The limited liability company (LLC) is a relatively new legal entity which got its start in the late 1980s. As the name implies, an LLC provides limited liability to its participants called “members” while containing the assets and operations of the business enterprise. Please keep in mind that LLCs are regulated at the state level, therefore management and formation matters may vary from state to state.

How to Form an LLC

LLCs are formed by filing an articles of organization (or other similarly titled document) and submitting a filing fee with the Secretary of State.

You’ll have to make sure the LLC’s name complies with applicable state rules or else the Secretary of State will reject the filing. The most common reason a name is rejected is that the proposed LLC’s name is too similar to that of an existing entity, whether the existing entity is an LLC, corporation, limited partnership, etc. Some states can be very laid back with regards what constitutes a similar name, while others are hyper-sensitive sticklers (hello Texas!).

You will also have to appoint a registered agent for your LLC. A registered agent is a business or individual designated to get served when your LLC is a party to a legal action such as a lawsuit or summons. Failure to maintain a registered agent or keep your registered agent’s address updated can produce undesirable effects for your LLC.

The Management and Operations of an LLC

An operating agreement typically determines the management and operational functions of the LLC. This agreement is made between the LLC’s members (the owners of the LLC) and the LLC. The operating agreement will also determine the allocation of income and tax liabilities. These documents can be extremely short or extremely long.

In the typical default management structure, the management of the LLC is vested in the members in proportion to their ownership interest in the LLC. However, the members can agree, either in the articles of organization or operating agreement, to vest management in a “manager” rather than each of the members.

Tax Basics

Thanks to a 1998 Internal Revenue Service ruling, LLCs are a hybrid vehicle which provides the liability protection of a corporation with the pass through taxation benefits of a partnership or S corporation. Pass through taxation means that the members of the LLC pay the taxes of the LLC on their individual 1040 tax return via a Schedule K-1. Thus, the income (or loss) is “passed through” to the members. This allows for the avoidance of double taxation on the LLC’s income.

I highly recommend seeking guidance from your CPA, as there will be tax issues–both personal and for the entity–that may influence your entity decision.

When is the LLC the best choice of legal entity?

Unfortunately, I don’t have a bright-line rule for when to be an LLC. The LLC is a very flexible legal entity combining the advantages of corporations such as limited liability and continuity of life with the advantages of partnerships such as pass through taxation and corporate informality.

Thus, if you are looking for a simple way to enjoy limited liability and you are not too concerned with raising capital or establishing a more traditional management system, the LLC is probably for you. But if you are looking to use various corporate-like methods, whether options or raising capital, the LLC may not be your best option. You can still create some corporate-like incentives for your employees, but I find that most employees have a hard time comprehending what a “membership unit” is as opposed to a share of stock.

Many entrepreneurs begin their startup as a sole proprietorship. Eventually, some sole proprietors desire to incorporate so they can reduce their personal liability and protect their personal assets. But the act of incorporating a going business does not, by itself, transfer the current business being conducted as a sole proprietorship to the new corporation.

The 2 main issues when incorporating a sole proprietorship

The 2 main issues involve the transfer of assets from the going business to the new corporation and the tax consequences from such transfer. [This article will address the transfer and not the tax issues.] Since the assets of the sole proprietorship will need to be transferred, formal conveyances of such property must be made from the sole proprietorship to the new corporation.

The process

The first step is to incorporate the new legal entity. The next step is to execute various transfer documents by the sole proprietorship, by the new company, and some by both the sole proprietorship and the new company. In return for the conveyance of property to the new corporation, the owner of the sole proprietorship usually receives corporate shares of the new corporation.

You’re not done yet

While the transfer is now complete, additional administrative steps may need to be completed depending on the nature of the business:

-Transfer assumed name
-Handle workforce commission issues
-Close sole proprietor bank account and open account in new corporation’s name
-Make necessary changes to insurance policies
-Transfer permits and licenses
-Contractual obligations
-Apply for new federal tax ID number
-Make appropriate revisions in estate planning documents

Furthermore, while there’s no requirement to publish notices of the intent to incorporate, creditors should be notified of the sole proprietorship’s termination and the existence of the new corporation. This will help prevent liability if creditors continue to believe the business is operating as a sole proprietorship.

While incorporating a sole proprietorship may seem like a large and painful task, I believe the benefits such as reduced personal liability outweigh any headache from completing the transaction.

If your startup company launches with more than one founder and your startup plans to eventually be acquired or seek venture funding, your startup’s founders stock should vest over time according to a vesting schedule.

