks serious problems maintaining good communication and reaching a consensus among the owners.

    COVID-19 Updates and Resources

    Federal and state legislation has attempted to ease the economic effects of the COVID-19 pandemic. Although the federal CARES Act expired in 2022, some forms of federal and state economic and tax relief may still be available. For current information, visit the following websites:

    • Small Business Administration (SBA) website at
    • U.S. Treasury website at
    • IRS website at
    • Your state’s secretary of state and tax agency websites (see Appendix A).


    A Short History of the LLC

    The LLC is the American version of a type of business organization that has existed for years in other countries. It closely resembles the German GmbH, the French SARL, and the South American Limitada forms of doing business, all of which allow small groups of individuals to enjoy limited personal liability while avoiding the more complex tax rules that apply to corporations.

    In the United States, the Wyoming legislature enacted the first LLC legislation in 1977, followed by Florida in 1982. In those days, doing business as an LLC was risky, in part because the IRS had not yet made it clear whether it would tax an LLC as a partnership or a corporation. In fact, because the central promise of the LLC—to enjoy the tax status of a partnership with the personal liability protection of a corporation—was uncertain, few business owners adopted this new form of business. And most other states were unwilling to pass legislation authorizing LLCs until the IRS gave its approval.

    The first break in the LLC stalemate came in 1988, when the IRS ruled that an LLC formed under the Wyoming statute was eligible for pass-through tax status. This nod of approval from the IRS created an immediate national wave of enthusiasm for LLCs in the business press, and all 50 states plus the District of Columbia quickly passed LLC legislation.

    But it wasn’t until January 1, 1997, that LLCs went mainstream. That’s when the IRS threw out its old and unnecessarily complicated tax classification regulations, agreeing that multi-owner LLCs could enjoy partnership tax status (and that one-owner LLCs could be taxed as sole proprietors) without needing to jump through previously required technical hoops. The IRS also decided to give LLC owners the flexibility to change their tax status by electing corporate tax treatment if they wish. (Chapter 4 explains this option.)


    If some of your co-owners will be passive investors only (those who invest in the LLC but don’t participate in its management or operation) —and you’ll have a small management group calling the day-to-day shots—you can sensibly consider having more owners. (See “Flexible Management Structure,” below, for more on this type of arrangement.) But I still think common sense limits the total number of members (including active owners and inactive investors). Once you get more than about ten investors, you’ll likely find that accounting and communication issues will use up too much of your time. Outside investors will want to stay informed and could make your business life more complicated if your management choices do not result in increasing profits in future years. Also, the larger your investor group grows, the more likely you are to run into securities law complexities (see Chapter 6 for more on this).

    Limited Personal Liability Protection

    The owners of an LLC are not personally liable for the debts of their business or claims made against it (with a few exceptions, discussed in “Exceptions to Owners’ Limited Liability,” below). This legal protection is written into each state’s LLC law. Because almost every business will accumulate debts and face some risk of being sued, this feature is popular and valuable. Without limited personal liability, all business owners are 100% legally responsible for repaying these debts, even if they have to use their own money. With limited liability, their personal assets should remain untouched, even if the business fails under a heavy weight of debts and judgments.

    Even successful businesses accumulate debt as a routine part of their activities. For example, when sales or net profits are low, employees, suppliers, and other routine business expenses must still be paid. A business might take out a loan or use a line of credit with a bank to handle cash flow fluctuations and pay bills. Many businesses also defer paying expenses by buying needed materials and supplies from vendors on account (usually with a 30- to 90-day grace period to pay these balances). Owners cannot count on their insurance policies to cover business debt: While commercial insurance can protect a business and its owners from some types of liability (for instance, slip-and-fall lawsuits), insurance never covers business debts.

    Flexible Capital Structure

    In addition to limited personal liability, LLC owners (members) obtain the benefits of a structure that allows ownership flexibility. Owners of an LLC invest money or property in the LLC in return for a capital interest in the form of an undivided percentage of the assets of the company. A member’s capital interest is often represented by “membership units,” much like shares in a corporation. For instance, a member who owns one-half of an LLC might own 500,000 out of a total of one million membership units. In other instances, an LLC won’t break down a capital interest into membership units, but will just say a one-half owner has a 50% capital interest. Either way, each owner’s ownership percentage (capital interest) will be used to divide LLC assets among the members if the LLC is sold or liquidated, or when a member wishes to sell a membership interest. The owners’ relative percentages of ownership also can be used—but do not have to be—to calculate how to divide profits and losses of the LLC, and for other purposes (for example, to apportion LLC management voting power).

