The Requirements of Forming an LLC and its Operating Agreements

Looking at forming an LLC? There are a number of ducks you need to have in a row to be able to do so. We take a look at some of the factors to take consider when launching your LLC entity.

Looking at forming an LLC? There are a number of ducks you need to have in a row to be able to do so. Will your business operate in more than one state? Will you be employing more than just one member? These are some of the factors you need to consider when looking into starting an LLC. You would also need to pen down an operating agreement. In this article, we take a look at some of the factors to take into account when launching your LLC entity.

Forming an LLC

Similar to corporations, which are formed by filing Articles of Incorporation with the state in which the business will be located, LLCs are also formed by filing Articles of Organization at a state level.

To file the Articles of Organization, you’ll need the LLC’s name, the name and mailing address of the registered agent, and possibly other identification information, see some common requirements below.

Here are some of the other common requirements for forming an LLC:

  • Identify your registered agent. A “registered agent” is an individual that your business designates to receive official papers for your organization, such as tax and lawsuit notices. LLCs are required to have a registered agent in each state it is registered in to conduct business.
  • Choose the type of management: Most LLCs are managed by their members. In this arrangement, all members take part in the decision-making process of the business. Each member is an agent of the LLC and has a vote in all business decisions. In a manager-managed LLC, the members turn over control of the business to a manager, which becomes the agent of the company. A member-managed structure is the default status in most states. If the LLC wants to be managed by a 3rd-party manager, it must be designated as such in the operating agreement.
  • Put Operating agreements in place (see more below): The operating agreement is an internal document that spells out how the LLC will operate and be run. While most states do not require an LLC to have an operating agreement for registration purposes, it is often a good idea to have one. In the absence of an operating agreement, state law will govern how the LLC operates.
  • Apply for your employee identification number (EIN): If the LLC has more than one member, it must get an EIN number from the IRS.
  • Out-of-state registration compliance: LLCs are required to register in each state where it conducts business, including appointing a registered agent for each state.

State of formation vs.  state of operations for LLCs

There are two types of LLCs: Domestic and Foreign LLCs.

A domestic LLC only conducts business in the state where it is formed. A foreign LLC conducts business in a state other than where the business was formed and initially registered. A U.S.-based LLC, for example, would be registered as a domestic LLC in one state and registered as a foreign LLC in all 49 other states.

Because of the additional administrative and compliance work required to register and operate a business as a foreign LLC, smaller businesses should consider registering in the state where you expect to conduct most or all of their business. As you obtain customers in additional states, you can register your business as a foreign LLC in additional states.

Your business’ operating agreement governs the operations of the business, enforced by the members/managers.

Does your LLC legally need an operating agreement?

No, it does not. But every tax and legal advisor will probably tell you that you should develop one. This is because an operating agreement is the primary governing document of the LLC and is very similar to a partnership agreement. It spells out the company’s interests, activities, management, and provisions governing the rights and obligations of its members.

These are some of the more common sections of an operating agreement to be aware of:

  • Equity Structure: This section details the ownership percentages of each member. Initial capital contributions, which can be either cash or non-cash contributions, are detailed. Other rules governing future contributions and distributions would also be included in this section, along with whether members are allowed to carry a negative capital balance.
  • Profit and Loss Allocations: Default allocations according to state law are made proportionately according to capital accounts. Non-proportionate allocations may be made if included in the operating agreement. For example, a member who has a 25% interest in the LLC can be allocated 50% of the LLC’s profits or losses in a particular year if this is disclosed in the operating agreement.
  • Management: Do the members of the LLC manage the day-to-day operations of the business, or will a non-member manager be appointed? How are non-member managers appointed and what authorities are they granted?
  • Voting: The default rule for LLCs is one vote per member, regardless of ownership percentage. If an LLC wants to have voted based on ownership percentages, this option must be identified in the operating agreement.
  • Different membership interests: Various membership interests can be formed. Examples include non-voting interests, preferred interests, and profits-only interests.
  • Anti-dilution protection: Every time a new member is admitted to an LLC, the ownership percentages of the existing partners decrease. Anti-dilution provisions prevent ownership percentages of existing members from decreasing by permitting one or more existing member(s) to keep his original ownership interest percentage whenever the LLC votes to add new members.
  • Restrictions on transfers: Can membership interests be assigned to individuals outside the LLC? Do membership transfers require unanimous approval from all members or only a certain percentage of members? Does the LLC have the “right of first refusal” when a member wants to sell his interest? Is there a buyout clause that describes the steps of how a buyout will take place?
  • Liquidation and dissolution: When members are ready to dissolve the business, this section details how an LLC’s assets will be liquidated. A typical liquidation begins with paying off the LLC’s liabilities, followed by distributions to members according to their capital accounts. Lastly, any remaining assets are distributed to members according to their percentage interests.

