An Overview of California LLCs for Startups
One of the most important decisions that a startup founder can make is determining what type of business entity to form. In Silicon Valley, an overwhelming number of companies that are formed in anticipation of investor funding are formed as stock or “c” corporations. Most of those companies are formed in Delaware for several good reasons, some of which we outlined in a previous article, Why Do Startups Incorporate In Delaware?
Delaware C Corporations are Not Always the Best Option for Startups
Forming a Delaware C corporation is not the best choice for every startup. There are some great reasons why founders may consider forming other entities, such as sole proprietorships, “B” corporations, general partnerships, limited partnerships, limited liability partnerships, and limited liability companies. We won’t discuss and compare all possible US entities. For further research, you may visit the Secretary of State website in your state to learn more about the various business entities available to you. Click here for the California Secretary of State business entities division.
This article provides a broad window into California limited liability companies (LLCs) and is organized to help founders determine whether an LLC is the right fit for their particular business.
A Few Words on What We Mean by “Startup”
An important disclaimer: any reference to “startup” in this article simply means the early (or startup) stage of any type of business. We don’t presume that “startup” necessarily means an accelerated growth tech company. Most successful companies that, at one time, used to be startups (like Twitter, Uber, or AirBnB) are now well past the startup stage.
What is an LLC?
An LLC is an unincorporated business organization whose members (or owners) have limited personal liability for the liabilities or obligations of the LLC.
Who Owns an LLC?
Owners of an LLC are called members.
Can Members of an LLC have any Personal Liability for the Actions of the Company?
A common misconception for both LLCs and c corporations is that the members or shareholders, respectively, have no liability for the actions of the company but this is not true. There are certainly instances where the courts will find owners personally liable, particularly when the company’s actions or inactions are egregious or excessively harmful. That being said, LLCs do a better job of shielding owners against personal liability than, say, sole proprietorships, where owners are always personally liable for the liabilities or obligations of the business. Minimizing the risk of personal liability is one of the main reasons why some founders choose to form LLCs and also why it’s so important to form the right business entity early on.
Businesses that are based in California should consider forming a California LLC. California has long been the hub for innovation and entrepreneurship, with a robust infrastructure of resources and support for practically every type of business at any stage. Founders often choose California as a launch pad in order to access talent, capital, strategic partnerships, or customers – all to scale up (not just “start up”) their companies.
Some founders prefer to form their LLCs in Delaware but the advantages of doing so are not as clear as for corporations, where venture capitalists strongly prefer to invest in Delaware corporations in exchange for stock in the company. A major downside of forming an LLC in a different state than where it has operations is that such an LLC would be required to pay annual fees to both the state where it was formed as well as the operating state.
It is possible to convert an LLC from a different, foreign state to a California LLC if the laws of the foreign LLC permit the conversion. However, it is highly advisable to consult with a good accountant and business lawyer in advance of such conversion. In some cases, it may make more sense to dissolve the foreign LLC and start fresh with a newly formed California LLC. Note: according to the California Secretary of State, a California corporation cannot convert into a foreign entity (an entity in another state).
Forming an LLC
An LLC is formed in California by filing Articles of Organizations with the Secretary of State (CA Secretary of State Form LLC-1) along with the payment of a statutory fee. The articles must be signed and filed by the organizer of the LLC and, if there is more than one organizer, all organizers must sign. The organizer(s) need not be members of the LLC. The members may be appointed in the operating agreement (see below).
Though it is not required by law for the members of an LLC to enter into an operating agreement (CA Corporate Code section 17702.01(d)), it is highly advisable that members do so in order to set forth rights, responsibilities, and liabilities of the members, ownership interests, what happens upon departure or addition of a member, dissolution rules, tax calculations and more.
Within 90 days after filing the Articles of Organization, and biannually thereafter, the LLC must file with the Secretary of State a Statement of Information (CA Secretary of State Form LLC-12). The Statement of Information contains the following:
There is a nominal filing fee of $20 for each Statement of Information plus any service fees that your registered agent may charge.
An LLC doing business in California must pay an annual franchise tax of $800 plus a graduated statutory fee from $900 to $11,790 for any year in which the LLC’s total income derived from or attributable to California is $250,000 or more. There is an exception until taxable years beginning on or after January 1, 2018 for small businesses (under $250,000 in income) solely owned by a deployed member of the United States Armed Forces for any tax year in which the LLC operates at a loss or ceases operations.
The LLC is not required to pay the franchise tax when filing the Articles of Organization, but must do so on or before 15th day of the 4th month of each taxable year thereafter.
Note: The fees that are quoted in this article are effective as of the date of the article. For accurate fees, please check the California Secretary of State website under Forms and Fees.
Contributions of Cash, Property, and Services
A contribution of cash by an LLC member in exchange for a membership interest in that LLC will not result in a taxable event for the contributing party. The same is true for contributions of property in exchange for an interest in an LLC so long as the LLC is treated as a partnership or disregarded for tax purposes.