    Example 1: Three people form an LLC. Two combine to contribute half the cash and property used to set up the LLC; the third invests the other half. Under a typical ownership scenario, the first two members each get a 25% capital interest in the LLC; the third member gets a 50% interest. Under standard provisions of an LLC operating agreement, the members would be allocated a corresponding percentage of LLC profits and losses. That is, each 25% member would be allocated 25% of the LLC’s profits and losses, and the 50% member would be allocated 50%. Also, if one of the members wishes to leave the LLC and sell their interest to the other members, the departing member can expect to receive a percentage of the current value of the LLC that corresponds to their capital interest percentage—a 25% member can expect to be paid 25% of the current value of the LLC.

    Example 2: Tasty Treats, LLC, is a neighborhood bakery owned by Ned, Sylvia, and four of their relatives. Only Ned and Sylvia work in the bakery. The LLC issues a total of 600,000 membership units to the initial investors. Under their LLC agreement, Ned and Sylvia, who contribute their know-how plus an investment of cash and property, get 200,000 membership units each; their relatives, each of whom makes a small cash investment, get 50,000 units each. If Ned were to resign from the LLC, he would get one-third of the value of the LLC (200,000/600,000). Likewise, if Ned and Sylvia were to decide to buy out their relatives, they could expect to pay one-third of the value of the LLC for all of their relatives’ capital interests.

    Assuming other members agree, in most states LLC members can contribute cash, property, services, or a promise to deliver any of the above in exchange for capital interests in the LLC. While it’s most common for all LLC members to contribute cash, it’s not unusual for a member to also contribute a vehicle or a piece of equipment to the LLC. I discuss these various types of contributions (and the tax ramifications of each) in Chapter 3.

    Flexible Distribution of Profits and Losses

    Many LLCs divide up profits and losses according to how much of the LLC each member owns. But they are not required to—LLC owners may choose to divide profits and losses any way they wish (subject to special IRS rules, which I discuss in Chapter 3). For example, if three equal LLC owners decide to divide profits 40%, 40%, and 20%, that’s fine with the IRS, as long as they follow its rules and pay taxes on what they receive.

    Example: Steve and Frankie form an educational seminar business, with each getting a one-half capital interest in the LLC. Steve puts up all the cash necessary to purchase a computer with graphics and multimedia presentation capabilities, rent out initial seminar sites, send out mass mailings, and purchase advertising. As the traveling lecturer and student pied piper, cash-poor Frankie will contribute only services to the LLC. (As explained in Chapter 3, Frankie will have to pay income tax on his one-half capital interest because it’s a form of payment for his services.) Although the two owners could agree to split profits and losses equally (in proportion to their ownership interests), they decide that it’s fair for Steve to get 65% of LLC profits for the first three years to pay him back for putting liquid assets (cash) into the LLC. After that, profits will be divided 50–50.

    When paying out profits to the members, LLCs have to consult their state’s rules on distribution. Many states dictate when distributions can legally be made. I’ll discuss these requirements in Chapter 4.

    Pass-Through Income Taxation of Profits and Losses

    Like partnerships and sole proprietorships, an LLC is automatically recognized by the IRS as a “pass-through” tax entity. This term refers to the fact that all of the business’s profits and losses “pass through” the business and are reflected and taxed on the owners’ individual tax returns. (I discuss pass-through taxation fully in Chapter 4.) By contrast, the profits and losses of a corporation must be reported and taxed on a separate, corporate tax return, at the corporate income tax rate. And, of course, money paid to corporate owners by way of salaries, bonuses, and dividends is taxed on the owners’ individual returns.

    Why do many small business owners prefer pass-through taxation? For one, it’s what most of us are used to. Every employee’s salary is taxed this way, as are the profits earned by a sole proprietor or partnership.

    Here’s another reason: The alternative to pass-through taxation— corporate taxation—is too complicated for most small businesses, at least when the business is in its start-up phase. Forming a corporation means more bookkeeping, more accounting, and more complexity. (I explain corporate taxation in detail in Chapter 2.)

