"Do-it-yourself" legal has exploded in popularity over that last couple of years. Given the cost savings and instant gratification of the internet it is no wonder small business owners are increasingly side stepping lawyers to form their business entities. If you decide to go at it alone make sure to do your homework. The cost savings can quickly dissipate without proper planning. Listed below are the seven most common mistakes I see LLC owners make and what they should do to avoid them.
1. Using the Wrong Signature Block.
There is a formal procedure an individual must undertake when executing documents on behalf of a corporation or LLC. One of the easiest ways that an LLC member can call his or her personal liability into question is for that member to improperly execute documents which are meant to solely bind the LLC. See, Zukel v. Great West Managers, LLC, 78 P.3d 480 (Kan. App. 2003). In Zukel, the managing member of an LLC was held to be personally liable on a contract between the plaintiff and the LLC. The Court specifically noted that the member neglected to use the proper mode of execution when signing the document in question, but had properly executed other documents involved with the transaction. Any document that a member is signing on behalf of the LLC should always be executed in the following manner: State the name of the LLC, followed by the name of member or officer with capacity, preceded by the words “per” or “by”, and followed by the title of the member or officer. For Example:
By: John Doe, Member
This procedure needs to be followed on every single document. As the case above illustrates, courts will look to varied forms of execution as evidence for intent to be held personally liable. It should be noted that Kansas courts will always try to ascertain the intent of the parties by analyzing the contract as a whole. Therefore, if you unambiguously agree to be held personally liable as a member in the body of the contract, chances are that you will not be able to get out of that personally liability solely by using the signature block above. The main point to be taken away from here is that by deviating in any way from the execution example above you are giving the creditor of your LLC an excuse to come after you personally if a dispute arises. The creditor may not ultimately be successful be it is much less costly to properly execute a document than it is to defend a lawsuit.
2. Neglecting To Utilize An Operating Agreement.
In Kansas, executing an operating agreement is not necessary to form a limited liability company. If an LLC does not employ an operating agreement it is deemed to be governed by the default rules of the Kansas Revised Limited Liability Act (“Kansas LLC Act”). The problem with this is that most Kansas business owners do not have the time or inclination to read and interpret Kansas Statutes. If members are unaware of the contents of the Kansas LLC Act chances are they are not operating their LLC in conformance with the statues. This not only exposes the members and managers to liability among each other it potentially exposes the members to personal liability under a piercing the corporate veil argument. By adopting an operating agreement the members can modify the default rules of the Kansas LLC Act to fit the company’s specific needs, as well as, provide an easy to follow blue print for all the members to follow. If you adopt an operating agreement make sure you understand and follow it. Two of the factors that favor disregarding a corporate entity in a personal liability action are: (1) failure to follow corporate formalities and (2) absence of corporate records. So if your operating agreement requires a majority vote of the members to enter into transactions on behalf of the LLC, the members must then go to a vote before any business transaction can take place and the vote should be documented in writing. This would no doubt prove to be a time consuming process and that is why you need to understand what you obligating yourself to before you sign an operating agreement.
3. Failing to Consider Estate Planning Implications.
This is another situation that is fairly painless to account for when forming your LLC but can be extremely costly and time consuming if it is left unaddressed. One’s impending death is never a fun topic to think about, but failing to account for it can leave your family and business in a state of flux if the unthinkable does happen. This is especially true in the case of the single-member LLC. One of the easiest things the sole owner of an LLC can do to avoid potentially costly probate proceedings is to make a payable on death designation on the member’s LLC certificate. Upon the member’s death the LLC interest will pass automatically to the beneficiary who can then step in and continue to manage the affairs of the business. In contrast, consider the case of a single-member LLC owner who unexpectedly dies without a will and is survived by a spouse and a minor child. Without a will or beneficiary designation there is no mechanism in place to transfer ownership to the spouse or a designated manager to run the business in the deceased member's place. This is especially problematic if the business is the family’s sole source of income because there is no longer anyone who is authorized to contract with suppliers, sign off on loans or lines of credit, or to simply manage the day-to-day affairs of the business. To gain control of the business the spouse must now turn to probate which becomes even further complicated because a minor child is involved. Under Kansas intestate succession laws the minor child and the wife each own a ½ interest in the LLC interest and a guardian ad litem may need to be appointed to protect the minor child’s interest.
4. Co-Mingling Company and Individual Funds.
One of the most tempting things for a business owner to do is pay for personal items out of company funds. Before heading to Target or paying the mortgage make sure you transfer the amount of money you need out of the LLC’s bank account and deposit it into your own. The timing and amount of distributions to be made to LLC members is largely a management issue, and a properly drafted operating agreement can grant members a wide range of flexibility in taking distributions should they ever get in a pinch. The caveat here is that if you already have an operating agreement in place dictating the timing of distributions, you must follow the procedure in the operating agreement. Therefore, know thy operating agreement well and plan and budget your expenses to the best of your ability. The moment you start paying for corporate items with personal funds or vise versa you are adding ammunition to any personal liability action that may someday be brought against you.
