If you don’t have a detailed practical understanding of the pick-your-partner provisions and charging order provisions in your state’s LLC statute, you shouldn’t engage in LLC practice.

On April 25, 2012 from 2 pm to 3:30 pm, I will be teaching a national teleconference seminar on LLC statutory pick-your-partner provisions and charging order provisions for National Business Institute.  For a PDF version of the sentence outline I will use in the seminar, click here.

• To create or acquire a checklist that tells you all of the legal and tax tasks that should be performed for clients who need comprehensive LLC formation services; and
• To use this checklist whenever you form an LLC.

When you form an LLC for a client, you should, ideally, perform all of the tasks on your checklist that are within your professional expertise; and you should help your client find other professionals who can handle LLC formation tasks that are beyond your expertise.

I’ve been forming LLCs since 1993. I still find that after I think I’ve done all I should do for a particular LLC formation client and I look at my checklist, I find yet additional tasks to perform. Unless you look at your checklist, you always forget something.

Obviously, if your client wants comprehensive LLC formation services:

• You and any professionals you associate yourself with should perform all of the tasks on your checklist;
• You should perform each of these tasks thoroughly; and
• You should perform each in accordance with the applicable best practice. (This means, of course, that first you have to determine this best practice.)

Obviously, if your clients want only a portion of the services on your checklist—i.e., they want only intermediate or basic services—that’s all you should provide; and you may have to provide some of these services less than thoroughly. But if this is the case, you should be clear about it in telling your client the scope of your representation—and I would argue that Rule 1.2 of the ABA Rules of Professional Conduct as in effect in most states so requires. Otherwise you might face a malpractice suit for what you didn’t do. And you should always begin by offering your client all of the services on your checklist.

Over a period of many years, I’ve spent scores of hours compiling my own LLC formation checklist, and I’ve asked a lot of other LLC lawyers to review my checklist. The resulting checklist is attached here. This checklist is the backbone of the third edition of Drafting Limited Liability Company Operating Agreements, my Wolters Kluwer LLC formbook and practice manual, on which I’m currently at work. The table of contents of the third edition as I currently envision it is here.

I’ll be quite grateful for any comments that, on the basis of your own LLC formation experience, you may have on either of the attached documents.

The reason, obviously, is that this is what, if they reflect on the matter, readers clearly want.  Obviously, if you ask these readers whether, in forming LLCs for their clients, they want do so as well as they reasonably can–i.e., at a high level of competence–their answer (even if they have not previously focused expressly on the question) will be a resounding yes.   But this means that what they want from such a book is not merely recommended or even clearly sound practices.  Rather; they want best practices.

But validly classifying specific LLC formation practices specifically as best practices is no easy task.  This is because, in almost all cases, the best LLC lawyers and law firms—i.e., the ones most likely to be using the best LLC formation practices—cloak these practices (and all of their other legal practices) in secrecy.  In my experience, they almost never disclose them in any detail in law journal articles, in practice manuals, in CLE outlines or in any other source.

So what can be done by a person such as myself–a person intent on writing the best possible LLC formbooks and practice manuals—to overcome this cloak of law firm secrecy?

Above all:

• We can scour the legal literature in the hope that the best law firms or the most skillful LLC formation lawyers have disclosed their secrets in these sources (even though we know in advance they probably haven’t done so);
• We can test our own considered ideas about best practices by seeking evaluation of them by other LLC lawyers we believe are forming LLCs for their clients with a high degree of competence; and
• We can test our ideas in blogs like this one and elsewhere on the Internet and in other public media–e.g., bar seminars–in the hope of receiving useful feedback from the community of LLC formation lawyers.

Indeed, if we want to write good books about LLC formation practice, we must do all these things.

“A best practice in forming LLCs means a method of performing a particular task in the formation that meets each of these four tests:

1. It produces an optimal result.
2. It produces this result at least as reliably as any alternative method.
3. It is not inferior to any alternative method in any significant respect.
4. It is superior to all alternative methods in one or more respects.

What constitutes an “optimal result” in performing a particular task varies, of course, depending on the task in question.

In theory, there may be two or more methods of performing the task, both or all of which produce an optimal result. However, in this circumstance, one method may be better than the others because it is easier to learn, easier to implement or faster to implement than the other methods.

EXAMPLE. A key task in any LLC formation is non-tax choice of entity—i.e., the analytical process of choosing between LLCs and other types of business organizations for a business start-up on non-tax grounds (such as the strength of their liability shields, their ability to confer statutory charging order protections, or the legal and other costs of their formation and operation).

In my experience, the best method for doing non-tax choice of entity is, briefly, the following three-step method.