    An LLC can elect to be taxed as a corporation. While most new LLCs will not choose to do so, a few will find that being taxed as a corporation actually reduces their tax bill. This might happen if an LLC wants or needs to keep some money in the business, rather than paying all of the profits out to the owners. The savings can occur if the owners’ tax rates are higher than the federal corporate tax rate (which is currently 21% for most corporations).

    Pass-through tax status also allows an LLC to pass business losses along to the owners to deduct from their other income (usually salary earned working for another company or income earned from investments). Many new businesses lose money in their first year or two. Fortunately, LLC members (like owners of partnerships) can subtract their LLC losses from their taxable income (assuming IRS rules are met).

    Owners of sole proprietorships, partnerships, LLCs, and S corporations may be eligible to deduct up to 20% of business income on their federal tax returns. Limitations on the deduction apply to personal service businesses, and the rules are complicated.

    We won’t go into all the details, but here are some of the important definitions, exceptions, and limitations associated with the 20% pass- through deduction:

    • You can deduct 20% of “qualified business income” (QBI) that is passed through to you from your unincorporated business on your individual federal income tax return. The final regulations (IR-2019-04) on this QBI deduction help to specify what is included and excluded in this type of income, but the most important requirement set forth in the statute is that the income must be “connected with the conduct of the trade or business.” The statute also says that certain types of capital gain, dividends, and interest income passed through the business are excluded from the definition, as well as compensation (salary) paid to an owner by the business.
    • The deduction can be limited or eliminated if the business owner’s taxable income exceeds specified threshold amounts (and special rules apply to service business owners).

    The deduction is not a tax credit, but just a deduction, so if your effective federal income tax rate is 25%, you can be on course to obtain an effective tax savings of 5% of your passed-through QBI.

    • The deduction cannot exceed 20% of your taxable income (counting all deductions), and if your net QBI is zero or less, you get no pass-through deduction for the year.
    • The deduction reduces only income taxes, not Social Security or Medicare taxes.
    • The pass-through deduction is scheduled to expire at the start of 2026.

    For more information, go to, and consult your tax adviser.

    Flexible Management Structure

    LLCs are managed by their members (known as member management) unless they choose to be managed by a manager or management group (known as manager management). LLCs with only a few members are almost always managed by all members—after all, most small business owners want to be active in management. For these LLCs, member management is simple and straightforward.

    But member management isn’t the best choice for all LLCs. Under the other option, manager management, an LLC is managed by a single manager or a small group of managers consisting of one or more selected LLC members, one or more nonmembers, or a mixture of the two. Manager management may make sense for an LLC in the following situations:

    • One or more of the LLC members want to invest in the LLC only, not help run it or take part in the management decisions.
    • The LLC members wish to give an outsider (a nonmember) a vote in management. For example, an outsider might insist on having a say in management decisions in exchange for lending the LLC money. To give the nonmember management authority, the LLC must select manager management and create a management group that includes the outsider.
    • The sole member of an LLC wants to manage the business but give membership interests to nonmanaging family members, who will step into a management role when the current owner-manager steps down.

    An LLC can easily choose manager management to handle any of these situations. In most states, a short clause is included in the articles of organization (the paperwork filed with the state to form the LLC) saying that the LLC is managed by a manager or a group of managers. (A few states refer to managers as “governors.”) In other states, the management structure of the LLC must be spelled out in the LLC operating agreement. (I discuss creating operating agreements, which are similar to corporate bylaws, in Chapter 6.)

    Let’s look at some management options for Ned and Sylvia’s LLC, Tasty Treats, which I introduced in the example above.

    Example 1: If Tasty Treats is set up with member management, all of the members, including Ned and Sylvia’s investing relatives, manage the LLC. This may initially seem like an overly complex management structure; after all, Ned and Sylvia are the only two owners who work in the bakery. In practice, however, it probably won’t be that complicated. The LLC operating agreement requires a full member vote only for major decisions, such as admitting a new member, selling a membership interest, incurring LLC debt outside the normal course of business operations, selling major LLC assets, dissolving the LLC, and the like. And these are exactly the types of big decisions these relatives want to be consulted on. Ned and Sylvia alone handle the day-to-day operation of the bakery and are allocated a guaranteed payout of LLC profits for their management duties, over and above their standard profit interest in the LLC.

