Fiduciary Duties in a LLC

Entrepreneurs who are organized in a limited liability company may not realize they have fiduciary duties to the company and to their fellow members. When we talk about fiduciary duties in a LLC, we typically mean the duties of care and loyalty — that is, to work in the best interest of the company and its members, and not for one’s own self-interest to the detriment of the company and its members. The issue of fiduciary duties in a LLC usually come up in the context of a member with a controlling interest using that control to benefit himself or herself at the expense of the LLC or fellow members, or the context of a member starting a venture that competes with the LLC.

Different states impose fiduciary duties upon actors in a LLC in different circumstances, although the general rule provides that managers of a manager-managed LLC, and members of a member-managed LLC owe fiduciary duties to the LLC and its members, while non-managing members of a manager-managed LLC do not owe such duties. However, it is unclear whether, in a nominally member-managed LLC that is in practice or by operating agreement managed by fewer than all of the members (such that the LLC effectively has “silent partners”), “non-managing” members are subjected to fiduciary duties. Finally, regardless of how the LLC is managed, some states also impose fiduciary duties upon a member that has a controlling membership interest (such as a majority of the equity or voting interest, depending on how the operating agreement, if any, is written).

Is Incorporating Necessary for Freelancers?

If you’re striking out on your own as a freelancer, you may be wondering if it is necessary for you to incorporate or form a LLC for your freelancer activities?

One of the main benefits of incorporation or LLC formation is the limited liability shield for the owner’s personal assets. However, limited liability does not extend to torts committed by you, so if you are negligent in performing your work, or if you get into a car accident while driving to a work-related matter, you are still personally liable even with a corporation or LLC. But limited liability can protect from other business liabilities, such as leases, loans, other debts, employment matters, etc. (assuming that such liabilities are not based on a theory of negligence). Of course, that protection is lost again if you personally guarantee liabilities like loans or leases.

Incorporating can also provide some tax benefits. It is possible for a freelancer to incorporate and then elect to be taxed as a S-corporation. That way, the freelancer can pay himself or herself both in salary and distributions — while salary may be subject to self-employment tax, distributions are not. However, you must take care not to pay yourself too much with distributions as opposed to salary, as the IRS looks out for business owners who pay themselves primarily with distributions in order to avoid paying self-employment taxes.

Finally, incorporating or forming a LLC can also make it slightly more likely to get hired. Companies are becoming increasingly wary of hiring independent contractors, as the IRS and federal and state departments of labor are beginning to crack down on misclassifications of employees as independent contractors. However, the fact that a freelancer has his or her own corporate entity that he or she performs their work through for multiple employers weighs in favor of an independent contractor classification.

Why a LLC May Be a Bad Idea

Limited liability companies, as a form of business organization, have exploded in popularity over the past two decades or so. Many startups have chosen to organize themselves as LLCs, preferring the flexibility and simplicity of a LLC over a corporation. But for many kinds of startups, organizing as an LLC may be a really bad idea for a number of reasons.

1. Taxes — some startup founders are concerned about the double-taxation of a C-corporation, and so seek LLCs, which by default are treated for taxation purposes as a disregarded entity (when the LLC only has one owner) or as a partnership (when the LLC has multiple owners). LLCs can also elect to be taxed as a corporation, including under Subchapter C, or Subchapter S (assuming the LLC qualifies). But the thing with pass-through taxation is that the members of the LLC are responsible for paying their share of the LLC’s taxes, whether or not cash is actually distributed to the members. And, depending on the LLC’s operations, members may be required to pay taxes in a number of states, significantly complicating the filing process for 

2. Issuing equity — Issuing equity, such as for employee compensation or to raise capital, can be difficult with LLCs. If the LLC is subject to pass-through taxation, investors may not want to take on the added burden of filing their share of the LLC’s tax liability, or paying it (assuming the LLC’s operating agreement doesn’t provide for automatic distributions to cover members’ tax liabilities). Moreover, it can be incredibly complex to issue equity to employees as incentive compensation. Again, if the LLC is taxed as a partnership, issuing equity to employees turns them into members, who cannot also be W-2 employees.

