By Tom Pedreira

Anyone can form an LLC without a lawyer's help. With many online legal resources available nowadays, it can be done quickly and cheaply. So why use a lawyer? The best answer is that there is a much greater likelihood that the owners of an LLC will run in to problems down the road if they do not have a lawyer involved at the outset. The following discussion illustrates how some of these problems can arise.

The statutory requirements for operating an LLC in the State of Washington are generally set forth at RCW 25.15. Pursuant to authority extended under the RCW, there are also various regulations promulgated throughout the Washington Administrative Code that pertain to LLC's either directly or indirectly. Rules developed by the Secretary of State's office, for example, are set forth at WAC Chapter 434-130. Federal laws such as IRS Treasury Regulations may also apply.

Unlike a corporation, the observance of "corporate formalities" may not be as an important part of maintaining the shield from liability and other protections and advantages offered by the LLC form of doing business. The term "corporate formalities" with a corporation normally means holding annual (or other regularly scheduled) meetings of the shareholders and directors, providing written notice in advance of such meetings, preparing detailed minutes of matters decided upon at such meetings, and so forth.

With an LLC, the failure to observe such formalities may not be considered a factor tending to establish that the members have personal liability for any debt, obligation, or liability of the Company where the Articles of Organization or Operating Agreement do not specifically require such formalities to be observed. However, this does not mean that members are completely free to ignore the separate legal identity of the Company. The members and the managers must carefully observe any operational formalities specified in the Operating Agreement, such as the meeting and voting requirements to take various actions. Observing those formalities will reduce the risk that a governmental agency such as the Internal Revenue Service, or a creditor, can claim that the Company is a mere sham created to provide tax benefits and improperly protect its members from personal liability.

Therefore, it is extremely important to maintain the formal integrity of the Company, which is a separate legal entity, in order to avoid personal liability. The Company must continuously look, act, and sound like a separate entity. For example, members must always keep in mind that the assets and funds of the Company are in the name of and owned by the Company, not by the members. Separation of the Company's assets from personal assets of the members is very important. All important transactions relating to the business of the Company should be documented and, if necessary, reflected in minutes of meetings or actions of the members. All contracts, including employment contracts, buy-sell agreements, profit-sharing plans, trust agreements, loans, leases, purchase contracts, and brokerage and investment accounts, should be made in the name of and on behalf of the Company and memorialized by appropriate documentation. When signed, such documents should be retained with the Company's business records.

As a continuing matter of sound practice, the Company's accountant and attorney should meet with the managers and/or the members at least annually, preferably early in the last month of each fiscal year, to make certain that all required actions are taken and properly documented. This includes a license renewal/annual report and a filing fee that must be filed with the Department of Licensing each year. The State of Washington operates on a staggered license renewal system, so the LLC will file its annual report in the same month in which it was formed. The notice for renewal generally arrives six weeks prior to the due date. It is important that the report be timely filed or a delinquency fee is imposed. If the delinquent report and fee are ignored, the LLC will be administratively dissolved by the Secretary of State.

The limited liability protection can extend both to liabilities for torts (such as negligence) and contractual liabilities. However, there are two important areas where an LLC will not protect a member from individual liability. First, the LLC will not protect a member from liability for torts where the member is a person whose conduct is found to be negligent or otherwise tortuous. Second, the LLC will not protect a member from contractual liabilities where the member contracts in his or her own name, (e.g. in his/her individual capacity). For instance, lenders often require members or managers to sign loan documents in their individual capacities as co-makers or as personal guarantors of LLC debts, in which event the individuals may become fully liable for the amount of the company's debt.

To best ensure that the LLC provides its members with limited liability protection, the members must adhere to certain rules and formalities. Courts of law have the power to ignore the LLC entity and impose liability on individual members for a number of reasons, chief among are:

(1) commingling of individual and company funds or other assets;
(2) failure of the member(s) to recognize the LLC entity by keeping good records;
(3) actions by members that reveal that the members themselves do not recognize the LLC entity, and
(4) use of the LLC entity as a means of defrauding others.