    Example 2: Now let’s look at how things would work if Tasty Treats were organized as a manager-managed LLC. Assume Ned and Sylvia’s relatives want no say in LLC business, which they invested in primarily to help out Ned and Sylvia. The relatives just want their share of annual LLC profits, and a proportionate percentage of the proceeds if it is later sold at a profit. The LLC elects manager management in its articles, and Ned and Sylvia are named as the LLC’s two managers. In this operating scenario, only Ned and Sylvia vote when any of the decisions specified in the operating agreement must be made.

    These examples illustrate the two basic management choices. No matter your choice at this level, when it comes to fine-print management provisions, you can manage your LLC in numerous ways. I discuss LLC management, decision making, and record keeping in more detail in Chapter 6.

    Exceptions to Owners’ Limited Liability

    While LLC owners, like shareholders of small corporations, enjoy limited personal liability for many of their business transactions, it is important to realize that this protection is not absolute. In several situations, an LLC owner can become personally liable for business debts or claims. This drawback is not unique to LLCs—many of these exceptions apply to all limited liability business structures, including corporations.

    Let’s look at the most common ways an owner might not be protected by limited liability.

    Personally Guaranteed Business Debts

    No matter how a small business is organized, whether as an LLC, a partnership, or a corporation, its owners can be asked to sign bank loan obligations or to personally guarantee to pay business debts. Owners who agree to this voluntarily give up their limited liability protection as to these loans.

    Example: A married couple owns and operates Books & Bagels, a coffee shop and bookstore. In need of dough (the green kind) to expand into a larger location, the owners ask a bank for a small loan. The bank grants the loan to the LLC on the condition that the two owners personally pledge their equity in their house as security for the loan. Because the owners personally guarantee the loan, if the LLC goes broke, the bank can seek repayment from the owners personally. If they can’t come up with the cash, the bank could even foreclose on their house. No type of business ownership structure—an LLC, a corporation, or a limited partnership—can protect owners after they have chosen to assume personal liability.

    Even if you have to personally cosign a business loan from time to time, in most other situations your LLC’s limited liability protection remains intact. That’s because most of your business debts will not be accompanied by a demand for a personal guarantee. For instance, typically your LLC’s lines of credit with vendors and other suppliers and all its routine bills are debts of the LLC only, not personal debts of the LLC owners. In short, unless you pledge personal assets for business debts by signing a guarantee, you’ll have no personal liability for them.

    Injuries to Others (Torts)

    Members and managers of an LLC, like corporate directors and share- holders, partners, and all other business owners, can be held personally liable for financial loss caused by their own careless behavior.

    Negligent acts, like those that result in car crashes, are the everyday stuff of American litigation (in legalese, a negligent and harmful act is a “tort”). In other words, members and managers do not have limited liability when they negligently cause harm to another.

    Hopefully, the LLC will pay for the loss or damage (or the LLC’s insurance company will). If the LLC can’t or won’t pay, the LLC member or manager is personally responsible. But each member is responsible only for his or her own careless acts—personal liability for torts does not typically extend to the other LLC members. In a two- member LLC, for example, one member is personally liable for his or her own negligent acts, but not for those of the other member.

    Example: Otto, one of the two owners of Otto’s Auto Parts Supply LLC, drives the LLC’s Mazda Miata to pick up a throw-out bearing for a customer’s Mercedes SUV. On the way, he negligently sideswipes a slow- moving Toyota Prius, a stunt that results in a $5,000 repair bill for damage to the Prius and a $25,000 medical claim for whiplash suffered by George, the Prius driver. If insurance doesn’t cover George’s damages, Otto can be held personally liable for the $30,000 (the LLC itself can be liable too if the accident happened on company time). But Mike, the other owner of the LLC, shouldn’t be held personally liable for Otto’s careless driving, nor should he be held personally liable if George obtains a legal judgment against the LLC itself.

    Although LLC law does not protect members and managers from the consequence of their own torts, insurance can. Commercial or automotive insurance and workers’ compensation may cover some or all of the damage caused by an LLC manager’s or member’s tort. But don’t rely on personal policies to provide business-related protection; they most likely won’t. It’s essential to get a reasonable amount of appropriate liability insurance to cover potential personal and business liabilities arising from LLC operations. Typically, a commercial general liability insurance policy will cover the following:

    • torts caused by business owners and employees in the course of business or on the business premises (a policy for bodily injury and property damage—so-called “slip-and-fall” coverage), and
    • fire, theft, and a long list of catastrophes.

