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How is an LLC formed and where is its business purpose stated?

By IncNow | Published March 23, 2016

filing cabinetEach state has its own unique statutory law that sets forth requirements to form a Limited Liability Company (hereinafter “LLC” or “Company”). Although these laws and their purposes are generally similar, do not assume what works in your home state is also the procedure in another state. That is a trap for the unwary.

Most states’ respective LLC laws are referred to as an “LLC Act”, (for example, the “Delaware LLC Act” or the “Illinois LLC Act”). Most states set forth their LLC laws separately from laws pertaining to corporations. One of the reasons for the separation is because LLC’s and corporations are like apples and oranges. Most formalities and rigidities required for corporations do not apply to LLCs.

Regarding the purpose, the Certificate of Formation does not usually state the purpose of the LLC. Instead, that is contained in the Operating Agreement. Should the Certificate of Formation and the Operating Agreement contain conflicting information, it is not always clear that the public filing prevails because these are contractual entities. In other words, the Operating Agreement of the parties should control over some statement in a document filed with the state before the Operating Agreement was finalized.

An LLC’s purpose usually is any purpose authorized by law. However for certain types of financings where the LLC is required to be a single purpose LLC, the LLC may only be permitted to engage in transactions related to the purchase, sale and operation of a particular real estate project.

Fundamentally, there are two organizational documents essential to every LLC formation, (1) a public document filed with the applicable Secretary of State and (2) a private document (“Operating Agreement” or “Limited Liability Company Agreement”).

Some states refer to the LLC’s organizational document filed with the Secretary of State as “Articles of Organization”; other states refer to this document as a “Certificate of Formation” (either will be referred to herein as a “Certificate of Formation”). Usually these bare bones Certificates of Formation only list the name of the LLC and its registered agent. Some states also require that a manager or managing member be listed along with an election to be “member managed” or “manager managed” (when a non-member third party is the designated manager). You should be careful when following the state’s pre-printed or online forms. Often times the instructions can be incomplete or misleading. For example, in New York it is optional to list whether an LLC is member managed or manager managed. However, if manager managed is not selected, the LLC by default is member managed, which may not be what your client wants or has in its Operating Agreement. Other states, like Delaware, do not require you to list whether the LLC is member managed or manager managed. You should also be aware that should an LLC be a “series LLC” that will also need to be listed in the LLC’s Certificate of Formation.

The LLC’s proposed name must be “available” with the Secretary of State. The LLC name cannot be identical or substantially similar to any other business entities in the state. For example, if you want to form ABC Capital, LLC, but there is already an ABC Capital, Inc., that would present a conflict making the proposed name unavailable. However, if ABC Capital, Inc. became administratively dissolved for failing to pay its franchise tax, then most states “recycle” that name and allow a new entity to be filed under the identical name. The secretary of state also reviews names, even if they are otherwise available, to ensure they do not have prohibited words in the name, such as “bank” (requiring bank commissioner pre-approval), “insurance” (requiring approval of a state’s department of insurance) or offensive or misleading language. The name must also end in an LLC indicator, such as L.L.C., LLC or Limited Liability Company (and in some states recognizing professional limited liability companies, PLLC or Professional Limited Liability Company). Do not use “Limited Liability Corporation” because that is impermissible and incorrect.

The LLC’s, named registered agent in the state of formation may be the office of the company itself in the state of formation. You can “self-represent” as the LLC’s registered agent. If you form an LLC in a state other than your own, the LLC will need to appoint a third party registered agent service to receive lawsuits and legal notices on behalf of the LLC.
Some states require the managing member or manager to sign the LLC Certificate of Formation. In other states, such as Delaware, an “Organizer” or “Authorized Person” can sign the LLC Certificate of Formation.

The question you may have is: How do you know who the members are? The members are the owners. The members’ names do not need to be listed in the LLC’s Certificate of Formation. Instead, that ownership information is contained in the Operating Agreement.

So how do the members prove the connection between them and the LLC if a third party Authorized Person signed the Certificate of Formation? One way is through a contract between the LLC and the Authorized Person, such as an incorporation service, which typically prepare and sign the Certificate of Formation and then file it with the state. Then the incorporation service’s Authorized Person sends the LLC Certificate of Formation back to you after it has received a file date and time stamp, plus a file number. Some Incorporation Agents will send out a cover letter indicating who ordered the LLC. That customer is the person who is typically responsible for coordinating with the other parties to the LLC, its Operating Agreement. Sometimes you can also request the Authorized Person sign a “Statement of Organizer” to set forth the initial members and or managers of the LLC and declare that the Authorized Person is not a member and has no further authority to act on behalf of the LLC in the future beyond signing the Certificate of Formation.