5. Backdating Organizational Documents.
In today’s economy more and more small business owners are finding themselves under the increasing threat of litigation from their creditors and suppliers. When most business owners find that their corporate records are lacking their first reaction is to go back and recreate the documents they may need in anticipation of litigation. Whether a business owner can do this or not all depends on if the events being described in the recreated documents actually occurred. For example, let assume that six months prior members of an LLC held a properly called meeting and received a sufficient amount of affirmative votes to sell a major asset of the LLC. Due to inadvertent mistake and the member’s busy schedule the minutes from the meeting were never recorded and placed in the LLC record book. Six months later when the members' realized their mistake they drafted minutes which accurately depicted what occurred during the meeting and dated the document as of the six months earlier. This process is known as “memorializing” and is perfectly acceptable. In, contrast let’s assume the members of the LLC never held a meeting and the method in which they sold the asset did not confirm with the procedure as set out in the LLC operating agreement. Realizing that they may have a problem, the LLC members quickly draft and sign off on minutes dated six months earlier for a meeting that never technically happened. This is a clear case of backdating that fabricates and needless to say it can get you into all kinds of trouble. Fraud not only opens up a claim for punitive damages, it is also a major factor Kansas courts analyze in determining whether or not to disregard an entity’s corporate status. When fraud is present the courts almost always are more likely to disregard a corporate entity and hold the members personally liable than if that fraud did not exist.
6. Forgetting to File Annual Reports.
Every LLC formed in Kansas to file an annual with the Kansas Secretary of State providing: (1) the name of the LLC and (2) the names and addresses of all members owning at least 5% of the company. The annual report may be signed by any member of the LLC under penalty of perjury. For companies whose tax year ends on December 31st, the annual report is due on April 15th. The technical calculation is the 15th day of the 4th month following the end of the LLC's tax year. If an LLC fails to file its annual report within 90 days of the report’s due date the articles of organization of the LLC will be deemed forfeited. Forfeited articles may only be reinstated by filing a certification of reinstatement along with all delinquent annual reports with the secretary of state. Forfeited articles means that the LLC loses its limited liability status and as such the members are no longer personally protected from the obligations of the company. In reality this isn’t as harsh as it sounds. K.S.A. 17-76, 146(c) provides that once you reinstate an LLC it relates back to the 1st day when the LLC was forfeited. This means that so long as the members take the proper actions to reinstate the LLC, it will be as if the LLC never lost its limited liability status. With that being said, an extended history of forfeited status may reflect poorly on the members and it is always much simpler and cheaper to file your LLC’s annual report on time rather than messing with the reinstatement process.
7. Transferring Assets Under the Threat of Litigation.
Members should never transfer assets in or out of an LLC without first considering the impact of the Kansas Uniform Fraudulent Transfers Act (KUFTA). A full discussion of the KUFTA is beyond the scope of this article but in its most basic sense the KUFTA gives creditors a four-year look back period to set aside any transfers that were made with actual intent to hinder, delay, or defraud any creditor of the LLC or its members. See K.S.A. 33-204(a)(1) and K.S.A. 33-209(a). Take as an example members of an LLC who begin receiving demand letters from a supplier for payments the LLC owes for materials purchased on credit. In response to such letters the members of the LLC hastily decide to form a new corporation and transfer the LLC’s only major asset to the corporation. If the supplier eventually sues, not only will it have a good argument to set aside the transfer it will also have a good case for punitive damages against the individual members of the LLC. In, Golconda Srew, Inc. v. West Bottoms, LTD, 894 P.2d 260 (Kan. App. 1995), the Kansas Court of Appeals affirmed a judgment of $10,000 in punitive damages against the individual shareholders of a corporation for making a transfer similar to the example above. The Court noted that the insiders involved in Golconda kept good corporate records and observed all corporate formalities, and it still found the insiders personally liable. See Id. at 268-69. This is just another example that fraud and injustice will always be the dominant factor analyzed by Kansas courts when deciding whether or not to disregard a corporate entity.
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When lawyers speak of “piercing the corporate veil” we are referring to the court’s ability to disregard a corporate entity and hold the individual stockholders or members personally liable for debts incurred by the business. This is why there is so much “to do” being made about keeping up corporate formalities. What is lost in most of these conversations is the real reason why it is so important. In reality, courts in Kansas are very reluctant to pierce the corporate veil. Absent a showing of fraud or deceit, spotty corporate records are seldom enough for a court to disregard an entity. Then why all the fuss? Because litigation is terribly expensive. The point is not to survive a “piercing the veil” argument; the point is to stop it before it ever gets started. Unfortunately, these lawsuits typically only arise when a business has failed, otherwise there would be no need to come after you personally. This makes the financial burden of defending a lawsuit even more cumbersome because you no longer have that business as a source of income. Analyzing the factors that courts use to decide these types of lawsuits will go a long way in helping you developing good corporate practices which in turn should dissuade the initiation of such actions. In the event that you are sued, avoiding the factors described below, should help you get out of litigation quickly and back to doing what great entrepreneurs do best… starting over.