    Of course, a general liability policy won’t cover damages caused by a member’s intentional, illegal, or fraudulent behavior.

    Special Considerations for Professionals

    If an LLC is organized to render licensed professional services, such as health care, law, accounting, architecture, engineering, and similar services, state law normally makes each individual professional personally liable for their own malpractice, even when the business is organized as a corporation, LLC, PLLC (professional LLC), or RLLP (registered limited liability partnership—see Chapter 2). That’s why it’s essential for each person to purchase adequate malpractice insurance to cover this additional professional tort liability (this coverage is usually required under state statutes that apply to professional practices).

    Professionals who are considering forming an LLC should also know that some states may not specifically protect a professional in a multi-member LLC from personal liability for the malpractice of other professionals in the firm (this exposure for the malpractice of another professional is known as “vicarious liability”). However, other state LLC, PLLC, and RLLP statutes do offer protection from vicarious liability.


    Breach of Duty to the LLC

    In a co-owned LLC, the managers (either its members in the case of a member-managed LLC or its specially appointed managers in the case of a manager-managed LLC) have a legal obligation to manage the LLC in good faith and in the best interests of the LLC and its members. This is known as their “duty of care,” and is similar to corporate directors’ and officers’ duty to their corporation. If members or managers of an LLC violate this duty of care, they can be held personally liable for any money damages that result.

    This duty of care is a relatively relaxed legal standard. Managers have been held to violate it only when they do something fraudulent, illegal, or so clearly wrongheaded that a fair-minded person would conclude they were taking a grossly negligent risk. LLC members and managers are not normally personally responsible to the LLC or other members for honest mistakes or even poor judgment in the carrying out of their job- related duties.

    LLC members and managers in smaller LLCs often rely primarily on commercial liability insurance to protect them from lawsuits brought by outsiders, at least at the onset. If they can afford to, they may decide to back up this basic coverage with personal liability policies covering members or nonmember managers for “insider” and other management-related lawsuits. Policies of this sort protect LLC members and managers from personal liability for their management decisions (these policies should be distinguished from commercial liability insurance policies, which insure the LLC against catastrophic damage and injuries to employees and outsiders).

    The duty of care applies to managers’ actions toward all members of the LLC. For example, in a manager-managed LLC, the nonmanaging LLC members can sue a manager who entered a fraudulent transaction that hurt the LLC financially. And in member-managed LLCs, a member who violates the duty of care might be personally liable in a lawsuit by the other members.

    Example 1: Fred is the sole manager of a real estate LLC. The LLC owns an apartment building, which Fred manages. Because of high tenant vacancies and extra repair costs, the LLC reports a loss for the year and is unable to distribute profits to its members at the end of the year. The nonmanaging members sue Fred for failing to properly manage the LLC. As long as Fred has done his best to obtain tenants and make reasonably necessary repairs, he should be able to show that he has met his duty of care—and, therefore, win the lawsuit.

    Example 2: Robert, Juliet, and Greg are the three owners of the Lucky Lock Company LLC, a member-managed LLC. They vote at a management meeting on whether to use one-quarter of the company’s cash reserves to market and sell the Neon Big-Lock Clock, a unique, three-by-five-foot lock plate with a neon clock display, which Robert invented. Greg is against the idea of committing company funds to promote a device that he believes no one will buy. But Robert and Juliet disagree with Greg, believing that the big clock will find a market. The neon clock idea does not catch on and Lucky Lock goes broke. Greg sues Robert and Juliet in their personal capacity. The judge finds that, although they made what turned out to be a bad business decision, Robert and Juliet did so armed with all the facts and in good faith, and did not breach their duty of care.

    But now let’s change a few facts and assume Robert and Juliet have researched the availability of certain key parts and know that several would have to be custom made, which means the Neon Big-Lock Clock will be very difficult and expensive to produce. Instead of telling Greg these facts, they keep their knowledge secret and vote to go ahead with the project. This time when Greg sues, the judge supports his claim and finds that Juliet and Robert have breached their duty of care. Greg is awarded a significant judgment.

    Robert and Juliet were liable in the second situation because of the way courts have interpreted a business owner’s duty of care. A company’s management has to follow the “business judgment” rule to avoid liability. This rule says that in making management decisions, managers will not be personally liable for honest business mistakes. Decisions that have some rational basis (based on facts known to managers or reported to them by someone with superior knowledge) should not give rise to personal liability even if they turn out to be mistaken and result in financial loss to the business and its owners. Let’s go back to the Lucky Lock Company and change the scenario one more time.