Although the legal formation happens at the time the Certificate of Formation is received by the state of incorporation, that delivery alone is not sufficient to ensure the proper filing, because an LLC is not considered legally formed until the Secretary of State attaches the “time and date stamp” and its state file number. Note that the state file number is different from the IRS Employer ID Number (EIN or Tax ID No.) which is obtained after the incorporation process and is not required for due formation.

The other legal requirement after the public filing of the Certificate of Formation, is the adoption of a private Operating Agreement for the LLC. Some states such as Delaware require every LLC have an operating agreement, but it can be “written, oral or implied.” It is a best practice to have a signed LLC Operating Agreement. Requiring your clients have written Operating Agreements is a best practice to reduce the likelihood of conflicts in the future, because usually LLC Operating Agreements provide for “prenuptial” provisions to reduce the risk of a dispute when there is a break-up. Note that Delaware has a provision that allows for an oral Operating Agreement as an exception to the Statute of Frauds (where normally writings are required for certain real estate transactions). Additionally, it should be noted that Delaware provides for maximum freedom of contract that allow members from the outset to establish an Operating Agreement that for example can even reduce or waives fiduciary duties. There are very few statutory requirements in Delaware that are un-waivable by agreement. Also the Delaware courts will generally enforce an LLC Operating Agreement as written even if unequitable to its members. This is called the “contractarian” approach. Delaware courts will treat the members to an LLC Operating Agreement like adults and follow the four corners of the Operating Agreement to make the members of the LLC “sleep in the bed they make” for themselves at the outset.

Be careful when clients or their accountants have filed their own Certificate of Formation. Often times they do not enter into an Operating Agreement, meaning the LLC may not even be “duly formed” even if it has a Certificate of Formation on record. Therefore, a Certificate of Good Standing should not be the only document you look for when deciding whether an LLC was duly formed. Also often the Operating Agreement by self-filers or the generic form provided by formation agents may not be appropriate for the client’s particular business or deal. For example, although a single member LLC Operating Agreement can be rather simple, such is not the case with a multi-member LLC Operating Agreement due to the need that it address potential partnership disputes in advance. For that reason, although the American Bar Association (the “ABA”) has a sample single member LLC Operating Agreement for use in real estate transactions, it has no such sample agreement for LLC’s with multiple members. Instead, the ABA has a 30 plus page checklist of all the factors to consider when drafting an operating agreement for a multi-member LLC. These factors include such issues such as whether to provide for amendment by unanimous consent, simple majority or some other super-majority. The checklist also asks whether to include arbitration provisions or court resolution of disputes. These are two small examples of the more than 100 questions to consider when drafting the LLC’s Operating Agreement.

 

With all of this discussion of Delaware, you may be wondering why a national webinar is focusing this much on a tiny state in the Mid-Atlantic. The reason is because although 90+% of the LLCs formed in a home state, in larger deals, banks and sophisticated investors often insist that the LLCs be established in Delaware, where LLC law is highly developed and therefore allows for more predictability.

Although you are located in one state, you can form an LLC from any state no matter where you operate. If you form an LLC in the state where you are doing business it is referred to as a “domestic” LLC. If you form an LLC in a state other than the state where you operate, it will be referred to as a “foreign” LLC in every other state in which the LLC is qualified to do business.

Therefore the first decision to make is where to form your LLC. The state of formation will control the internal affairs of the LLC. Some states, such as Delaware, are favored by lenders or managers of LLCs because their courts provide predictable results and honor the LLC agreement as written. You may also want to check the “name availability” in both the domestic state and each foreign state where you will register your LLC. If the name of the LLC is not available in a foreign state, then the LLC will need to file under a “forced DBA,” for example, “ABC Capital of Delaware, LLC.”

In summary, the process of forming an LLC starts by filing a certificate of formation with the Secretary of State, but that is NOT the end of the “formation process”. Usually due formation requires that the LLC also have a signed Operating Agreement. It is usually in the Operating Agreement where the purpose of the LLC is set forth. Most LLCs have general-purpose clauses (any purpose authorized by law), while some LLCs used in commercial real estate transactions have narrow purpose clauses limited to a particular transaction.

Attorneys also will need to check applicable state laws in the state of formation for special requirements. For example, New York requires that a notice of formation of each LLC (and of each foreign LLC that seeks authority to do business in New York) be published for six weeks in two newspapers (see NY Limited Liability Company Law Section 206).

MORE: What is a DBA?

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When deciding where to form your company, consider that Delaware has advantages over your home state that may benefit you. Go