Founding teams might not stay together. And having a missing founder or two with a nice chunk of your startup’s common stock is not a scenario your startup wants when it comes time for an acquisition or venture capital financing.

So instead of the founders getting all their shares of common stock on Day 1, the founders get their stock according to a vesting schedule. The standard vesting schedule for startup companies is four years with a one year cliff and monthly vesting thereafter until the founders reach 100%. The one year cliff means that the founders do not get vested with regards to any common stock until the startup’s first anniversary. Thereafter, the founders get vested every month at an amount equal to 1/48th of the their total common stock.

If a founder leaves before the startup’s first anniversary, the founder leaves without any common stock. If a founder leaves after 15 months, the founder will have 31.25% of his common stock vested (25% after the first year, plus the 2.083% vesting each month for 3 months). Thus, the missing founder leaves the startup with much less shares than if the founders stock had vested immediately. This makes it easier to get the necessary approval (and other issues) to go forward with an acquisition or venture capital financing.

You need to customize your articles of incorporation and corporate bylaws if you are serious about doing things the right way at your startup company. But be careful how you customize these important startup documents. Don’t fall into a common trap where you think you are customizing your startup documents, but in reality, you are only tinkering with things of nominal importance. To avoid this trap, customize your startup documents according to the relationships within your startup company rather than to your industry.

For example, imagine you and a friend are launching a startup that will develop dashboard widgets for OS X. Both of you plan to put equal time and capital into the startup. While searching for corporate bylaws to help guide your drafting, you come across the following 2 documents:

Bylaws “A”, from a startup company in Mountain View, California that develops similar widgets for Windows Vista with 2 co-founders, one the software developer and the other the pure “money” person, and

Bylaws “B”, from a lemonade stand in Nome, Alaska with 2 co-founders, who put in equal time and capital to run the lemonade operations.

Which set of bylaws will be the better guide for you to draft your dashboard widget startup’s documents? Bylaws “B” by a pretty good margin, even though the Alaskan lemonade entrepreneurs are a long, long way from Silicon Valley.

While the Mountain View startup’s bylaws might at first seem like a great match, the relationship between the 2 co-founders, with one person contributing sweat equity and the other pure capital, makes this company’s bylaws practically irrelevant to your startup company. Sure, you both deal with tech stuff but your respective co-founder relationships drastically differ. On the other hand, the lemonade stand co-founders put in both equal time and money–just like your startup company. Since the lemonade stand co-founders (hopefully) framed their relationship issues in their bylaws, their bylaws will be a much better drafting guide for you. And your startup company will reap the rewards when something goes wrong and your startup’s bylaws are needed to help resolve a dispute between you and your co-founder. They will be on point and address issues likely to come up in your particular situation.

Bylaws should be drafted according to the relationships between co-founders, shareholders, and officers. They should not be overly concerned with your product or service. Therefore, by customizing your startup documents according to relationships within your startup company rather than your industry, you will end up creating valuable documents for your startup company.

Filing for S-corporation status with the IRS requires compliance with strict time guidelines. Form 2553 must be filed by the 15th day of the third month after your corporation’s fiscal year. For most corporations, that means you must file by March 15 for the S-Corporation election to be effective for the current fiscal year.

If you file Form 2553 late, your election to be an S-corporation becomes effective the next fiscal year. However, if you qualify, you can file late and make your S-corporation election retroactive using IRS Revenue Procedure 2003-43. Your corporation will qualify to file Form 2553 late if:

1. Your corporation intended to be an S-corporation as of the intended effective date on your Form 2553;

2. Your corporation failed to obtain S-Corporation status solely because it did not file Form 2553 on time;

3. The original due date of your Form 2553 was less than 2 years ago;

4. Your corporation had reasonable cause or inadvertently failed to file form 2553 on time;

5. Your corporation has not filed tax returns for the year(s) it intends to be an S-Corporation (or your corporation filed tax returns as an S-Corporation using Form 1120S);

6. You file Form 2553 within 6 months after the original due date (no extensions) of the first tax return for which your corporation intended to be an S-Corporation; and

7. All of your corporation’s shareholders have not reported income in a manner inconsistent with your corporation’s intention to be an S-Corporation.

If you meet these requirements and wish to file a late election for S-Corporation status, write the following language at the very top of your Form 2553: “FILED PURSUANT TO REV. PROC 2003-43″ and include a statement, on a separate sheet, addressing requirement #4 above. And make sure all shareholders sign both documents.

When you incorporate your startup company, two main decisions arise. First, what type of entity should your startup company be? Second, where should you incorporate?

