A limited liability company is as easy to set up as it is to screw up. Though it is justifiably advisors’ favored business structure due to its simplicity, flexibility and liability protections, there are still a select few “corporate formalities” that should be observed. The primary such formality is what’s known as the operating agreement, and it is just as important to keep it updated as it is to draft it in the first place.
Wyoming created the first limited liability company act in 1977, and other states followed suit in due course. LLCs are thus governed by state law, and each state imposes slightly different requirements on the creation, structure and ongoing business of LLCs formed pursuant to its laws. No state requires the LLC to file its operating agreement with the state, and almost no states even require an LLC to have an operating agreement in the first place.
(That is, with a few notable exceptions like California and New York, because they’re California and New York and think they’re better than everyone else and always have to do things the hard way. I actually had a law school professor tell me that advising a client to form a California LLC should be considered legal malpractice because the state is so business-unfriendly. I suspect he was only half-joking. But I digress.).
So if most LLC owners aren’t required to create an operating agreement, why go through the trouble at all? Three reasons: personal asset protection, governance and preventing transition disruption.
1. Personal Asset Protection
One of the primary reasons for creating an LLC instead of operating as a sole proprietor or partnership is fairly obvious: limiting liability. More specifically, an LLC is designed to shield an LLC member’s personal assets from creditors of the LLC. The fundamental concept is that the LLC is a separate legal person, with the ability to earn revenue, incur liabilities, enter into contracts, etc. Importantly, LLCs can sue and also be sued. If a judgment is entered against an LLC, the assets used to satisfy the judgment are generally the assets of the LLC (i.e., not the separate personal assets of the LLC member(s)).
I say “generally” because it is easy to lose the liability protections afforded by the LLC structure if its members do not treat the LLC as a legally distinct entity separate from personal affairs. This can happen by co-mingling LLC and personal funds, signing documents personally rather than as an agent of the LLC, and – you guessed it – failing to maintain certain records like an operating agreement.
Basically a court will look to see if the LLC is merely a member’s “alter ego” with the member and the LLC being one in the same. If so, the “corporate veil” of liability protection can be “pierced” and the member’s personal assets exposed. Let me put it another way: Clark Kent can’t escape personal liability for all the property damage he causes to Metropolis just because he operates as Superman LLC.
A well-drafted and up-to-date operating agreement will help demonstrate to a court that the LLC is indeed separate and worthy of liability protection. Don’t let the lack of an operating agreement be your kryptonite.