A Guide to Forming a Multi-Member LLC in California.

A California Limited Liability Company (LLC) is a business entity formed under the laws of the state of California. It similar to a partnership, providing management flexibility and the benefit of pass-through taxation.

A multi-member LLC is owned by multiple people or "members." A standard practice is to have the members choose a single person or a group of people, called "Managers," to run the organization. Forming a California LLC takes places in two stages.

You will first file your Articles of Organization with the California Secretary of State. This can take up to a week. Once you have successfully filed your Articles of Organization you can complete the remaining items in the same afternoon and sign them all simultaneously.

1. Decide On Each Member's Ownership Interest

There are a number of factors to consider when deciding on each Members ownership interest: who will be working full time vs. part time, who is contributing the initial funding beyond the Membership Contributions and who is willing to put in more, to name a few.

One common mistake among early entrepreneurs is to give away too much ownership to people who have not taken as much risk as you have or sunk as much time and money into the company, explained well by entrepreneur and investor Mark Suster. As a general rule, DO NOT CREATE 50/50 OWNERSHIP SPLITS, explained by Rich Barton of Zillow on a great Geekwire article. There are some exceptions to this general rule if the Members have a proven work history.

2. Choose The Manager or Board Of Managers

When you have more than one member owning interest in the LLC, it advisable to have a manager or board or managers. These are the individuals that will run the company on behalf of the other members and will have the authority to bind the company. You do have to list your manager(s) in a the operating agreement, but you should state in your operating agreement that the LLC will be manager managed.

3. File Executed Articles of Organization With The California Secretary Of State

The Articles of Organization are what you file with the California Secretary of State to form your new LLC. There are minimum requirements that need to be listed in the Articles of Incorporation in order for them to be accepted. The attached form is provided by the California Secretary of State and includes the minimum information which is required for the Articles of Incorporation to be accepted by the state (see page 3 for the actual Article of Incorporation).

Complete the provided form and mail it to Secretary of State, Document Filing Support Unit, P.O. Box 944228, Sacramento, CA 94244-2280 with the $70 fee. For completing the Articles of Incorporation, put the name of one of the founders and their address for the Agent For Service of Process. You will also check the box "Manager" or "More Than One Manager" under Section 5 since the LLC will be managed by a single or multiple Managers.

4. Execute Multi-Member Manager Managed LLC Operating Agreement

An operating agreement is an agreement among limited liability company ("LLC") Members governing the LLC's business, and Member's financial and managerial rights and duties. LLCs operating without an Operating Agreement can be declared unformed.

An Operating Agreement is similar in function to corporate by-laws, or analogous to a partnership agreement in multi member LLC's. In single member LLCs, an operating agreement is a declaration of the structure that the member has chosen for the company and sometimes used to prove in court that the LLC structure is separate from that of the individual owner and thus necessary so that the owner has documentation to prove that he or she is indeed separate from the entity itself.

Limited Liability Companies are very flexible in nature and the operating agreement defines each member or manager's rights, powers and entitlements. This includes capital accounts, membership interest, distributions of profit and allocated tax responsibility, just to name a few. This internal document is an agreement set by the company members that contains provisions for critical items and rules that run the company. Operating agreements can be amended at any time by the company members or managers.

5. Members Execute 83(b) Election For Ownership Interest With Vesting

Each member whose stock is subject to a repurchase option (vesting) should complete an 83(b) election and mail them into their nearest IRS office. In California mail to: Department of the Treasury, Internal Revenue Service, Fresno, CA 93888-0002 Founders of startups typically have vesting put on their founder stock.

As ownership vests, the IRS views this as additional income and you would normally be taxed on this. If the value of the interest that vests is large, then the member could be hit with a large income tax. Filing an 83(b) election allows you to recognizes “income” upon the purchase of the membership interest. Since the purchase price for the membership interest and the fair market value are the same, the member would have to pay nothing if they properly filed their 83(b) election.

6. Each Member Executes A Intellectual Property Assignment Agreement

When forming a company it is important that each founder assign to the company all relevant intellectual property developed prior to the formation as well as after the formation of the company. An intellectual property assignment agreement specifically deals with pre-formation inventions, though you can assign both existing and future inventions in one document as long as you make a "present assignment" (i.e., "I hereby assign" as opposed to "I agree to assign" which is a promise to assign in the future) of both types of intellectual property. You want to make a present assignment so that the company does not have to try to collect extra assignments down the road in litigation, so that anyone that buys your company doesn't have to ask for extra paperwork, etc. By executing an Intellectual Property Assignment Agreement in connection with the purchase of membership interest, you can assign all or part of your IP to the company.

If any of the Members have a patented technology which was developed for the company or that would be utilized by the company, they should assign it to the company. This should be done in a separate patent assignment agreement and have additional payment (consideration) attached to it. The other alternative is to have the patent holding Member license the patented technology to the company. This is typically not a good idea. It puts the company at risk of potentially loosing key technology at some point in the future if that Member departs. Investors are usually reluctant to invest in a company that does not own its key patents.

