One question that I am often asked by individuals interested in starting a new business or making an investment in real estate is “Do I need to set up a Limited Liability Company (LLC) for my new venture or can I wait until I have the business up and running before I form the LLC?” In almost every case my answer is that the LLC should be established from the beginning as this is an important first step before you begin the operation of your new venture.
Limited Liability Companies are fairly new creations of the law, however, they are favored over corporations due in large part to the ease of establishing an entity that provides liability protection to its owners. Since most LLC’s are what are known as “disregarded entities”, the income and expenses are reported on the owner’s personal tax return and they are not taxed separately like a corporation would be. Originally, most states required that a LLC have more than one member, but that is no longer the case in most states, including Arizona.
When you embark upon a new business venture you run the risk of being sued by a variety of different sources. If you borrow money to establish your new company and it fails, you are personally responsible to the lender. If you obtain products or inventory on credit, or sign agreements with franchisors or landlords and fail to pay under the terms of the agreement, you may be sued. If someone is injured while on your business premises, or becomes sick or injured from an alleged defective product that you may have sold (such as food from a restaurant) you may be sued. If you hire employees they may sue for harassment or wrongful termination. There are literally hundreds of liability risks that any business faces, some can be insured against while others cannot. If you decide to run your business as a “sole proprietorship” or as a “partnership” you can be personally held responsible for any claims against your business. If I open a small hot dog stand and start selling hot dogs, and I get a “bad batch of dogs” that results in customers getting sick, those customers can sue me personally for their injuries. And if those customers get judgments against me, not only can they take the assets of my hot dog business, but they can go after my car, my house and my personal bank accounts. If I had only set my new business up as a LLC, the only assets my judgment creditors would be successful in grabbing would be those of my business. By setting up a new company as an LLC you only put the assets of that entity at risk. If things turn out bad (and unfortunately a large majority of new business ventures do fail), you can walk away from the investment without having risked your other assets. Many owners of rental real estate today either purchase or transfer real estate to an LLC for a variety of reasons including limitation of liability from tenant or tenant’s guests injury claims, or so as to be able to easily transfer real estate to others through an assignment or sale of the membership interests in the LLC as opposed to having to go through the formality of a Deed closing.The key is to establish the LLC before you begin business. A client of our firm had opened a retail store and after renting space for the business, set up an LLC to conduct the business. Unfortunately, the business failed due to the slow economy, and eventually closed. After our client closed the store and surrendered the premises, the Landlord sued the owners personally for the remaining 2 ½ years of remaining rent on the lease term. Although the business owners had set up the LLC, it was not until after they had personally signed the lease, and they were held personally liable for the rent. If they had set up the LLC from the beginning, and had been able to negotiate the Lease such that the Landlord leased to the LLC without the client having to personally guarantee the lease, they could have walked away from the lease when the business failed without being personally responsible for the balance. Although landlords almost always request that the owners of the LLC personally guarantee the lease, this is an item that can be negotiated, and I have negotiated away personal guarantee provisions many times, usually by offering additional security other that the personal guarantee.
If there is more than one member of the LLC that will effectively be partners, it is vitally important that the members negotiate and sign an “Operating Agreement” that will place in writing the rights and responsibilities of each party and will help provide a framework for the management and operation of the business. Our firm has extensive experience in organizing new businesses for our clients, so give us a call if we can be of assistance. There are many additional points to consider when deciding how to best establish a new business that far exceed the limited scope of this article. Feel free to call or e-mail with any questions that you may have.