    Example 3: Again, Robert, Juliet, and Greg discuss at a management meeting whether to use one-quarter of the company’s cash reserves to market and sell the Neon Big-Lock Clock. This time, Robert and Juliet disclose to Greg that certain essential parts would be very difficult and expensive to produce. Based on this disclosure, Greg is even more against the idea of committing company funds to promote a device that he is strongly convinced will not appeal to many customers. Greg’s opinion, along with the information that casts doubt on the profitability of the Neon Big-Lock Clock, is fully discussed at the membership meeting. Nevertheless, based on their experience in the clock business and the fact that many offbeat designs (for example, the cuckoo clock) have been extremely profitable, Robert and Juliet vote to proceed (and Greg is outvoted two to one).

    Again, the Neon Big-Lock Clock is a disaster. Can Greg successfully sue the other owners personally for their bad business judgment? Probably not, according to the business judgment rule. Robert and Juliet made an informed business decision without underhandedness, concealment, misrepresentation of facts, or other fraud or illegality. The fact that they guessed wrong should not make them personally liable to Greg.

    Disclose, disclose, disclose! The above example highlights a basic LLC management rule: Full and fair disclosure of all material facts is an essential element of the LLC managers’ and members’ duty of care to the LLC. If this duty is met, the business judgment rule will normally protect members and managers from personal liability for their management decisions.

    If an LLC member or manager is sued for breaching his or her duty to the LLC, can’t the costs of the suit alone be disastrous to the defending member or manager? Not necessarily. If the member or manager wins the lawsuit, the laws of many states permit or require “indemnification” by the LLC. This means that the LLC must pay any legal expenses, fines, fees, and other liabilities owed by the LLC member or manager. But again, state rules often require the person to be indemnified to have acted in good faith and in the best interests of the LLC to receive indemnification. And, as you might guess, intentional misconduct, fraud, and illegal acts normally aren’t covered under these rules.

    Financially irresponsible acts can also lead to a loss of limited liability. As I mentioned above, an LLC must satisfy certain financial standards before a managing member or a manager can approve a distribution of profits. These standards prohibit an LLC from paying out profits if it can’t afford it. If these standards are ignored and the company is later sued, the member or manager who approved the distribution may be personally on the hook for the amount of the invalid distribution. See Chapter 4 for more on this.

    Losing the LLC’s Limited Liability

    In the situations above, LLC members can be held personally liable for specific acts or events that occur in the course of their business. But the limited liability status of the LLC itself can also be lost, if a court finds that you didn’t run the LLC as a separate business entity.

    Courts are likely to disregard a corporation’s separate legal status and hold its owners personally liable (in legal slang, “pierce the corporate veil”) only in extreme situations. Typically, this occurs when owners fail to respect the separate legal existence of their corporation, but instead treat it as an extension of their personal affairs. For example, if owners fail to follow routine corporate formalities, such as adequately investing in or capitalizing the corporation, issuing stock, holding meetings of directors and shareholders, and keeping business records and transactions separate from those of the owners, a court is likely to find that the corporation doesn’t really exist and that its owners are really doing business as individuals who are personally liable for their acts.

    To maintain the LLC’s separate status, owners should follow these basic precautions:

    • Act fairly and legally. Do not conceal or misrepresent material facts or the state of your finances to vendors, creditors, or other outsiders. Or, put more bluntly, don’t engage in fraud.
    • Fund your LLC adequately. You don’t have to invest a lot of money in your LLC, but do try to put enough cash or other liquid assets in at the beginning so your LLC will be able to meet foreseeable expenses and liabilities. If you fail to do this, it is possible that a court faced with a balance sheet that shows a very minimal investment may disregard your LLC’s limited liability protection. This is particularly likely if you engage in a risky business that obviously requires a substantial operating budget.
    • Keep LLC and personal business separate. Nothing will encourage a court to disrespect your LLC entity more than your own failure to respect its status as an entity separate from its owners. This means you should open up a separate LLC business bank account. As a routine business practice, write all checks for LLC expenses or payouts of profits out of this account, and deposit all LLC revenue into it. Do all of this even if you set up a single- member LLC. And of course, keep separate accounting books for your LLC—these can consist of a simple single-entry system, such as your LLC check register and deposit slips. A double-entry system will serve you better when it comes time to prepare your end-of-year income tax returns, especially if yours is a multi- member company, which will have to prepare and file IRS Form 1065, the informational return for partnerships (see Chapter 4). You should also keep written records of all major LLC decisions.

