SPECIAL REPORT: ABA Panel Outlines Potential Situations in LLCs that Need to be Considered at Time of Formation
- May 13, 2010
The LLC is one of the most widely used, but by no means straight forward, ownership entities today. When creating the original LLC contract, many potential situations need to be anticipated.
A panel for young lawyers at the 21st Annual Spring Symposia of the American Bar Association’s Real Property Trust & Estate Law group discussed the various scenarios that should be considered in LLC formation.
The questions to be addressed in the initial LLC contract include: How and when the investors contribute their capital; who makes decisions for the entity and how much control he or she has; how disagreements among investors are resolved; whether and to whom investors will be allowed to sell their interests; and how the cash is distributed
The LLC provides for the greatest flexibility in how it can be structured and managed, pointed out panelist Sterling S. Willis, the head of the Real Estate and Commercial Finance groups at Fishman Haygood Phelps Walmsley Willis & Swanson LLP, New Orleans. The LLC can be formed with any variety of ownership structures and the investors can go into great detail about their requirements, he said.
The benefit of LLCs is that they can be taxed like a partnerships, with pass through taxation, at the same time they provide limited liability for their owners. By comparison, sole proprietorships carry no personal liability. A partnership, while benefitting from avoiding double taxation, has little limited liability protection. And corporations, while providing limited liability, are taxed at the corporate level. S Class corporations provide pass through taxation, but limit the number of members.
The only downside to the LLC is that this entity was created only in the past 20 years and there is not a lot of case laws associated with it, said Willis.
Kenneth M. Jacobson, partner at Katten Muchin Rosenman LLP, Chicago, indicated that there are LLC formation checklists that can be used to make sure a variety of potential business circumstances are taken into account.
For example, the LLC formation document should stipulate that in the event of a capital shortfall, such as if a key commercial space tenant leaves, who the person or persons who makes the decision to put in the capital should be, as well as the pay-in period, and the consequences for owners who fail to contribute the required capital.
Owners need to address whether the managing partner is invested with “tsar like” powers, or if they are given broad discretion in the day-to-day operations but not in other circumstances. And it also needs to be decided whether owners of the company will be allowed for example to invest in competing commercial real estate.
Disputes inevitably occur in the course of the investment, and LLC owners need to take into account these potential disputes, Willis suggested. For example, can the minority block the wish of the majority; can a disinterested party be given the role of breaking a deadlock; and will there be mandatory arbitration.
Exit strategy is another major area of consideration in LLC formation. Jacobson noted it needs to be agreed what constitutes cash, when it is distributed and who makes the decision to distribute it. The cash can be automatically distributed, or the manager can make that decision.
The LLC also needs to determine how it wants to handle cases in which individual investors want to exit the company. For example, what votes will be required, and it needs to be stipulated in the document whether one member has to right to sell to another member, or does the LLC have the right of first refusal.