3. Management may not be so easy — Some like LLCs for their simplicity and flexibility, but I’ve found that the more you exercise that flexibility, the less simple LLCs can get. The structure of a LLC is largely an agreement among the members of the LLC, which can (for the most part) take the form the members want, as opposed to the more structured rules of a corporation. But LLCs are a relatively new form of business organization compared to corporations, so the caselaw supporting LLCs is nowhere near as developed as that of corporations. As a result, with a unique and complex structure of a LLC, it is difficult to predict how that structure would be view by courts or government agencies.

LLCs can work well for smaller family-owned or several-partner businesses, as it can free owners from some of the paperwork requirements of corporations. But for a startup that will need to raise capital or will need a complex equity or management structure, a LLC may not be as an ideal choice. 

Vesting — Critical to Multi-Founder Startups

Founders in multi-founder startups often are (or at least should be) concerned about ensuring that their fellow co-founders are committed to the startup and will work toward the goals assigned to them. Many startups run into issues with “dead equity” — a founder leaves the company at an early stage with a significant chunk of the equity of the company, then deadlocks over management or strategic decisions occur among the remaining founders and the departed founder’s equity is needed to break the tie under the company’s organizational documents. These concerns are also often shared by the startup’s investors, who obviously don’t want founders departing a company in which the investor has contributed significant sums of money. As a result, most founders take “restricted” equity subject to a vesting schedule. Under this structure, the equity is considered restricted because the company holds an option to repurchase the equity from the founder at the purchase price; when the equity “vests”, it is released from this option and no longer subject to repurchase by the company. However, aside from the company’s right of repurchase, the founder exercises all rights and responsibilities attendant to ownership of the equity, such as, depending on the terms of the company’s organizational documents, the right to vote or right to distributions of company profits. Vesting schedules can take whatever form necessary to address any particular founder concern — if co-founders are concerned about their partners leaving the company early, a vesting schedule may be lock-step with time spent with the company, or vesting may be set according to certain business milestones that a particular founder is expected to achieve.

Splitting Equity Among Co-Founders

One of the first big questions that co-founders have with each other is how to split the founders’ equity. Many teams simply decide to quickly move past the questions by deciding to split the equity evenly. However, myself and most commentators believe that this is usually the wrong decision. Splitting the equity evenly means that each co-founder is contributing equally to the company; however, contributions are rarely equal . Co-founders need to sit down and have an honest conversation about how to split the equity, based on what each founder is contributing. There are a number of good reasons why co-founders should have this conversation at the beginning. One, the equity split conversation is a difficult one, and if you cannot or will not have this conversation, what are you and your co-founders going to do when you need to have a tough conversation about something you can’t ignore or easily compromise on? Second, because co-founders usually do not contribute equally to a company, the co-founders who contribute more may begin to resent putting in more of the effort for not a comparable share of the founder’s equity. So how do co-founders decide how to split up equity? Legal Hero has created a handy spreadsheet/calculator that can be used as a starting point for discussions, by allowing co-founders to mark down each’s contribution or anticipated contribution to the company. Of course, the split generated by the spreadsheet should be used as a basis for, and not the end of, the conversation about equity — the percentages can and should be tweaked based on what the co-founders think is fair. Everyone should think the split is fair before moving on, because if you can’t come to full agreement on that issue, your prospects for being able to come to agreement on other issues is more remote. Factors that co-founders should consider when splitting equity include: (1) who is going to be the primary co-founder or CEO and which other co-founders will be performing executive-level roles (i.e. treasurer/CFO, COO, CTO); (2) who, if anyone, will be working full-time on the business; (3) who came up with the idea, and who has been or will be validating the idea; (4) who can or will be raising outside capital; (5) who, if anyone, is an expert in the industry or has contacts in the industry; and (6) who, if anyone is critical to launching the product or generating revenue. Additionally, co-founders should also consider what, if any, capital each is contributing to the company. Capital includes not only cash, but also intellectual property, equipment, or office or retail space.