The beauty of a Limited Liability Company is in its flexibility and simplicity. With this vehicle, business owners may easily set up their ventures with lower costs, less time, and far fewer questions through which to wrestle. Combine that with certain tax elections, and small businesses can get off the ground with a relatively light burden.
However, the simplicity in the beginning leads many a business owner to believe they can forego necessary care and diligence—business meetings held in the car or at a restaurant; proposals written down on napkins; distributions and salaries sealed only by a handshake.
None of us would like to believe that we would one day field a lawsuit over a passion project. “He’s my best friend since freshman year of college, and we’ve always had an understanding!” “She’s my sister, and we just wouldn’t handle things like that in our family.” Sadly, many disputes can, and do, still arise in business, even with the best of intentions.
In the good times, everyone is focused on growing a business—increasing sales, developing a product or service, expanding the rolodex, and generally doing the things that draws one to the work in the first place. However, when the…. not so good times come, everyone dives for the paperwork. And all too often it is lacking.
In one Texas case[i], two cousins and a college friend started a number of businesses together. Filing the required documentation to start an LLC seemed simple enough. They listed the three of them as the governing persons.[ii] After that, they could focus on making money, right? Cheers!
But then troubles came a year later. Two of the three began to carry on the business without the third’s involvement.[iii] At this point the two drew up Company Agreements for their various businesses.[iv] By this point they articulated a 50-50 split in membership interests, leaving the third initial governing person out of the picture.[v] However, the third testified in court to having contributed around $10,000 to the business, by which he claimed to be entitled to a distribution of a third of the profits.[vi]
The First Court of Appeals in Houston looked to the Texas Business Organizations Code (“TBOC”), which governs LLCs in Texas. The court reasoned that these statutes require “a limited liability company to include a statement of the amount of cash contributions made by each member and a statement of the agreed value of any other contribution made by each member in the written records of the company and that these records establish the allocation of a member’s share of the profits and losses of the company.”[vii] Because the business had no record of the third person’s contributions that he made to the LLC, the court concluded that he presented no evidence that he is entitled to one-third of the profits of the LLC.[viii] Citing TBOC Section 101.501, the court held that the profits and losses are allocated on the basis of the agreed value of the contributions made by each member, as stated in the company’s record.[ix]
Of course, the company of subject lacked these records. As this case shows, your rights to the fruit of a business are only as real as the paper kept therein.
Not only was he not entitled to profits, but he wasn’t legally a member of the company. The court made clear that a “member” of an LLC is “a person who is a member or has been admitted as a member in the limited liability company under its governing documents.”[x] Providing an important refresher on corporate formalities, the court went on to explain that Texas law requires “each filing entity, including limited liability companies, [to] keep ‘books and records of account,’ ‘minutes of the proceedings of the owners or members,’ ‘a current record of the name and mailing address of each owner or member of the filing entity,’ and ‘other books and records as required by [respective statute].’”[xi]
In our office, we talk to a lot of companies that are lacking some element of these. Most situations require an easy fix—documenting a transfer, memorializing an agreement, or even simply obtaining a signature. Of course, you want to take care of the easy fix before it becomes a difficult conflict.
Starting a business from scratch is hard work and consumes a lot of your time and resources, but the risks involved are not something to shrug off. Maintaining business formalities is an important aspect of all business ventures, especially when seeking to benefit from legal protections. Despite not being required to maintain the same amount of records and submit reports as, say, a corporation, LLC owners are still wise to maintain corporate formalities, at the very least those required by law.
Whether you are an established business in need of a records tune-up or a budding entrepreneur looking for guidance on where to start, Carpenter & Croft can help make sure your records are in top shape. Stay focused on growing your business, and let us help you protect it with the right paper. Give us a call at (254) 300-7909. We would be happy to help.
[i] Sohani v. Sunesara, 546 S.W.3d 393 (Tex. App.—Houston [1st Dist.] 2018), aff’d, 608 S.W.3d 532 (Tex. App.—Houston[1st Dist.] 2020).
[ii] Id. at 398.
[iii] Id. at 399.
[iv] Id. at 400.
[v] Id.
[vi] 546 S.W.3dat 397, 400.
[vii] Id. at 407.
[viii] Id. at 408.
[ix] Id. at 406 (emphasis in original).
[x] Id. at 404 (quoting Tex. Bus. Orgs. Code § 1.001(53)(A).
[xi] 546 S.W.3dat 405 (quoting Tex. Bus. Orgs. Code § 3.151(a).