Factors Justifying a Disregard of the Corporate Entity:
In Kansas, there are eight (8) factors which are significant in justifying a disregard of a corporate entity: (1) undercapitalization of the entity, (2) failure to observe corporate formalities, (3) nonpayment of dividends, (4) siphoning of corporate funds by the dominant stockholder, (5) nonfunctioning of other officers or directors; (6) absence of corporate records; (7) the use of the corporation as a façade for operations of the dominant stockholder, and (8) the use of the corporate entity in promoting injustice or fraud. See Amoco Chemicals Corporation v. Bach, 222 Kan. 589, 594 (1977). In Emprise Bank v. Rumisek, 215 P.3d 621 (Kan. App. 2009), the Kansas Court of Appeals specifically applied the eight factors above to the use of a limited liability company.
Members of an LLC have a good faith duty to put at the risk of the business unencumbered capital reasonably adequate to cover any future liabilities. See, Service Iron Foundry, Inc. v. M.A. Bell Co., 2 Kan. App. 2d 662, 676 (Kan. App. 1978). What is considered reasonably adequate capitalization really depends on the nature of the industry the business operates in and the risk that it entails. Before forming an LLC you will want to forecast what your start-up and operating costs are going to be. The best way to do this is talk to a business owner already operating in the industry. SCORE (Counselor’s to America’s Small Business) also recommends you add 20% to your projected operating costs to account for any unexpected costs that may come along. In addition, Kansas courts will analyze whether there is adequate insurance in place to cover potential risk of loss. You will want to make sure you put insurance in place prior to forming your LLC and adjust your coverage if the company’s exposure to risk increases. This duty also extends throughout the life of the company. So if the company takes on further liabilities without sufficient assets to cover such liabilities it will mostly like be viewed negatively by the courts under this factor.
Failure to Observe Corporate Formalities
With corporations, Kansas courts will strictly scrutinize every activity the company ever engaged in to ensure that it conforms with corporate formalities. In Scutte v. Peter, an unpublished Kansas Court of Appeals case, the Court took interest in a corporation’s activities noting that “many, but not all, of the corporate formalities were observed”. In this case, despite that the corporation held annual meetings, keep minutes of those meetings, maintained separate banking accounts, filed annual reports with the secretary of state, and filed corporate tax returns, the Court still took issue with loans the corporation entered into because the loans were not authorized by the procedure stated in the corporation by-laws.
Generally, limited liability companies do not require the same rigid formalities that corporations do. The Kansas Revised Limited Liability Act (“Kansas LLC Act”) is permissive and gives the member’s of an LLC a wide range of latitude in holding meetings, designating quorums, and voting procedures. Therefore, in a limited liability company analysis this factor should probably be given less weight than as if analyzing a corporation. Even so, courts will no doubt look to see if members properly followed procedures as dictated in the company’s operating agreement or in the Kansas LLC Act. In addition, observing corporate formalities will aid members in avoiding the other factors under this analysis, such as, failure to keep corporate records and siphoning of corporate funds. This is why having an operating agreement in place and following it is so important. If an action requires a meeting and vote of the members make sure you do it and record minutes of that meeting in the LLC record book. If the operating agreement requires quarterly distributions of excess cash to the members, then make those distributions. Make sure you strictly keep LLC funds in a separate company banking account and use it only to pay for LLC expenses, file all your tax returns on time, and make sure you file your LLC annual reports. Even if the operating agreement doesn’t require it, members should hold and document an annual meeting to discuss the prior year’s events, to review the operating agreement, and to authorize an upcoming actions to be taken on behalf of the LLC. Many of these actions will also carry over in analysis of the other factors.
Nonpayment of Dividends
Unless the members of a limited liability company choose to be taxed as a corporation this factor will usually be disregarded by courts when deciding whether or not to set aside the limited liability status of an LLC. Even if a LLC is taxed as a corporation the non-payment of dividends should not be a problem so long as excess funds are reinvested in back into the LLC.
Siphoning of Corporate Funds
Anytime members use LLC funds to pay for their personal expenses they are siphoning corporate funds for purposes of this factor. See Kvassay v. Murray, 15 Kan. App. 2d 426 (Kan. App. 1991). Members who make frequent withdrawals to themselves out of LLC funds, not in accordance with the LLC operating agreement, will also find themselves in trouble under this factor. As mentioned in earlier posts, the amount and timing of distributions to members is largely a management issue, however, a LLC is prohibited from making a distribution to a member when the liabilities of the LLC exceed the fair market value of the assets of the LLC. See K.S.A. 17-76, 110(a). For purposes of this calculation liabilities of the LLC do not included nonrecourse liabilities. Additionally, if members take distributions rendering the LLC unable to cover its liabilities courts may also make a finding that the LLC was undercapitalized.