If any of the members have a relevant patent or trademark to assign to the company then they must assign them to the company. You should do this shortly after the execution of the Intellectual Property Assignment Agreement in Step 4. These assignments can be made electronically with the Patent and Trademark Office at: Electronic Trademark Assignment System (ETAS): http://etas.uspto.gov/ Electronic Patent Assignment System (EPAS): http://epas.uspto.gov/ It is a best practice to have in writing the assignment of a patent to the company, which is stored in the company records. The document attached here is that patent assignment agreement.

7. Each Member Records Patents Or Trademarks Assignment

Every founder and employee should sign a Confidential Information and Invention Assignment Agreement. This agreement has two primary functions. First, this agreement implements confidentiality into the relationship between the Founder and the Company. Second, this agreement assigns to the Company all of the intellectual property and work product related to the company that is developed by the signing individual while the person works for the Company. This is different than the Intellectual Property Assignment Agreement seen above which assigns Company related intellectual property from BEFORE they were with the Company.

8. Each Member Executes A Spousal Consent Of Operating Agreement

In a community property state like California, a spouse will by default own 1/2 of the marital assets including any equity purchased with marital assets. Therefore, a spouse will almost always need to agree to the terms of the Operating Agreement as well. This can be done with a Spousal Consent. It is a good practice for each Member to sign a Spousal Consent even if they are not married so they can acknowledge that they are not married. It is good for the company to know about all potential shareholders.

9. Make S-Corporation Election

One of the attractive, but often confusing, aspects to forming a limited liability company (LLC) is the flexibility of electing how the LLC and its owners, called "members," will be taxed. This flexibility exists because the federal government does not recognize an LLC as a classification for federal tax purposes. In fact, multi-member LLCs are often taxed as partnerships while single-member LLCs are taxed as sole-proprietorships. However, even though an LLC is not a corporation, it can choose to be taxed as one. When members of an LLC choose to be taxed as a corporation, the default is to be taxed as a C-Corporation.

However, an election can be made to be taxed as an S-Corporation. Being taxed as an S-Corporation allows LLC members to take advantage of certian tax benefits not available to partnerships or sole-proprietorships while, at the same time, avoiding the "double taxation" concept of a standard C-Corporation.

So, the question is, "Does it make sense for an LLC to be taxed as an S-Corporation?" In short, the answer to the preceeding question has to do with money and how much of it the LLC makes. If the business of the LLC generates a nice profit over and above what would be considered reasonable compensation for the services that the owners provide, the LLC may be unnecessarily subjecting its profits to self-employment taxes.

This is because the profits of partnerships and sole-proprietorships are subject to self-employment taxes, which as of February, 2012, are 15.4% of profits (i.e., $100,000 profit is subject to $15,400 in self-employment taxes). Being taxed as an S-Corporation allows the LLC to pay its employee-members (i.e., those members who are actively working the business of the LLC) a wage in addition to the LLC's profit. This is a benefit because only the wage is subject to the self-employment tax while the profit distributed to the LLC member or members is not (NOTE: Members who are not actively working the business will not qualify for payment of a wage; so S-Corporation election is not likely to impact a passive member's tax liability).

More often than not, this results in a lower tax liability or "tax bill" for the members. The catch, however, is that the wage must be "reasonable," meaning that the wage cannot be too low. In order to determine whether a wage is reasonable, LLC members should consult with a tax attorney or CPA. It is important to note that in addition to paying LLC members a reasonable wage, there are other restrictions to the S-Corporation election.

First, the LLC may not have members who are corporations, partnerships, or non-resident aliens. Second, the LLC may not have more than 100 members, and third, the LLC can only have one category of ownership (i.e., cannot have multiple categories of ownership such as voting and non-voting). For single member LLCs, meeting the above criteria usually is not a problem.

For multi-member LLCs, however, this criteria can be troublesome; so care must be taken to confirm prior to making the election that the LLC will qualify for S-Corporation taxation. Electing to be taxed as an S-Corporation requires filing a form 2553 with the IRS no more than two months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the tax year preceding the tax year it is to take effect. This election is optional and to make the election with the highest level of confidence and clarity, the appropriate professional, such as an attorney and/or CPA, should be consulted.

10. Request EIN from IRS

Your Employee Identification Number (EIN) is your company's social security number or tax ID number. It allows you to get a bank account and is required to hire any employees. An EIN can easily be obtained online (Monday - Friday: 6:00 a.m. to 12:30 a.m. Eastern time and Saturday: 6:00 a.m. to 9:00 p.m. Eastern time) One of the Managers can get the EIN in less than 10 minutes. He will need his Social Security number and the filed Articles of Organization with the assigned California entity # printed on the Articles.

 

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