Funding Your LLC: Avoiding Mistakes

I recently answered an Avvo question about capital contributions and loans to an LLC. The question and answer are reproduced, in somewhat edited form, below.

Q: I am the sole member of an LLC. What is the best way to make capital contributions? Can I do this in the form of a loan?

A: It is important to distinguish your capital contribution (in exchange for which you receive your membership interest) from loans (which are to be repaid).

The LLC Operating Agreement should have an exhibit that states the amount of your capital contribution. You should make a deposit of that amount into the LLC’s bank account. If your LLC has membership certificates, you (as a member) are entitled to have one made out in your name, showing your membership interest (100%, or all of the Units), and signed by you as the Manager (which role should be specified in the Operating Agreement).

Each loan should be documented by a loan agreement and promissory note. To avoid “imputed interest” problems, the interest rate in each case should be at least as great as the relevant Applicable Federal Rate.

It is important that the LLC be sufficiently capitalized, that separate LLC bank account and accounting books be maintained, and that the loans be documented appropriately to avoid “alter ego” problems – please see Beware Your Alter Ego (discusses corporations, but applies similarly to LLCs).

Check out all posts about LLCs.

Dana H. Shultz, Attorney at Law? +1 510 547-0545? dana [at] danashultz [dot] com
This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact a lawyer directly.

11 comments

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  2. Jesse says:

    I’ve been wondering this very thing. I’m trying to start one or two single-member LLCs on a shoestring budget. I don’t expect the businesses to require much capital — a little, but mostly just my labor. I expect them to either start generating a positive cash flow (even if small) relatively quickly, or not work out at all.

    Since I’ll be the sole-member, I’ll have 100% ownership regardless of how much capital I contribute. And since I have a limited budget I don’t want to tie up more capital than necessary in the LLCs.

    To inject more capital into the LLC after formation without jeopardizing my limited liability, I’d have to go through the formality of loaning the money to my single-member LLC and having the LLC pay me back? With interest?

    Say I form an LLC and capitalize it with more money than it ends up needing (say it has a positive cash flow and low expenses) — how would I be able to get the initial capital back out? Or would I have to gradually expend that amount on expenses while taking other proceeds out of the business?

    Also, I’m curious about this statement: “and signed by you as the Manager (which role should be specified in the Operating Agreement).” Are you saying that a single-member LLC should be manager-managed with the sole member appointed as manager?

    My thinking was that a single-member LLC would be member-managed by the sole member. Same difference either way in that the same person is going to be managing the LLC, but is there some reason to go out of your way to make it manager-managed, does that help avoid alter ego problems?

  3. Dana says:

    @Jesse
    If you anticipate successive capital contributions, you can set the LLC up with units rather than percentage interests, and issue more units in exchange for later contributions. Whatever you do about capital contributions / loans, work closely with your accountant / tax advisor to keep all the records clean and accurate.

    If the LLC has excess capital / cash, you can take it out as a member distribution.

    Member-manager is fine: You should have both roles specified in the Operating Agreement, and you should be clear about which activities are performed by which roles – e.g., the Manager (rather than the member) (a) signs agreements on behalf of the LLC; (b) signs the membership certificate (and gives it to the member); and (c) determines whether cash is available for distribution (and, if so, distributes it to the member).

  4. Jesse says:

    @Dana
    Thanks for your reply.

    you can set the LLC up with units rather than percentage interests, and issue more units in exchange for later contributions.

    That’s applicable even to a single-member LLC? I’m not familiar with that, I’ll have to try to find some info. I don’t necessarily anticipate successive capital contributions, I just don’t want to have to contribute more than necessary initially and I want to know what I can / need to do to contribute more later.

    If the LLC has excess capital / cash, you can take it out as a member distribution.

    Oh, ok, I thought that the initial capital contribution was a special case where pulling the money out of the LLC might cause some problem.

    You should have both roles specified in the Operating Agreement, and you should be clear about which activities are performed by which roles

    I didn’t realize that distinction would be important for a single-member LLC, where the manager would be the only member, and the only member would be the manager. Is that a peculiarity of single-member LLCs that’s necessary to avoid alter ego problems? It’s really important to establish those roles in the operating agreement and sign contracts as XYZ LLC by John Doe, LLC Manager instead of XYZ LLC by John Doe, LLC Member?

  5. Dana says:

    @Jesse
    Any time one signs on behalf of an entity (corporation or LLC, no matter how many members), it is important that the signatory identify his position in the entity: President, Manager, etc. A member is not authorized to bind an LLC any more than a shareholder is authorized to bind a corporation.

    It is not necessarily the case that a problem in this area is going to create alter-ego personal liability. The point is that one wants to be prudent, to play by the rules, to stay as far away from the edge as possible so that if certain acts or omissions do push one toward alter-ego liability, you are not already so close to the edge that you will fall over.