    When Personal Creditors Can Go After LLC Assets

    As explained above, the LLC’s limited liability shield protects the personal assets of LLC owners from lawsuits that arise from LLC business operations and claims, with a few exceptions. However, this protection doesn’t always work the other way—that is, an LLC owner’s business assets are not necessarily protected from creditors seeking to satisfy personal debts or lawsuit judgments against the owner.

    In most states, because an interest in an LLC is the personal property of each LLC owner, a personal creditor of an LLC owner can seize the owner’s interest in the LLC. Creditors obtain a “charging order” against the owner’s interest in a business, such as a partnership interest, an LLC interest, or stock in a corporation. A charging order is like a lien against the owner’s business interest, which allows the creditor to receive profit payments that would otherwise go to the owner.

    Example: Sam defaults on a personal bank loan unrelated to his LLC business, and the bank obtains a charging order against Sam’s LLC membership interest. This order allows the bank to be paid any profits that would otherwise be distributed to Sam under the terms of the LLC’s operating agreement.

    A charging order might not do a creditor much good if an LLC does not regularly distribute profits to members. In that case, the creditor may be able to ask a state court to foreclose on the LLC member’s interest. If state law allows this and the court agrees, the creditor can become the new legal owner of the LLC. However, under many state laws, a creditor who forecloses on an LLC interest does not become a full owner. Instead, the foreclosing creditor becomes a “transferee” or “assignee” who is entitled only to all economic rights associated with the interest, such as a share of the profits paid out on the interest and the value of the interest when the business is sold or liquidated. Typically, an assignee or transferee cannot manage or vote in the LLC, nor assume other membership rights granted to full members under the LLC operating agreement. Again, if the LLC does not pay out profits regularly and there is little chance of the business being sold or liquidated, these economic rights might not mean much to a creditor.

    Exception in some states for one-owner LLCs. In a some states, if a court orders the foreclosure of a member’s interest in a single-member LLC, the person who buys the foreclosed interest becomes a full member with voting rights. Further, in exceptional cases, the old owner may have to exit the LLC, with the new owner (the one who bought the interest in the court-approved sale of the original owner’s interest) becoming the new owner of the LLC.

    Some states allow transferees or assignees of LLC memberships to petition a court to force a dissolution of the LLC, an extreme remedy. To determine whether an LLC owner’s personal creditor can obtain a charging order, foreclose, or force a dissolution of your LLC, consult a knowledgeable business lawyer.

    More information on charging orders and foreclosure for single-member LLCs. For more information on state laws on charging orders and foreclosures, visit Nolo’s overview of state laws on the subject at

    Basics of Forming an LLC

    In Chapter 6, I discuss in detail what you’ll need to do to form an LLC. This section covers the basic requirements.

    What Types of Businesses Can Form LLCs?

    With few exceptions, LLCs may be formed for all types of businesses. You may even form one LLC to engage in several businesses—for example, furniture sales, trucking, and redecorating can all be operated under one legal (if not physical) roof. But certain kinds of businesses, mostly financial in nature, might be either restricted or prohibited from setting up an LLC in your state. For example, companies that engage in the banking, trust, or insurance business are typically prohibited from forming LLCs.

    Certain professionals may also be prohibited from forming an LLC in some states, or at least be subject to special rules when forming one. For example, the initial LLC members may need to obtain a statement from their state licensing board, certifying that they all have current state licenses, and file it with their LLC articles. State restrictions for professionals apply to doctors and other licensed health care workers, lawyers, accountants, and, in some states, other professionals such as engineers and architects. In some states, such as California, certain professionals are not able to form an LLC and need to form a professional corporation or partnership (RLLP) instead. In other states, professionals have to form a PLLC (professional LLC) or at least follow special procedures if they choose to form an LLC. Typically, they must comply with one or more of the following rules:

    • Only licensed professionals in a single profession—or in a group of related professions—may own a membership interest in a professional LLC.
    • If your state allows PLLCs, a PLLC must generally use a special professional LLC designator in its name—typically the words “Professional Limited Liability Company” or the abbreviation “PLLC.”
    • Each member must carry a specified amount of malpractice insurance.