Nonfunctioning of Other Officers or Directors
Unlike corporations LLCs are not managed by directors; they are managed either directly by the members themselves or by a manager designated by the members. K.S.A. 17-7693(a). Technically, the members and managers may designate the responsibility of managing the LLC to officers or any other agent, but this factor usually won’t be applicable to LLCs in a piercing the veil analysis.
Absence of Corporate Records
Failure to file annual reports, file tax returns, keep financial statements, and to document the transactions of the LLC can all weight negatively against members of an LLC under this factor. Keeping good corporate records helps to establish the separate legal identity of your LLC. The more detailed documentation you keep the easier it is to convince a judge to grant your summary judgment motion.
The Use of the Company as a Façade
This factor comes into to play when a corporate entity is used as a front for the owners to carry on their own personal business through the entity. Kansas courts are typically more likely to find the presence of this factor when there is evidence of undercapitalization, lack of corporate formalities, and siphoning of corporate assets. Common examples could include making large withdrawals of cash or other property rendering the LLC insolvent, not properly documenting transfers of assets, and failing to follow procedures in the LLC operating agreement.
The Use of the Corporate Entity in Promoting Injustice or Fraud
This is by far the most important factor analyzed by Kansas courts as it can be the sole justification for disregarding corporate entity. “Injustice alone will support a disregard of the corporate entity.” Kvassay v. Murray, 15 Kan. App. 2d 426, 440 (Kan. App. 1991). Here, the court tends to weigh all the other factors to determine whether some sort of impropriety occurred. Taking on an obligation with no intention of paying it back, engaging in fraudulent transfers, depositing cash into the entity and removing it when equally convenient all weigh negatively under this factor. With that being said, it is important to note that a creditor’s mere inability to collect a judgment is not enough to show fraud or injustice resulting from use of the corporate entity. See Luckett v. Bethlehem Steel Corp., 618 F.2d 1373, 1379 (10th Cir. 1980). This would after all defeat the entire purpose of forming an entity with limited liability protection. Where owners find themselves in trouble is when they engage in transactions that have no other business purpose solely than to hinder the collection efforts of a creditor. In a lawsuit creditors will do their best efforts to make even the most honest transactions appear as self-dealing or illusory. This is why you must document every transaction engaged in by the company especially transactions involving the LLC members or other entities owned by the members and articulate the transaction’s specific business purpose. Proper planning and adequate record keeping can go a long way in dispelling these types of allegations.
Keeping good company records and acting in an ethical strait forward manner is not only good from a legal prospective but it is also just good business practice. Sometimes litigation over an unpaid corporate debt is going to unavoidable. Engaging in proper business practices along with proper business and asset protection planning should aid you in getting these cases properly dismissed or in settlement before having to expend large amounts of money on defending a full blown lawsuit.
In this article I discuss how a LLC generally shields its members from liability and to what extent this protection is limited. The distinct advantage of the LLC over other unincorporated entities such as the partnership and sole proprietorship is that it insulates the owners from any of the debts and liabilities of the company. However, this protection is not absolute and there are several ways in which members of the company can lose this protection. The biggest misconception I see from clients is that they believe a LLC will protect them from litigation in almost any situation. This is simply not true, a person will always be liable for his or her own fraudulent, reckless, or illegal behavior. In other words, if you back out of your driveway on the way to work in the morning and ram your neighbor’s car you can’t jump out and yell: “Not my fault… I have an LLC.” It doesn’t work that way you will always be liable for your personal actions.
How Members are Protected:
Generally, when a company is sued by a creditor or supplier for any unpaid debts the members of the LLC will not be held liable for any deficiencies. This simply means that creditors of the business can reach the company assets however once those assets are exhausted creditors cannot go after any of the member’s personal assets to make up the difference. Therefore, the members of the LLC stand only to lose the money they contribute to the company.
Limitations of Limited Liability:
Here are some instances when a member may be found liable regardless of his or her membership in the LLC:
1. Negligence or Fraud of an Individual Member: As mentioned in the opening paragraph the general rule is that an individual member of an LLC will always be liable for his or her own torts. This means that if you personally act fraudulently, recklessly, negligent or illegally to cause harm to someone else or the company you can be held personally liable for those actions even if such action were undertaken in a business capacity.
2. Personally Guaranteeing LLC Debts: This is another misconception of clients. In almost every major transaction of the LLC such as buying real estate or vehicles the banks and creditors will require that the members agree to be personally liable for LLC debts before extending credit to the company. In these cases if the LLC subsequently defaults the members will be held liable for any deficiencies.
3. Piercing the Veil: Courts will hold an individual member personally liable for LLC obligations in three reoccurring situations: i) when company formalities are ignored; ii) when the LLC is inadequately capitalized at the outset, and iii) to prevent fraud.
Steps To Avoid Personal Liability:
Upon formation the LLC the members should take all necessary steps to treat the LLC as an entity separate and apart from the members. The following list should always be followed when setting up a new LLC:
1. Obtain a Employer Identification Number (EIN): An EIN is a tax identification number that the IRS uses to identify business entities. It is to businesses what the social security number is to individuals. You many apply for an EIN online HERE.