  6. Jesse says:

    @Dana
    Perhaps I’ve been misinformed, because that wasn’t my understanding. For example, here are some quotes from “Form Your Own Limited Liability Company” published by Nolo:

    Legal Authority of LLC Members and Managers

    Generally, the members (if member-managed)…of the LLC can legally bind the LLC to a contract, business transaction, or course of action…

    How to Sign Papers on Behalf of Your LLC

    …first state the name of the LLC, then sign your name on its behalf.

    Example:

    Tom signs the contract as follows:

    Park Place Plasterers, Ltd. Liability Co.

    By: _____[Tom's signature]_____,

    Tom Park, LLC Member/Manager

    My understanding of the “Member/Manager” part of the example is that they’re saying to write one or the other depending whether the LLC is member-managed or manager-managed.

  7. Dana says:

    @Jesse
    Re the first quotation: The members can sign because they are managers, not because they are members.

    Re the example: “Member/Manager” means that the individual is *both* a member and a manager. That form of signature is fine, as is signing merely as Manager. What I recommend *not* doing is signing merely as a member.

  8. Jesse says:

    @Dana
    Sorry, I should have posted the full quote (below).

    This book repeatedly draws distinctions between member-managed and manager-managed LLCs, starting with this description:

    Responsibility for Managing an LLC

    Under most states’ default legal rules, all members (owners) are automatically responsible for managing the business (this arrangement is called “member-management”), unless they specifically appoint one or more members and/or nonmembers to manage the LLC (this option is called “manager-management”).

    I read the passage I quoted again, and I still believe the book is saying that they can sign becuase they are members of a member-managed LLC:

    Legal Authority of LLC Members and Managers

    Generally, the members (if member-managed) or managers (if manager-managed), or other duly appointed representative (such as an officer) of the LLC can legally bind the LLC to a contract, business transaction, or course of action, as long as the transaction is within the LLC’s normal scope of business.

    It’s safest to assume that any contract or transaction signed on behalf of your LLC by anyone in management will be legally binding.

    Caution
    If you’re uncomfortable with others obligating your business, an LLC is probably not the right business entity for you. You may want to stick to a sole proprietorship, where you have the only say, or to a limited partnership, where you can get full management authority if you are the only general partner.

    All of the passages quoted there are under the heading Legal Authority of LLC Members and Managers. The “caution” part doesn’t make sense, but that’s another story.

    Based on the way this book distinguishes between member-management and manager-management, and the way the example is introduced, I still think the example of how to sign a contract is indicating to sign either as “Member” or “Manager”, depending whether member-managed or manager-managed, but I now see it as ambiguous and open to interpretation.

    How to Sign Papers on Behalf of Your LLC

    To make sure you and other LLC members will enjoy this limited liability, members should always sign LLC papers, documents, contracts, and other commitments clearly in the name of the LLC, not in their own names.

    The best way to do this is to first state the name of the LLC, then sign your name on its behalf.

    Example:
    Tom is one of two members of Park Place Plasterers, Ltd. Liability Co. He enters into a long-term contract to refurbish apartments in a high rise condominium. Tom signs the contract as follows:

    I don’t think this book would indicate that a member of a member-managed LLC should sign as “Manager”, because I don’t think that designation is even mentioned in the sample “Operating Agreement for Member-Managed Limited Liabilty Company” included in the book. I believe all it says with reference to management is:

    Management: This LLC shall be managed exclusively by all of its members.

    The sample operating agreement for a manager-managed LLC, on the other hand, repeatedly uses the designation “manager”.

  9. Dana says:

    @Jesse
    I use the same form of Operating Agreement as a starting point for all LLCs that I form, even those that are single-member, member-managed. The reason: One never can tell whether more members might be added later, so I want my client to be as prepared as possible for that eventuality.

    The Manager is expressly identified and is given that title (as a defined term). The reason: The Operating Agreement has detailed provisions about the Manager’s duties, rights and obligations.

    I appreciate that if you are forming your own LLC, trying to minimize the cost and time required to do so, you might use a “short-form” Operating Agreement. Nevertheless, under CA law you will be a manager, even if that term is not defined in your OA (assuming that you are forming the LLC in CA, though other states have similar provisions). Please see the Sections of the Corporations Code at http://www.leginfo.ca.gov/cgi-bin/displaycode?section=corp&group=17001-18000&file=17150-17158.

  10. Dennis Doser says:

    If you can have multiple members who own units of interest, can you establish a cash value for a unit of interest and have new members buy in for that amount per unit? If, so, can you give an existing member a finder’s fee or commission or any type of cash reward for finding new members?

  11. Dana says:

    One of the great things about an LLC (as contrasted to a corporation) is that the LLC can have different members make different per-unit capital contributions for units representing otherwise-identical membership interests.

    I know of no prohibition against the finder’s fees / commissions that you have described. However, to avoid any possible allegations of self-dealing, the payments should be disclosed to, and approved in writing by, all other members and the Manager(s).