Forming California Limited Liability Companies

The organizers have great freedom in creating a limited-liability company ("LLC"): rights and interests can be arranged in ways that are not permitted with corporations or limited partnerships. For example, voting rights, management rights and profit/loss rights need not be related. The organizers therefore have to consider many issues regarding how they want the LLC organized. In addition, there are legal restrictions and relatively complicated tax issues that must be considered as part of this process. This document presents issues that the organizers will want to consider.

Member-Managed v. Manager-Managed.

First, some definitions: A member-managed LLC is similar to general partnership in that each member can bind the entity (i.e. sign binding contracts on behalf of the LLC); with a manager-managed LLC, only the designated manager(s) have authority to bind the LLC. However, with a manager-managed LLC you can still build in member approval of specified decisions.

Articles of Organization and Operating Agreement.

Essentially, the LLC is begun by filing Articles of Organization with the Secretary of State. (Section 17050(a)), along with an $80 filing fee. No Operating Agreement is required–but if one is not used the default provisions of the LLC statutes apply, which many organizers will not want. The Operating Agreement can be entered into either before or after the filing of the Articles of Organization. (However, it is probably wise to do this before filing the Statement of Information (discussed elsewhere in this document), which must be filed within 90 days of the filing date of the Articles.

The Articles of Organization must contain the following:

  • The name of the LLC, which must include either "Limited Liability Company" or "Ltd. Liability Co." or "LLC" as the last words of the name. Also, the name may not contain the words, "bank," "insurance," "trust," "trustee," "incorporated," "Inc.," "corporation," or "Corp." Finally, the name must not be the same as or misleadingly similar to the name of any California LLC or any foreign LLC qualified to do business in California.
  • The latest date on which the LLC is to dissolve. Any date may be chosen, but generally the organizers will want to choose a date 30 or 40 years in the future. The members can always dissolve the LLC earlier if they like.
  • The LLC may have any purpose, except that it cannot conduct banking, insurance or trust company business (Section 17002) or professional-corporation types of business (law, accounting etc.).
  • The name and address of the Resident Agent, which must be an individual living in California or a corporation. If an individual is designated a P.O. Box cannot be used; only a street address for his/her residence or business is accepted.
  • The Articles must indicate whether the LLC will be managed by one manager, more than one manager, or by all members. The names are not required to be identified in the Articles, although the information must be filed with the Secretary of State in the Statement of Information (Form LLC-12) within 90 days of filing the Articles of Organization. (Section 1715(b).)
  • The Articles must be submitted with original signatures of the organizer(s); faxes and photocopies are not accepted.

Items that can't be changed.

Certain items are required by state law and cannot be altered:

  • The basic definitions created by the LLC statutes.
  • Certain rights of a member to receive a return of contribution upon termination of that member's interest. (Sections 17005(b)(2), 17100(c).)
  • The right of the members to dissolve the LLC by the vote of a majority or such higher percentage as may be specified in the Articles or Operating Agreement. In other words, you cannot eliminate the right to dissolve by a vote of the members. (Sections 17005(b)(3), 17103(c), 17350(c).)
  • The right of the members to approve a merger by the vote of a majority or such higher percentage as may be specified in the Articles or Operating Agreement. Again, you cannot eliminate the right of members to approve a merger. (Section 17551.)
  • A member's right of access to books and records. (Section 17106.)
  • The requirement that one cannot provide for less than a majority-in-interest of the members to amend the Articles. (Section 17103(b).)
  • The fiduciary duties of the manager(s), although this may be restricted–perhaps, for example to intentional wrong-doing–but not eliminated with the informed written consent of the members. (Section 17005(d).)
  • The right of a member obligated to render services to withdraw from the LLC. (Section 17252(b).)
  • The requirement to dissolve the LLC in certain instances (the term of the agreement specified in the Articles; the vote of a majority in interest to dissolve, unless a greater percentage is specified in the Articles or the Operating Agreement; the entry of a decree of judicial dissolution). (Section 17351(a).)
  • The requirements for formation, dissolution and mergers of LLC's.

Issues to Consider That Differ from the Defaults.