2. Open a separate bank account in the name of the LLC: A bank account should immediately be opened in the name of the LLC and the cash contributions of the members should be immediately deposited in this account.
3. Do not commingle LLC and personal accounts: Members should never pay for their personal expenses out of the LLC account and should never cover business expenses with their personal accounts.
4. Adequately capitalize the LLC: Adequate capitalization really depends on the unique demands of each business. Based on the day-to-day activities of the LLC the members should make sure that there is enough capital in the LLC to cover any reasonably foreseeable liabilities.
5. Obtain business liability insurance: Business insurance and umbrella policies provide members a funding source other than their personal assets should they become liable personally because of their own misconduct or negligence.
6. Follow formal LLC procedures: One of the biggest mistakes that members make is failing to properly indicate that they are signing LLC documents on behalf of the company. Any document signed by a member on behalf of the company should specifically state that the member is signing on behalf of the company. In addition, all LLC business should be properly conducted as dictated in the company’s operating agreement. This includes electing officers for the company, following proper voting procedures, and holding annual meetings and recording company minutes.
7. Be Ethical: Acting responsibly and in good faith with your business creditors and customers will go along way in avoiding personally liability. Courts are always more willing to pierce the veil of a LLC if there are indications of misconduct on behalf of the members.
If used the way it was intended the LLC can prove to be a valuable tool insulating business owners from activities arising solely out of the business.
The Kansas single-member LLC can be a good entity choice for the solo entrepreneur especially if the business is operating in a high-risk industry and the business is not all that asset intensive. However, as an asset protection tool the single-member LLC does have certain flaws.
Charging Order Protection of the LLC:
Traditionally, the Kansas limited liability company offers two layers of protection. The first layer protects the LLC member’s personal assets from the claims of creditors of the LLC. Please see, Limitations of Limited Liability Protection. The second layer, called charging order protection, has the opposite effect. It protects the assets of the business from the claims of the individual business owner’s creditors. Charging order protection has its roots in partnership law and the basic premise behind the protection is to protect co-owners of a business from the individual misfortunes of their partners. To better understand this it is best to think of an LLC membership interest as having two parts. The first part is the member’s “economic rights” in the company. These rights include the member’s entitlement to the profits and distributions of the company and the overall value of the membership interest. The second part involves the member’s “non-economic” rights in the company. These include the member’s right to manage the day-to-day operations of the company and to control the general governance of the company. For example, suppose you have a business partner who negligently injures another person in a car accident and that injured person secures a large judgment solely against your business partner. Charging order protection prevents the judgment creditor from effectively gaining access to your partner’s “non-economic rights” accompanying the LLC membership interest. The judgment creditor can gain access to your business partner’s “economic interest” and may become entitled to any profits that are distributed from the company to your business partner, but that is the extent of its reach. Therefore, the charging order is actually meant to serve the non-debtor member by protecting the innocent member from having to involuntarily share control of the business with the debtor member’s creditor. The dilemma with the single-member LLC is that no other business owners exist to justify charging order protection and for this reason the trending theme among courts has been to deny the protection to single-member entities.
Adverse single-member LLC rulings first emerged in the consumer bankruptcy arena, however, we are now seeing it being challenged elsewhere. The first adverse case, In re: Ashley Albright, surfaced in 2003 out of a Colorado bankruptcy court. In this case the debtor, Ashley Albright, was the sole member and manager of a Colorado LLC at the time she filed for Chapter 7 consumer bankruptcy. The bankruptcy trustee contended that because Ms. Albright was the sole member of the LLC, that upon her filing for bankruptcy he gained complete control over the LLC and was entitled to liquidate the property in the LLC and distribute the proceeds to the bankruptcy estate. The Colorado Bankruptcy Court agreed providing in part:
“[t]he charging order, as set forth in Section 703 of the Colorado Limited Liability Company Act, exists to protect other members of an LLC from having to involuntarily to share governance responsibilities with someone they did not choose, or from having to accept a creditor of another member as a co-manager. A charging order protects the autonomy of the original members, and their ability to manage their own enterprise. In a single-member entity, there are no non-debtor members to protect. The charging order limitation serves no purpose in a single member limited liability company, because there are no other parties’ interests affected.”
Other bankruptcy courts have since followed suit by favorably quoting Albright. Most notably, In Re A-Z Electronics, 350 B.R. 886(Bankr. Idaho 2006).
So what does this mean to you? In Kansas if you are operating a single-member LLC and you are considering filing personal bankruptcy you are running the risk that the bankruptcy trustee may be given full membership rights in your LLC and will have the ability to liquidate the non-exempt assets of your business in order to satisfy the claims of your personal creditors. Secondly, even if you never file for personal bankruptcy, a judgment creditor may still have the ability to successfully petition an appropriate court to acquire full rights to your LLC membership interest.