    Call your state LLC filing office if you are a licensed professional. If you have a vocational or professional license, before spending any more time reading about LLCs, you should call your state LLC filing office to see if you can form an LLC in your state. Ask about any special rules or restrictions. You might have to (or be able to) form a PLLC, professional corporation, or an RLLP instead. An experienced business lawyer in your state can help you choose the best structure for your professional practice.

    State LLC Laws

    LLCs are regulated by the LLC statutes (laws) of the state where they are formed, though the laws are often similar from state to state. The laws typically cover issues like how to buy out the membership interest of a departing member. While state LLC law usually gives you great latitude in drafting your LLC operating agreement, this is one area where states may have mandatory requirements. Some states require the LLC to pay a departing member the fair value of the membership interest within a reasonable time after his or her departure. The statute may also say what the minimum fair value of the interest can be, or how it must be determined, or the maximum time a departing member must wait to receive payment.

    LLC statutes are generally not lengthy. In just a few minutes, you should be able to find the section of law you are interested in. In Chapter 7, I discuss how to find and research your state’s statutes. Of course, once you have read the statutes yourself, it makes sense to check your conclusions with a lawyer. But this should cost less than it would if you relied on the lawyer to do the basic statutory research and explain what the law says.

    How to Form an LLC

    The basic legal step required to create an LLC in most states is to prepare and file LLC “articles of organization” with your state’s LLC filing office. (Some states call this document a “certificate of organization” or a “certificate of formation.”) Many states supply a blank one-page form for the articles of organization—you’ll simply need to fill it out and send it in with a filing fee.

    Many states allow you to prepare and file LLC articles online, from the secretary of state’s website. (See Appendix A for information on finding that office.) You can also use Nolo’s online filing service, available on Typically, you need only specify a few basic details about your LLC, such as its name, principal office address, agent, office for receiving legal papers, and the names of its initial members (or managers, if you’re designating a special management team to run the LLC). I’ll discuss articles of organization in more detail in Chapter 6.

    You’ll have to pay a filing fee when you file your articles to create your LLC, but the fees are modest and one-time-only in most states. Some states do, however, have larger recurring annual fees, which range from $100 to $500 or more each year. California, for example, charges an annual minimum franchise tax of $800 (currently waived for LLCs’ first taxable year), plus an additional “total income” fee (calculated on gross income plus the cost of goods sold and costs paid or incurred in connection with the trade or business) that can reach up to $12,000 per year for high-income LLCs.

    A few states require you to take an additional step before your LLC will be official: In a local newspaper, you must publish a simple notice of your intent to form an LLC.

    Once your articles of organization are on file and any publication requirement is met, your LLC is “official.” But even though it is not required by state law, you also should create an LLC operating agreement. This is the document where you set out the ownership rules for your business (much like a partnership agreement or the bylaws of a corporation). A typical operating agreement includes:

    • the members’ capital interests
    • the rights and responsibilities of members
    • how profits and losses will be allocated
    • how the LLC will be managed
    • the voting power of all the members (and any managers)
    • rules for holding meetings and taking votes, and
    • buyout provisions, which lay down a framework for what happens when a member wants to sell his or her interest, dies, or becomes disabled.

    You should have an operating agreement even if your LLC has just one or two members. The main reason is as simple as it is important. An operating agreement makes it more likely that a state court will respect the LLC’s limited personal liability protection for its owners. This is particularly key in a one-person LLC, which—without the formality of an agreement…—looks a lot like a sole proprietorship. Once your paperwork is completed and filed, you’re ready to do business! See the checklist for forming an LLC in Appendix C for some more practical details.

    Practical information on starting and running a business. Nolo offers many helpful resources that explain the steps involved in opening any new business. First, check out Nolo’s website at Here you’ll find articles and FAQs full of free tips for starting your business. For more, read Nolo’s best-selling book Legal Guide for Starting & Running a Small Business, by Stephen Fishman. It offers a comprehensive, two-volume treatment for entrepreneurs on how to start and operate a business. The Small Business Start-Up Kit: A Step-by-Step Legal Guide, by Peri H. Pakroo, gives you a quick lowdown on how to open the doors of your new business quickly, from choosing a name, to finding a location, getting a business license, and much more.

    We hope you enjoyed this sample chapter. The complete book is available for sale here at

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