The following are items that organizers will likely want to change through the Operating Agreement:

  • Voting rights, which otherwise are set by each members' interest in the current profits of the LLC.
  • Fiduciary duties (although these can only be limited, not abolished).
  • Rights of non-members (for example, creditors of a member) to inspect LLC records.
  • The default that a member give six-months' notice before resigning.
  • The default that an event of dissolution dissolves the LLC unless all members vote to avoid dissolution (rather than allowing a majority of interests of both capital and profits interests to vote to avoid dissolution).
  • The default that non-members can vote the proxies of absent members.
  • The priority and proportions of distributions after dissolution. The default, after creditors are paid, is (in order of priority): satisfaction of certain unpaid distributions, the return of member contributions, and finally payments to members in the proportion in which such members share in distributions (which is covered elsewhere in this document).

Allocations and Distributions.

  • Allocations involve the apportionment of tax and book income and loss among the members, and distributions concern the transfer of cash or other property from the LLC to members.
  • Allocations do not always have to track distributions during a particular accounting period, but the following rule must be obeyed for tax purposes: a member's total distributions during the term of the LLC must equal the member's capital contributions plus that member's aggregate share of LLC income less that Member's aggregate share of LLC losses.

Amendments.

Unless the Operating Agreement provides otherwise, the Operating Agreement may only be amended with the unanimous consent of all the members. However, the Operating Agreement cannot provide for less than a majority-in-interest of the members to amend the Articles. (Section 17103(b).)

Security exemptions.

One current problem with LLC's is that while interests in member-managed LLC's apparently do not constitute "securities" requiring registration with the state and federal governments, interests in manager-managed LLC's are presumed to be securities. However, even if the LLC is manager-managed there are ways around the problem.

  • California securities laws probably can be complied with by filing a Notice of Transaction. (Section 25102(f).) Four criteria must be satisfied:

    1. There are no more than 35 members.

    2. All purchasers must either: (1) have a pre-existing personal or business relationship with the LLC or any of its managers of such a nature and duration as would enable a reasonably prudent purchaser to be aware of that person's/entity's character, business acumen and general business and financial circumstances; or (2) have the capacity to protect their own interests in connection with the transaction, by reason of their business or financial experience or that of their professional advisors (in other words, the person is a "Sophisticated Investor").

    3. Each purchaser must sign a document representing that the purchaser is purchasing for his/her/its own account and not with a view to sale of the LLC interest.

    4. There is no advertising or general (public) solicitation with respect to the sale of the LLC interests.

  • However, if all of the members are California residents, then federal registration laws do not apply due to the "intrastate offering exemption."
  • Alternatively, the federal registration requirements may be satisfied through a Regulation D filing.
  • For a total offering price of up to $1 million (only $500,000 if the previously mentioned 25102(f) filing is made with the State of California):
    (1) There can be no general solicitation or general advertising, which includes but is not limited to newspapers, magazines, radio, television and any meeting where the attendees were invited by such means.
    (2) The issuer must provide accurate and complete disclosure of all material information in a manner that is not misleading.
  • For a total offering price of up to $5 million:
    (1) There can be no more than 35 purchasers.
    (2) No general solicitation or general advertising is permitted.
    (3) If sales are made to even one non-Accredited Investor, specific information disclosures are required (which increase depending on the size of the offering). "Accredited Investors" include any individual whose net worth, alone or jointly with his or her spouse, is $1 million (note that as of summer of 2010 the personal residence is not counted as part of net worth); any individual who has personal income of more than $200,000 (or joint income with his or her spouse of more $300,000) in each of the last two years and who reasonably expects the same level of income in the current year; certain institutional investors; certain private business-development companies; and entities in which all equity owners are accredited investors.
  • For a total offering price with no limit:
    (1) The number of purchasers other than Accredited Investors must not exceed 35.
    (2) Each purchaser must be a Sophisticated Investor or an Accredited Investor.
    (3) General solicitation and advertising are prohibited.

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Methven & Associates
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Phone: (510) 649-4019 Fax: (510) 649-4024
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Copyright 2004 Bruce E. Methven, All Rights Reserved.

The foregoing article constitutes general information only and should not be relied upon as legal advice.