As of now it seems the only true entity affording both personal liability protection and charging order protection is a properly administered multi-member LLC. However, exercise caution before adding a new member to your business just for the benefit of gaining charging order protection on the off chance you may some day file bankruptcy or become subject to a personal judgment. There are many considerations that must be taken into account before bringing on a partner. First, by adding a partner you are converting from a single-member LLC to a multi-member LLC which is considered a formation transaction for tax purposes even though no actual new business is formed. Depending on how the transfer of membership is structured it could create income tax consequences for the existing LLC member. Secondly, you must be careful when adding a partner with a nominal interest such as 1% ownership. While the courts have not articulated that a minimum ownership amount is required, it is best to avoid any activity that can be viewed as a sham transaction by the court. In addition, you must pay close attention to the value of the property the acquiring member is either contributing or using for purchase in relationship to the membership interest he or she will be acquiring. If the new member does not pay or contribute fair market value for the membership interest it can create numerous difficulties for you under the Kansas Uniform Fraudulent Transfers Act. Finally, adding an additional member to your LLC raises a whole host of business planning issues. You will need to make sure you have a detailed operating agreement in place and a comprehensive buy-sell agreement should be considered.
When utilized properly a single-member LLC still affords the same personal liability protection as a corporation and offers much greater protection than a sole proprietorship. So if you operate an asset-light business a single-member LLC may be perfectly fine for you, but proper business and asset protection planning will always be dictated by your individual facts and circumstances. Please remember though with a single-member LLC it is absolutely vital that you strictly follow all corporate formalities when operating the business to ensure that it is viewed in the eyes of the court as a separate and distinct entity from yourself. If you currently operate your business through a single-member LLC , I suggest you consult with your attorney regarding the above considerations to ensure that you have taken the proper precautions to minimize your liability risk.
The solo business owner has three main choices when it comes to choosing the entity which is the best vehicle for conducting his or her business: 1) the sole proprietorship, 2) a single-member LLC, and 3) a corporation. The focus today will be on the single-member LLC and the sole proprietorship.
When a Sole Proprietorship May Make Sense:
The sole proprietorship is the simplest and cheapest of all business entities to form. In fact, as soon as you commence business as a solo you will be operating as a sole proprietorship by default. For this reason, most all businesses start out as sole proprietorships. Accounting for taxes is also relatively simple for sole proprietors. For legal purposes the sole proprietorship is not considered separate and distinct from the owner, they are one in the same. Therefore, any income generated by the business is simply reported on a Schedule C of the owner’s Form 1040. However, because the owner and the business are legally considered one in the same the owner will be personally liable for any and all of the obligations of the business. This is the biggest drawback of the sole proprietorship and one must decide if the simplicity and cost savings of operating as a sole proprietorship outweigh putting the owner’s personal assets at risk.
When a Single-Member LLC May Make Sense:
For risk adverse solo business owners the limited liability afforded by the single-member LLC may outweigh the elevated formation costs and formality requirements that accompany forming a limited liability company. Unlike the sole proprietorship, the single-member LLC is considered a separate legal entity apart from the owner of the business. For this reason, the member (owner) of the LLC generally will not be held personally liable for any obligations created on behalf of the LLC. However, this limited liability is not absolute and the owner of a single member LLC must do everything in his or her power to ensure that the LLC is treated as a separate and distinct entity from the member. With the advent of online document preparation and do-it-yourself formation guides the costs of forming an LLC have diminished significantly. However, please keep in mind that the mere formation of an LLC does not by itself grant the owner liability protection. As mentioned above, the owner must expend time and energy ensuring that the formalities of operating as an LLC are met. This includes, but is not limited to, adequately capitalizing the LLC, keeping business and personal funds separate, following proper voting procedures, filing annual reports, and holding annual meetings and recording company minutes.
Generally the greater the risk of the business you are engaging in the more likely you will want to choose an entity which affords personal liability protection. If you are just starting out nothing prevents you from operating as a sole proprietor and later forming an LLC or corporation as the business grows or as you want to bring on investors. If you decide to operate as a sole proprietor it is a good idea to purchase an umbrella insurance policy to provide an additional funding source for any potentially incurred liability through the business. Please note that operating as a single-member LLC does have its drawbacks, most notably the lack of charging order protection. For a more in-depth article on single-member LLCs please visit our article, The Kansas Single Member LLC.
This article covers the basic considerations that Kansas entrepreneurs should know before deciding whether to operate their business as a Kansas LLC, a Kansas corporation, or electing S corporation status. Unlike the sole proprietorship, these entities limit the personal liability of their respective owners, however, they require additional planning, formality requirements, and expenses in forming and maintaining the status of the entities.
Kansas LLC Advantages:
1. Avoidance of Double Taxation:
The most discussed advantage of LLCs over corporations is the avoidance of the “double taxation"that accompanies Kansas corporations. This not only includes dividends paid out to the corporation’s shareholders but it also includes any increases in the value of the assets held by the corporation when such assets are sold or the corporation is liquidated. By default, Kansas LLCs are treated as “pass-through” entities for tax purposes. This means that the LLC itself is not assessed any tax liability; all income, gains, losses, credits, and deductions accumulated through the business are passed directly to its members resulting in only one assessment of tax liability.