Of the two, entrepreneurs focus primarily on choice of entity–LLC, Corporation, etc.–and usually just incorporate in their home state. And home state incorporation will make sense for most. But for a few startup companies, incorporating in a foreign state like Delaware, will be a better decision.

Delaware’s division of corporations lists 4 reasons to incorporate in Delaware on its website:

Why Choose Delaware as Your Corporate Home?

More than half a million business entities have their legal home in Delaware including more than 50% of all U.S. publicly-traded companies and 60% of the Fortune 500. Businesses choose Delaware because we provide a complete package of incorporation services including modern and flexible corporate laws, our highly-respected Court of Chancery, a business-friendly State Government, and the customer service oriented Staff of the Delaware Division of Corporations.

Talk about selling your state short. I’ll see their four reasons and raise them one. Thus, the following are my top five reasons to incorporate in Delaware:

1. Flexible Laws. Delaware’s General Corporation Law is the most advanced and flexible business formation statute in the United States. It is designed to provide maximum flexibility in the structuring of business entities and the allocation of rights and duties among founders and shareholders.

2. No Wildcard Juries. If you do end up going to court to settle a dispute, Delaware’s Court of Chancery uses judges instead of juries. I don’t know about you, but I’d rather place my startup company’s legal fate in the hands of a well-trained expert than people whose legal experience consists of The People’s Court and Law and Order re-runs.

3. Precedence = Less Litigation. Since judges are used, decisions are issued as written opinions that your startup company can rely on. Thus, most Delaware corporations do not end up litigating disputes because their professional advisers examine these published opinions and construct deals to avoid lawsuits.

4. It’s Free! (Well, almost). Delaware charges $89 to incorporate. A little bit cheaper than California ($100..but they nail you for $800 every year in franchise fees), New York ($125), and a lot cheaper than Texas ($300). [note: Even if you incorporate in a foreign state like Delaware, your startup company may still be subject to registration as a "foreign entity" and compliance with the laws of states you transact business in.]

5. Privacy. In a world where personal privacy is constantly eroding (the Google 3D Mapping truck should be driving by my house anyday now), Delaware does not require director or officer names to be listed in the formation documents. Thus, Delaware provides a level of anonymity from snoopers.

Even though this post makes a big push for incorporating in Delaware, you shouldn’t assume Delaware is the default choice for your startup company. The fact so many large, public companies choose Delaware should demonstrate that large, public companies tend to benefit the most from incorporating in Delaware.

So think about it and discuss incorporating in Delaware with your co-founders and professional advisers. But note that if you are planning to work with an investment bank or venture capital fund, you will likely have no choice but to become a Delaware entity. And for the five reasons above, that may not be such a bad thing.

The Secretary of State fails new businesses by not requiring you to record your company bylaws. It signals to the entrepreneur that articles of incorporation are more important than company bylaws, leaving bylaw drafting a mere afterthought.

Every business is different and has issues that need to be addressed in its bylaws. Therefore, “template” bylaws you can acquire via Google or your local bookstore are a one-size-fits-all approach to a unique situation.

Using template bylaws and filling in the blanks with your company’s name is like purchasing a suit that only comes in one size. And while you may initially file this one-size-fits-all suit into the back of your closet, the day will come when you will have to wear this suit out in public and pray it doesn’t rip at the seams.

Subchapter S status was enacted so that startup companies and other entrepreneurs would not shy away from choosing a corporate form of organization because of the potential for double taxation. A corporation that elects Subchapter S status is treated for federal income tax purposes as a partnership, but maintaining the corporate advantage of limited liability for its shareholders. Thus, corporations that elect Subchapter S status are known as ”S corporations” while all other corporations are called ”C corporations.”

Running a startup, you have a billion things to do. Don’t forget to add “First Organizational Meeting” to your to-do list.

This meeting should take place after the issuance (or effective date) of your certificate of incorporation. But don’t wait too long, as you have some important business to handle, such as: adopting share certificates, choosing a bank, adopting a fiscal year, and arranging for necessary permits.

After you have made the decision to incorporate, the next question is “where to incoporate?”

You can incorporate in your own state and be considered a domestic corporation, or you can incorporate elsewhere and do business in your own state as a foreign corporation.

Generally, if most of your business will be conducted in your own state, you will likely benefit more from incorporating in your own state. However, your decision should also consider each state’s relative:

(a) incorporation expenses;
(b) taxes;
(c) jurisdictional issues;
(d) rights, powers, and liabilities of directors; and
(e) the extent of the corporation’s regulation.

For some, choosing where to incorporate may be a real easy decision. But for others, it may necessiate some serious thought.