These are just several of the many different provisions that can be included in an operating agreement. Having a team of advisors who are experts in LLCs, including CPAs and attorneys, is critical if you do not want to omit important sections of your business’ operating agreement.

Filing your LLC annual report

Many states require LLCs to file an annual report to remain in good standing. These reports usually require the business to provide the state with identification information, such as the names and addresses of directors along with the LLC’s registered agent’s name and mailing address.

Some of these annual reports, such as Texas’s franchise tax report, only require an annual filing but have no corresponding fee unless the business owes taxes. Other annual reports, such as California’s franchise tax report, requires an annual minimum fee of $800 regardless of whether or not the LLC reported a profit.

LLCs vs. C corporations for investors

Registering your business as an LLC makes sense for the majority of businesses, for all the aforementioned reasons, but LLCs may still be frowned upon by institutional investors for the following reasons:

  • Taxes: First, investors don’t want to be burdened with the compliance requirements of being a member of an LLC. U.S. federal partnership taxation can get complicated and expensive. Investors don’t want their individual taxes to be either complicated or expensive. There are also potential state reporting requirements if the LLC is considered to have an active trade or business in one or more states. While members of an LLC have annual tax reporting obligations, investors in a C corporation only deal with tax reporting requirements when they sell their shares in that C corporation.
  • Legally can’t invest: Certain investors, such as venture capital funds, are unable to invest in partnerships if the VC fund has tax-exempt partners. These partners can’t accept active trade or business income due to their tax-exempt status.
  • Delaware C corporation is the standard: Many investors and venture capitalists prefer businesses they invest in to be Delaware C corporations for several reasons. First, the Delaware Court of Chancery hears numerous corporate cases every year and makes it easy to research prior court cases and precedents. The court also features judges instead of juries. These judges are subject-matter experts in C corporations. Second, Delaware makes it easy to form a C corporation and offers flexibility regarding how to structure the business and its board members.

Can an LLC be converted to a C corporation?

You may wonder if you can’t just start your business as an LLC and convert it to a C corporation at a later date. The short answer to this is: Yes, you can.

There are 3 different ways to convert your LLC to a C corporation:

  • Statutory conversion: A “certificate of conversion” is filed with your particular state that converts LLC members to stockholders of your new corporation, and transfers assets and liabilities from the LLC to your new corporation. The LLC then ceases to exist. This option is usually the quickest and least expensive way to convert an LLC to a corporation.
  • Statutory merger: Similar to a statutory conversion, except there are more steps and paperwork involved.
  • Non-statutory conversion:  This is the most complicated and expensive way to convert an LLC to a corporation. You should usually be able to avoid using this type of conversion.

There are potential tax consequences with each conversion method. It is advisable to discuss the right conversion option for your business with your tax and legal advisor as there can also be potential tax consequences with each conversion method.

Fusion CPAs understand the tax implications per entity and can look at your business needs to help you decide on the most suitable entity type for you. We can also help you initiate changes to your entity type if you wish to embark on a conversion.

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