2. Charging Order Protection for Multi-Member LLCs:
In my opinion this is the single biggest advantage that an LLC can provide over a corporation. Please remember, this protection is not afforded to single member LLCs operating in Kansas. Unlike its solo version counterpart, the Kansas multi-member LLC not only provides its members with personal liability protection (assuming it was not the member's personal negligence which caused the liability) it also protects the assets held in LLC from the personal liabilities incurred individually by the owners of the LLC. LLC membership interests are considered the personal property of the LLC owners and as such can be levied against to satisfy any personal judgments ordered against the business owner. However, Kansas has limited the extent to which LLC membership interests may be used to satisfy personal obligations of the member. Under K.S.A. § 17-76, 113 a judgment creditor can only acquire the “economic” rights of an owner’s membership interest in the LLC, meaning that the creditor can collect any distributions paid out by the LLC to the individual owner to satisfy its judgment but the judgment creditor acquires no rights to participate in the management and operation of the LLC. In contrast this protection does not exist for corporate stock. This means that if a creditor successfully petitions a court to execute a writ of execution against the owner’s corporate stock with the unsatisfied amount of the judgment that not only will the creditor gain the “economic” rights of the stock, the creditor will also be entitled to all voting rights that accompany the stock. Depending on the number of shares acquired, the creditor can use these voting rights to remove the corporation’s current board of directors and implement a board of its choosing with the purpose of liquidating the corporation’s assets to satisfy the creditor’s judgment.
3. Less Formality:
Finally, in my opinion it is easier to comply with Kansas LLC formality requirements than it is to comply with Kansas corporation formalities. The LLC is designed to be managed directly by the members of the company or by a manager elected by its members. In contrast, the corporation is designed to have a three-tier management structure. The shareholders of the corporation hold annual meetings to elect the Board of Directors of the corporation who in turn govern the day-to-day business operations of the corporation through the election of corporate officers.
Kansas Corporation Advantages:
Despite the LLC advantages outlined above a Kansas corporation may make more sense for some Kansas entrepreneurs in certain situations.
1. Incentive Compensation:
Both LLCs and corporations afford the ability to offer incentive compensation programs to retain key employees by offering these employees the opportunity to acquire ownership interests in the business. However, in the case of the LLC, the proper tax treatment of these equity interests and the fiduciary obligations they create requires a more complex evaluation than which is required when issuing stock grants or options through a corporation. This is not to say, that the LLC should be completely avoided because of its complexity on this issue. The LLC in fact provides greater flexibility in tailoring an incentive compensation program because, unlike a corporation, a LLC is free to allocate ownership benefits through the discretion of an agreement rather than pro rata based on ownership percentage. With that being said, for the entrepreneur who wants a strait forward system for the distribution of ownership to the business’s key employees mainly through the use of a employee stock ownership plan (ESOP), stock options, or restricted stock then the corporation is probably a better fit.
2. Self-Employment Tax:
The existence of significant self-employment taxes could also create a situation where it is advantageous to elect subchapter S corporation status rather than operating as an LLC. In an S corp., a shareholder pays self-employment tax only on money received from the S corp. as compensation for services rendered, the shareholder DOES NOT pay self-employment tax on profits that pass through to the shareholder as a distribution. In contrast the application of self-employment tax to LLC members is somewhat in a state of flux. At one time it looked as if the IRS was going to exempt passive or limited membership interests in LLCs from self-employment taxes, however to date the IRS has not taken any affirmative steps in this direction. Therefore as the rules currently stand a member in an LLC will pay self-employment tax on the member’s entire share of LLC profits regardless of the member’s status. For the Kansas entrepreneur that desires the less formal requirements of an LLC, but also desires the reduction in self-employment taxes that a corporation offers, she or he should consider utilizing the LLC structure and voluntarily electing corporation taxation and subchapter S status through the check the box regulations.
Please keep in mind that self-employment taxes are just one consideration in a myriad of tax issues that need to be addressed when choosing the appropriate entity for a business. I personally feel the LLC is such a versatile tool that it can be molded to meet the needs of almost any entrepreneur, however, there is no bullet-proof or sure fire answer to which entity is right for you. The topics discussed above are just a few of the issues to consider when researching these entities. The decision on how to structure your business should be made with input from your business attorney and in conjunction with your tax and financial advisors.
Over Twenty years ago Kansas became the 3rd state, behind Wyoming and Florida, to enact legislation introducing the limited liability company (LLC) as an option for Kansas business formation. Since that time the LLC has grown from an obscure and little known entity in Kansas to one of the most commonly used business organizations by today’s entrepreneurs.