If a member of an LLC taxed as a partnership contributes services to the LLC and receives a profit interest in that LLC (i.e. not an interest in the share of distributions upon sale or dissolution), the interest will not be taxable upon receipt.
Generally speaking, founders who wish to issue incentive stock options to their employees and consultants are better off setting up corporations for convenience, due to the complexities of effectuating the same in an LLC and resolving the partnership tax accounting.
If you ever have any doubts or questions about taxation of either a corporation or LLC, please consult an accountant.
Tax Treatment of an LLC
An LLC is considered a “pass-through entity”, whereby its income and losses flow through and are taxable or deductible by the members. Thus, there is a single level of tax, and losses are fully deductible by members, though not in excess of their bases in their membership interests.
If an LLC has only a single member, the entity is disregarded for federal tax purposes, and all assets and liabilities of the LLC are treated as owned by the sole member.
Pass-through tax treatment for an LLC may be a disadvantage to a profitable business that may need to reinvest a significant portion of its profits (i.e. in the case of a manufacturer or any business with very high overhead), because the members will be taxed on their allocable share of the profits and may not receive any distributions with which taxes may be paid.
Distributions in the form of cash or property to members of an LLC that is taxed as a partnership are generally not taxable events to those members. However, if a member receives a distribution in excess of his or her membership interest, that gain is recognized to the extent of the excess. A member’s bases in his or her LLC membership interest is reduced by the distributions made to that member.
A distribution to a member of a single-member LLC is not a taxable event since that member is treated as having owned the assets of the LLC.
Taxation on Disposition of Interest and Liquidation
An LLC that is treated as a partnership for California tax purposes is subject to an annual fee based on income. As stated above, California also subjects LLCs to an annual minimum tax of $800 for the privilege of doing business in California. Not every LLC doing business in California is required to pay this tax but every LLC that is formed in California or has an intrastate transactional presence will likely need to pay the annual fee. In a 1996 case, the California State Board of Equalization found that an out-of-state corporation, which only has a single limited partner that was doing business in California, did not need to pay the $800 minimum tax.
Management and Control
There are two places which state how the LLC is managed: the Articles of Organization; and the LLC operating agreement.
Founders who form an LLC have an opportunity, at the outset, to state in the Articles of Organization whether the LLC will be member-managed or manager-managed. If the Articles state that the LLC will be managed by managers, the members would obviously not participate in the management of the LLC’s business, would not be agents of the LLC, and could not bind the LLC.
An operating agreement can (and should) be used to specify how the LLC will be managed, how managers may be elected, if at all, whether members may remove managers etc. Management can be highly concentrated in a single person or several individuals with no right of participation or removal by the other members. Alternatively, management can be distributed among a corporate-style board of elected or appointed directors and officers. If founders of an LLC wish to set up a corporate-style board, then the same should be set forth in a detailed and written operating agreement. In other words, if stated in a written operating agreement, an LLC may have officers, including a chairperson and/or president, a vice president, secretary, chief financial officer, or other officers with other express titles, powers, and duties.
If there is no mention of officers in the operating agreement, managers may appoint the officers, subject to other agreements that may exist between the LLC and such appointed officers. There is no requirement that officers of an LLC be members or managers of the LLC and any single person can hold one or several different officer positions.
Member-Managed vs. Manager-Managed LLCs
In a member-managed LLC, a member may participate in the management and control of the LLC and may also legally bind the LLC. Conversely, in a manager-managed LLC, the manager(s) would be an agent of the LLC for the purpose of its business affairs and their actions, in the ordinary course of business, can bind the LLC (whereas members cannot).
Either the Articles of Organization or the operating agreement may set forth any restrictions on managers in a manager-managed LLC or members in a member-managed LLC to bind the LLC.
Personal Liability of Owners in an LLC
As a general rule, members or managers of an LLC are not personally liable for the debts, obligations, or liabilities of the LLC, solely by virtue of being a member or a manager. The following are the exceptions to this rule:
Transferring Interest in an LLC
The right to receive distributions is transferrable without the consent of the other LLC members. However, the transfer of such interest does not also transfer all of the transferring member’s other (i.e. voting) interests in the LLC. Any transferee is entitled to receive written instructions from the LLC describing the scope of interest that has been transferred.
A transfer of a member’s entire interest (including voting rights) must be approved by all LLC members in order to be valid, unless otherwise set forth in the operating agreement. If all the LLC members do not consent to the transfer of a member’s entire interest or if the operating agreement does not otherwise permit such a transfer, then the transferring member retains his or her voting rights associated with the transferred interest. Similarly, if a member becomes dissociated from an LLC, that member’s LLC interests will lose their voting rights, if any.
