Limited liability companies (LLCs) have quickly become the preferred choice for new small businesses. The LLC has several advantages over forming a partnership or a corporation. Historically, new business owners who sought to minimize tax liability would establish a partnership and business owners who sought to minimize personal liability would establish a corporation. That is because corporations are taxed separately from their owners (shareholders), but shareholders are generally not liable for the corporation’s debts. Partnerships are just the opposite. LLCs are a relatively new form of business entity created to achieve the best of both worlds — providing business owners the tax advantages of a partnership and the protection from liability that corporate shareholders enjoy.
LLCs are easy to establish. The only documentation Arizona law requires is a two-page articles of organization — a form the Arizona Corporation Commission posts, with instructions, on its website. And there are only two steps. First, you file the articles of organization and filing fee (currently $50) with the Arizona Corporation Commission. Second, you publish the articles of organization in your local newspaper after the Arizona Corporation Commission approves the filing.
Although LLCs offer many advantages, there are several pitfalls you should be careful to avoid, particularly when there is more than one member of the LLC. First, consider carefully whether the LLC should be manager-managed or member-managed. Unless otherwise specified in the articles of organization, the members have equal management rights over the LLC. If, for example, one or more members invests capital in the LLC but does not intend to have any management role, it might be best to designate the other member(s) — or even a third party —to manage the LLC.
Second, be sure to have an operating agreement setting forth the rights and duties of the LLC members and managers. Arizona does not require LLCs to have an operating agreement so many LLC members choose not to do so. Although it may be easier and cheaper to skip the operating agreement in the short term, the decision can be catastrophic. I have litigated many times disputes among members of an LLC without an operating agreement. Trust us, it gets messy.
At the outset, chances are that the members and managers of an LLC will have a consensus about their respective roles and the way in which the business should be conducted. As with any relationship, however, the longer the business operates, the more likely it is that disagreements will occur. Without an operating agreement, the default provisions in Arizona’s LLC Act apply and those provisions do not always protect a member or manager’s interests. For example, the LLC Act does not currently provide for the expulsion or forced buyout of a member under any circumstances. To remove a manager, the LLC Act may require the consent of the manager being removed. Because of the LLC Act’s limitations, disputes among LLC members often lead to costly litigation and even the destruction of an otherwise viable business. The most effective means for each member to protect his or her interests and the long-term interests of the LLC, therefore, is to have a lawyer prepare an operating agreement.
Operating agreements need not be highly detailed or sophisticated, although a more detailed operating agreement will generally provide greater protection to its members. If you’re considering establishing an LLC, or if you’ve previously established an LLC without a written operating agreement, it may be worthwhile to get an estimate of the cost for completing one. The short-term investment may be less than you think and it may save you a lot more money and aggravation in the long run.
• Brian Foster is a 20-year Ahwatukee resident and senior partner at Snell & Wilmer L.L.P. in Phoenix. Reach him at (602) 382-6242 or firstname.lastname@example.org. Kelly Kszywienski is an associate at Snell & Wilmer.