The Kansas Limited Liability Company (LLC) is best described as a hybrid between a Kansas partnership and a Kansas corporation. Generally speaking the Kansas LLC is a legal vehicle which provides limited liability to all of its owners (referred to as “members” for Kansas LLC purposes), allows all members to participate in the management of the business, and avoids the tax consequences of doing business as a corporation (i.e., double-taxation). "Limited liability” is emphasized because contrary to popular belief the protection afforded to these entities is not absolute and corporate formalities must be followed to ensure that you are getting the maximum amount of protection from your LLC. When utilized correctly, the Kansas LLC can be extremely adaptable and most of the characteristics described above can be modified to fit the particular needs of the Members through the use of a properly drafted operating agreement.
Types of Kansas LLCs
A LLC can be formed for just about any purpose in Kansas, including not-for-profit, below are the four main characterizations of LLCs that are formed in Kansas:
1. Single Member Kansas LLC: The Single Member LLC is a good business tool for the individual entrepreneur because it is the only unincorporated business organization that affords limited liability protection to its owner. However, the protection afforded is fickle and special safeguards must be followed to ensure that the LLC is viewed as separate and distinct entity from the Member.
2. Multi-Member Kansas LLC: This is just as it sounds in that it allows for multiple owners to participate in the company. The members may choose to be involved in the day-to-day business decisions of the company or alternatively they may designate a manager to perform these functions on their behalf. This is the key distinction between LLCs and Limited Partnerships. LLCs allow every member the opportunity to manage the business while in a Limited Partnership one partner is designated the general partner to perform the day to day business operations of the company and the rest of the partners are designated limited partners with no say in the general management of the partnership.
3. Professional LLC: In Kansas there are roughly twenty-seven different professional services that are certified or licensed by the State of Kansas and thus are eligible to form a professional LLC. The most common use of professional LLCs are by attorneys, dentists, physicians, and real estate brokers.
4. Agricultural LLC: In Kansas, an LLC is restricted from owning or leasing agricultural land unless in qualifies as a limited liability agricultural company (LLAC). The LLAC limits ownership to 10 members and at least one of the members must reside on the farm or be actively involved in the management of the farming operation.
Forming a Kansas LLC is relatively simple. The only two requirements are: 1) filing articles of organization with the Kansas Secretary of State, and 2) Paying the appropriate filing fee ($165.00 or $160.00 if filing online). An LLC is recognized as a separate legal entity as of the date that the articles are filed, unless designated otherwise by the members in the Articles. Once your Kansas LLC is formed you must file a annual report each year with the Kansas Secretary of State’s Office to maintain your limited liability company status.
1. Articles of Organization: The articles of organization put the world on constructive notice that the members of the LLC are generally protected against liabilities of the company and that the members are not proper parties to any proceedings against the LLC entity. The content of the articles is governed by K.S.A. 17-7673 which requires the following mandatory disclosures:
2. Operating Agreement: The operating agreement is generally considered the most important document of the LLC as it governs the affairs of the LLC and the conduct of its business. In Kansas an operating agreement is no longer required for formation but it is strongly recommended that the members adopt one. If the members do not adopt an operating agreement the LLC will be governed by the default rules contained in the Kansas Limited Liability Act.
3. Member Resolutions: Member Resolutions formally document the authorization of the limited liability company to enter into certain transactions. Member resolutions help to establish the separate legal identity of the company.
By default the management of the LLC is vested in the members of the company, however, the members may also choose to designate a manager to run the day-to-day operations of the company.
1. Management by Manager: Through the use of an operating agreement the management of the company may be vested in one or multiple managers. The manager does not have to be a member of the LLC and his or her responsibilities can be as broad or as limited as the members designate in the operating agreement. If management by manager is elected then the operating agreement must also designate the process for electing and removing managers.
2. Management by Members: Unless stated otherwise the management of the LLC is vested with the members. Each member’s right to participate in management is proportionate to that member’s interest in the LLC and majority vote controls. However, these rules may be modified in the operating agreement.
In 1996 the IRS adopted what are called “check-the-box” regulations. These regulations provide that an LLC with at least two members can elect to be classified as either an association taxable as a corporation or as a partnership. Additionally, a single member LLC may elect to be classified as an association taxable as a corporation or as an entity separate from its owner (a disregarded entity). In both cases the multi member LLC will operate as a partnership and the single member LLC will operate as a disregarded entity unless an affirmative election is made to be taxed as a corporation.
Therefore by default the LLC is considered a “pass-through” entity meaning that no tax is paid at the LLC level. All income, gain, loss, deductions, and credits which are earned through LLC operations are simply passed through to the individual members and reported on their personal tax returns. Conversely, if the members choose to have the LLC taxable as a corporation, the LLC will be treated as a separate tax paying entity and is subject to corporate income tax at the company level and again at the individual member level when the members take their respective share of profits from the LLC, hence the term double taxation.
John Thompson is a shareholder with Kennedy Berkley Yarnevich & Williamson, Chartered assisting entrepreneurs, families and farmers in the areas of estate and business planning.