Raising Capital in an LLC
An LLC can be capitalized in the following ways:
Certain types of investors are attracted to LLCs because of the organizational and structural flexibilities, the ability to make special allocations and deduct losses, and the ability of members to actively engage in the management of the LLC without risk of personal liability.
Business Continuity of the LLC
Unless the Articles of Organization or operating agreement state otherwise, death, bankruptcy, withdrawal, or legal incapacity of a member may result in dissociation of a member but will not result in the dissolution of the LLC. The events triggering the dissolution of an LLC are typically set forth in a written operating agreement and will vary, depending on the general nature of the business.
Fiduciary Duties of Members and Managers in an LLC
Every member of a member-managed LLC owes the LLC a fiduciary duty of care and loyalty. This duty is not violated simply by virtue of the member acting in his or her own best interest.
Same as above, every manager in a manager-managed LLC owes the LLC and its members a fiduciary duty of care and loyalty. In a manager-managed LLC, a non-manager member has no fiduciary duties to the LLC or to other members, even if that member is a majority member (contrast with the common law fiduciary duty of a majority shareholder to minority shareholders in a corporation).
The fiduciary duties of managers and members in a member-managed LLC may only be modified by a written operating agreement with the informed consent of the members.
All states generally recognize the formation of LLCs, though the statutes authorizing them vary from state to state. By way of example, just as a foreign LLC is required to file a foreign qualification to do business in California with the California Secretary of State, a California LLC must qualify as a foreign LLC by filing the appropriate paperwork and paying the applicable fees to do business in other states.
Anonymity of Owners
The names of members in a manager-managed LLC need not be a matter of public record, but the names and addresses of managers must be listed in the LLC Statement of Information filed with the California Secretary of State. If the LLC is member managed, the names and addresses of its members will become public record in the LLC Statement of Information. Owners of an LLC that wish to remain anonymous may either select a manager managed LLC or form their LLCs in Delaware or Nevada, where the members’ identities need not be public record.
Restrictions on Type of Business
Neither domestic nor foreign LLCs may provide professional services in California. This precludes professionals such as doctors, lawyers, and accountants from using LLCs to do business in California. LLCs may, however, render services pursuant to a license, certificate, or registration if authorized by the California Business and Professions Code, the Chiropractic At, the Osteopathic Act, or the Yacht and Ship Brokers Act.
Foreign LLCs in California
The California Revised Uniform Limited Liability Company Act (RULLCA) states that the laws of the state or foreign country under which an LLC is organized govern its organization and internal affairs, including the liability and authority of its managers and members. In some instances, it makes sense for owners to form a foreign LLC (an LLC formed outside of the State of California). For example, California prohibits professional LLCs, does not offer complete anonymity of its members or managers, and does not authorize series LLCs, which is common for certain ventures such as real estate investment.
However, forming an LLC in a state other than California may be more costly than doing the same in California. There may be additional filing and annual maintenance fees and annual fees for maintaining a registered agent in the foreign jurisdiction. Foreign LLCs must pay fees to the state or jurisdiction under which they are formed as well as fees to the State of California (or wherever they operate) for the privilege of doing business in California (or in such other state). Further, the owners of the foreign LLC must keep abreast of the local laws in that jurisdiction and may even need to engage local legal counsel to provide support. Therefore, except for the reasons stated above, there may be little or no other reasons for businesses that are headquartered in California, or whose members reside primarily in California, to form an LLC outside of California.
A Comparison to C Corporations
C corporations, unlike LLCs, are subject to double taxation, and corporate losses remain in the corporation, unable to be utilized by the shareholders, whereas, losses of an LLC maybe passed through and generally may be deducted by the members. On the other hand, corporations may mitigate the losses and effects of double taxation through the payment of salaries and bonuses to employees and shareholders.
A corporation may be a preferred entity when the income of a business is to be reinvested back into the business, since the income is not passed through to the shareholders except to the extent the corporation pays dividends. Based on the formation trends for Silicon Valley venture-backed companies, there can be no denying that a stock or “c” corporation is the standard vehicle of choice for those accelerated growth companies seeking VC investments. Plainly put, investors expect issuance of stock to themselves and stock vesting for founders, not LLC membership interests. Issuing incentive stock options to personnel can be achieved with relative ease in a corporation and, though possible with an LLC, is more complex and less common. Finally, a corporation can deduct medical expenses for all shareholder-employees, and the receipt of this benefit will not be income to the persons insured, while LLC members are subject to taxation on the receipt of these benefits.
Thought it is true that the great majority of businesses that become publicly traded are conducted in corporate form, with advance planning and the inclusion of appropriate provisions in an LLC operating agreement, a startup that forms initially as an LLC can be converted into a corporation on a tax-deferred basis in advance of an initial public offering. Many founders select LLC formation due to flexibility in management and the ability to deduct losses from income and then convert the LLC to a c corporation prior to raising outside investments
When to Use LLCs
Businesses that might find LLCs particularly attractive entities include the following:
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