1. Determine which types of business organizations are available to the business start-up client in question under applicable state law. For example, the state-law business organizations available to an individual forming a single-owner business are, in most or all states, (i) sole proprietorships, (ii) single-shareholder corporations and (iii) single-member LLCs. To perform this step, you must, of course, have a complete list of potentially relevant state-law business organizations.
2. Identify the non-tax advantages and disadvantages of each of these organizations for your client. To perform this step, you must, of course, have a complete list of potentially relevant non-tax advantages and disadvantages. In the example, the obvious chief non-tax advantage of LLCs and single-shareholder corporations over sole proprietorships is that they provide liability shields, while sole proprietorships do not.
3. Choose among these organizations for your client by netting these advantages and disadvantages. In the example, the chief non-tax advantage of a single-member LLC over a single-shareholder corporation for most individuals forming single-owner businesses is the greater informality and flexibility of single-member LLCs, particularly with respect to their management structure.

In my experience, the above three-step method is the only method for doing non-tax choice of entity that will yield an optimal result. Thus, there is no need to compare this method with alternative methods before characterizing it as the non-tax choice of entity “best practice.”

It is true that, in seminars and other forums, lawyers sometimes suggest that non-tax choice of entity and tax choice of entity cannot be analytically separated in an LLC formation and thus must be done simultaneously. In my view, this position is manifestly wrong, since the factors relevant in non-tax and tax choice of entity are entirely different from one another. Thus, the two methods should never be mixed. Rather, you should apply each of the two methods processes independently of the other and should then reconcile any difference in outcome.

As you no doubt know, “best practices” is a concept in wide use in medicine, manufacturing and other non-legal fields, but not in the law. It is a concept that I want to be express, pervasive and unifying in my book.

In a series of posts in this blog, I will be presenting, as succinctly as I can, my key thoughts on the subject of LLC formation best practices as I develop them in drafting and revising the Third Edition. I’ll be very grateful for any comments you may have on these posts.

This is a trick question, since, as a practical matter, you should evaluate your Act on the basis of three quite separate sets of criteria.

A few points by way of background:

• First, we know from IRS filing information and other sources that in most or all states, about one third of all LLCs are formed as single-member LLCs by individuals; and we know that these individuals have little or no knowledge of LLC law, are not represented by lawyers with LLC competence, and in most cases do not adopt operating agreements for their LLCs.  I’ll refer to these individuals here as “unsophisticated individuals.”
• Second, we know from the same sources that in most or all states, most other LLCs are formed by just two or three individuals and that these individuals, too, are unsophisticated and generally do not adopt operating agreements.
• Third, the above sources make clear by implication that in most states (Delaware may be an exception), only a very small proportion of LLC founders (perhaps less than five percent) are “sophisticated” individuals and entities—i.e., individuals and entities that possess a solid knowledge of LLC law or whose lawyers possess this knowledge.

In my view, the above considerations lead remorselessly to the following four conclusions:

1. LLC acts should be drafted primarily to meet the needs of unsophisticated members whose LLCs have no written operating agreements.  This is not a matter of conservatism or liberalism; it is a simple matter of fairness.  Unsophisticated individuals don’t have the knowledge or the money to protect themselves in forming LLCs.  So the state has to help them.  Sophisticated individuals do possess this knowledge.  They don’t need the state’s help (except as I’ll explain below).
2. LLC acts should contain all of the mandatory and default provisions necessary to provide unsophisticated individuals who are forming single-member LLCs with a sound “off-the-shelf” operating agreement—i.e., an operating agreement whose provisions, taken as a whole, will work for more such individuals than any alternative set.
3. Similarly, LLC acts should contain all of the mandatory and default provisions necessary to constitute a sound “off-the-shell” operating agreement for unsophisticated individuals forming multi-member LLCs.
4. Finally, LLC acts should provide permissive provisions that endow sophisticated individuals with maximum contractual freedom to tailor their operating agreements to meet their needs and interests.  In practice, this means that these acts should contain all of the “flexibility” provisions of the Delaware Limited Liability Company Act—provisions that the Delaware corporate bar has diligently and skillfully developed over a period of almost 20 years.

What does all this mean as to the actual provisions that LLC acts should contain?  In subsequent posts, I’ll present my views about these provisions as applicable to (i) unsophisticated individuals forming single-member LLCs; (ii) unsophisticated individuals forming multi-member LLCs; and (iii) sophisticated individuals and entities.

In the case of LLC formation clients, “what they behold” includes operating agreements.  So what can you do to make the operating agreements you draft for your clients more beautiful?  Below are some tips.  (I’ve sought to implement all of these tips in the operating agreements you can access by clicking on the “LLC Forms” button in the top navigation bar of this blog.)