These problems are particularly prevalent with small, closely held LLC's. As a precautionary measure, we suggest that all of our LLC clients observe the following four principal objectives:

1. Formalities. The LLC should always maintain an LLC record book or binder at its principal place of business. Kindly review the attached copy of RCW 25.15.135 that outlines the documents one should maintain at the principal place of business.

2. Segregation of Funds. The LLC should be run as a totally separate business and financial unit, with separate books and accounts and without co-mingling of funds, affairs, and transactions with those of its members (whether individuals or corporations), managers or affiliated LLC's. Commingling or confusion of personal and company funds is the single most common cause of courts disregarding an LLC entity and imposing personal liability on its members. The temptation to use the company checkbook to pay a personal expense, or vice versa, must be avoided.

If one must access company funds for personal use, or vice versa, it must be evidenced as a business transaction such as a loan (evidenced by a promissory note), a sale or redemption of all or a portion of a member's LLC interest, or as a disbursement to members. Keep in mind that one should obtain prior written consent of all of the members and managers to any business transaction or loan involving a member or manager. Distributions to members should be done in accordance with the distribution provisions of the LLC Operating Agreement and documented as such in the LLC books and records. Remember that distributions to members should not be made if it would leave the LLC with insufficient operating revenue to meet current liabilities.

If one needs to inject additional funds into the LLC, it can be done as a loan from a third party, a loan from one or more members, or as a pro-rata contribution of capital by all members. The important thing to remember is that it be accurately reflected in the LLC's books and records. If one has doubts as to proper documentation of fund transfers between the LLC and its members, please don't hesitate to call.

3. Signatures. There should be no representation by a member or manager that would lead outsiders to believe that the business is being conducted as a sole proprietorship or as a general partnership. Stationery, business cards, signs, advertising, invoices, and other business materials should clearly identify the business by the full LLC name. Be particularly careful to clearly identify members as a representative of the LLC when dealing with vendors and other trade creditors of the LLC. If accounts are opened with trade creditors, the accounts should be in the name of the LLC and never in the name of a member. Otherwise the member may be personally liable for the account and the account in the name of a member may be used by other creditors as evidence of members' disregard of the LLC entity. If a creditor will not accept and rely on the credit of the LLC, members can provide personal guaranties.

4. Working Capital. The company should have adequate capital to meet its obligations and such contingencies as are reasonably to be expected in its business. An additional basis upon which courts have disregarded limited liability entities has been for gross undercapitalization of the business entity. Undercapitalization occurs when the principals of the business fail to invest an amount of risk capital which is commensurate to the initial business needs of the venture. Once the business is under way and enjoying a cash flow, questions inevitably arise as to how much money should be taken out of the LLC in distributions to its members. As a pass through entity, the members of an LLC are taxed on their proportion of the LLC's net taxable income. As such, there may be a natural inclination of members to distribute all the available income from the LLC. Nonetheless, the limited liability statutes in every jurisdiction generally provide that an LLC may not distribute assets to its members if it would leave the LLC insolvent or unable to pay its debts. Also, the members will be liable to the LLC or its creditors to the extent that such distributions render the LLC insolvent.

Accordingly, in making distributions to members, the distributions must be made in accordance with the distribution provisions of the LLC Operating agreement and documented as distributions in the LLC's books of account. Distributions to members should not be made if it will leave the LLC with insufficient operating revenues to meet its current liabilities. As a rule of thumb, one should always leave in the LLC that amount which is necessary for the LLC to meet its current liabilities.

Tom Pedreira, a business attorney with the Mikkelborg firm, has formed corporations and LLC's for many clients.  In having done so, his goal has been, and constinues to be, providing the best legal services he can as cheaply as possible. At the same time, he supports clients using online resources for services in this area.  However, he is cautious to tell them to be mindful that such services may be cheaper, but they are not a substitute for competent legal advice.