1)     Formality and dignity.  Beauty is inherently formal and dignified.  Think of a Bach fugue or a Cezanne landscape.  So start your operating agreements with a title page that states the title of the agreement and its date.  This title page will give a formality and dignity to the agreement that will support its aesthetic pleasingness.

2)     Simplicity.  Though its parts may be complex, beauty in its essence is simple.  So use a clear and simple system for denoting the parts, sections, subsections and sub-subsections of your operating agreements.  Thus, for example, don’t include in the agreement sub-subsections such as “2.7.3.4.”  I see this method of numbering provisions in operating agreements all the time.  It’s not only confusing and irritating.  It’s complicated and it’s ugly.

3)     Tranquility.  Beauty is tranquil.  So use a lot of white space in your agreements.  White space rests the eyes of people studying the provisions of your agreements and enables them to read them tranquilly.

4)     Order and unity.  Beauty has an inner order and unity.  So start each of your operating agreements (after the title page) with a summary of contents and a detailed table of contents, and use headings to clearly denote these parts of the agreement and each other part, including the body of the agreement and each of its exhibits.  And clearly denote the various parts within the agreement’s body—e.g., its statement of the parties, its statement of background, its terms and conditions and its signature blocks.  This will not only help readers navigate the agreement and find what they’re looking for in it; it will give them a sense of the agreement’s beauty.

5)     Variety.  Beauty is enhanced by variety.  So use a beautiful font in the text of the provisions of your operating agreements—this this will generally mean Times New Roman—but vary font types in the agreements depending on whether the words in question in them constitute titles, tables of contents, section headings, or subsection headings.

6)     Prose style.  Use a beautiful prose style.  This means writing your agreements in plain English (even the tax provisions to the extent possible) and avoiding ugly legalisms such as “whereas” and “hereinafter” and “recital.”  In general, if you’re thinking about using a word in your agreement that only lawyers use, don’t use it.

EXAMPLE.  Arthur Able and Bill Baker are equal members of AB, LLC.  AB, LLC, in turn, holds real estate with a fair market value of $1 million.  Arthur holds his AB membership directly in his own name.  Bill holds his through a single-member LLC named “Cosmic Holdings, LLC,” of which he is the sole member.

I think the above ownership structure creates a serious trap for Bill.  One of major benefits of holding property in an LLC is that all U.S. LLC acts except that of Pennsylvania provide LLCs and their members with statutory charging order protections.  (And I understand that Pennsylvania case law provides charging order protections for Pennsylvania LLCs and their members.) 

I will write about charging order protections at greater length in future posts.  However, in essence, LLC statutory charging order provisions provide that if a creditor holds an unsatisfied judgment against a member of a multi-member LLCs on the basis of a claim unrelated to the LLC’s business:

• The creditor may obtain a lien (a “charging order”) against the LLC on the debtor-member’s right to receive distributions of LLC profits, requiring the LLC to distribute to the creditor any LLC profits it would otherwise distribute to the member to the extent of the judgment.
• However, the creditor may not levy on the debtor-member’s voting rights or other management rights in satisfaction of the claim.

In my view, the fact that LLC statutes provide for charging order protections and that corporations do not is the single greatest business organization law advantage of LLCs over corporations.    

To explain:  In the above example, Bill, as noted, holds his ownership in AB through a single-member LLC.  What this means as a practical matter is that if Bill accidentally but negligently runs over and kills a brain surgeon on business unrelated to the LLC and the brain surgeon’s estate obtains a $20 million judgment against him, the estate can levy on his single-member LLC membership; it can obtain Bill’s voting rights; and, by exercising deadlock voting power, it can force the LLC to sell its assets and distribute Bill’s share of the proceeds to the estate.  This is because charging order protections only protect LLC members; they do not protect the members of single-member LLCs that are members of multi-member LLCs.

By contrast, assume that Arthur is the AB member accidentally killing the brain surgeon.  In this situation, charging order protections will enable the estate to obtain a charging order against AB, LLC; but, because Arthur holds his membership in AB directly, the estate cannot obtain Arthur’s voting rights and thus cannot force AB’s dissolution.

In short:  Think long and hard before advising your LLC formation clients to hold their memberships in multi-member LLCs through single-member LLCs.  First, your client will thereby lose charging order protections.  Second, as a practical matter, he won’t need a second liability shield; so why bother with a single-member LLC?  Third, in any law suit, the “anonymity” he thinks he will obtain through his single-member LLC will quickly turn out to be worthless.