LLC Termination vs. Dissolution: Understanding the Difference

LLC termination and dissolution both signal the end of a startup. Although these terms are sometimes used interchangeably, according to the law, they have different meanings. 

As a startup founder, knowing the main differences between termination and dissolution is critical to preserving your reputation, protecting your assets, and avoiding the legal and financial consequences of a botched-up startup shutdown.

In this article, you will learn:

• What LLC dissolution and termination mean and how they differ.

• Why startup founders terminate or dissolve an LLC.

• A step-by-step guide on how to shut down a startup.

• The most common startup closure mistakes founders make and how to avoid them.

What is LLC Dissolution?

An LLC dissolution occurs when a startup decides that it no longer wants to do business and starts winding down. Sometimes, the decision to dissolve a company is enforced by a court (for reasons we will discuss later). The process involves settling debts and liabilities and distributing remaining assets to stakeholders. 

What is LLC Termination?

An LLC termination follows company dissolution and is the final act, i.e., the LLC ceases to legally exist after it resolves its debts and files the necessary paperwork with the state. 

The main difference between the two is that a dissolution is when a startup initiates business closure, meaning that the company continues to exist until the dissolution process is complete. While the process is ongoing, the LLC can still perform essential tasks like:

• Sell assets to raise cash for debt settlement purposes.

• Distribute remaining funds to members (in order of importance and as stipulated in the operating agreement).

• Complete necessary legal and/or tax filings.

Once these tasks are completed and the paperwork is filed, the LLC's legal existence ends and it is terminated.

Reasons for Dissolving or Terminating an LLC

The reasons for dissolving or terminating an LLC could either be voluntary or involuntary. Let’s explore both.

Voluntary LLC Dissolution or Termination

Achieving Business Goals

Sometimes, a startup is formed to achieve a specific target, whether to develop and scale a successful product (and sell the company down the line) or operate for a limited duration to capitalize on time-sensitive opportunities. Whatever the case, once these goals are achieved, the founders may choose to dissolve the company.

A real-world example:

Beats Electronics is a well-known example of a startup that achieved its business goals and then dissolved. The company was founded with the specific objective of developing and selling high-end audio equipment. 

After achieving significant market success, Beats was acquired by Apple for $3 billion in 2014. While Beats initially operated as a separate brand under Apple, it was eventually integrated into Apple's product line. This resulted in the dissolution of the original Beats Electronics LLC.

Merging with Another Company 

Two LLCs in similar fields might decide to merge and create a stronger entity. This often involves dissolving the original LLCs and forming a new one.

A real-world example:

In 2018, "T-Mobile US" and "Sprint Corporation," two major telecommunications companies, merged to form "T-Mobile". Both T-Mobile US and Sprint dissolved to establish the new company, which later went on to become one of the largest wireless carriers in the United States.

Members Deciding to Part Ways 

Founders may choose to dissolve their LLC in light of frequent disagreements, changes in personal circumstances, or the desire to move on. The operating agreement usually outlines how the startup shuts down in such circumstances.

A real-world example:

Rdio, a music streaming service founded in 2010, faced internal conflicts among its leadership regarding strategic direction and financial management. As time passed, these disputes hindered the decision-making process and caused Rdio to lag behind its main competitors, Spotify and Pandora. After years of ongoing internal issues and struggling financially, Rdio filed for Chapter 11 bankruptcy and was eventually acquired by Pandora, leading to its dissolution.

Financial Losses 

If the startup consistently loses money and has no real path to profitability, the best course forward might be to dissolve instead of incurring more debt.

A real-world example:

Boosted, an electric skateboard company that expanded into scooters, dissolved in 2020 due to financial struggles. Despite the high quality of its products, Boosted faced high production costs, logistical issues, and stiff competition. These challenges – combined with supply chain disruptions during the COVID-19 pandemic – worsened its financial standing. 

Boosted ceased operations after it could not secure additional funding or find a buyer. The case is a prime example of how a company can struggle to remain profitable despite having a solid product, especially within super-competitive niches.

Involuntary LLC Termination or Dissolution

Court-Ordered Dissolution

A court can order an LLC to forcefully dissolve due to one or more of the following reasons:

• Fraudulent activity: Includes embezzlement, using company funds for personal use, or falsifying financial records, all actions that severely damage an LLC's financial health and reputation and can prompt a court-ordered dissolution to protect creditors and the interests of honest members.

• Unending deadlock between members: Continual disagreements can deadlock the decision-making process and grind operations to a halt. Without a viable solution in sight, a court might have no other choice than to dissolve the LLC to prevent further losses and facilitate a proper division of assets.

• Lawsuits leading to insolvency: If an LLC faces significant lawsuits resulting in hefty settlements, it might become insolvent (i.e., unable to pay its debts). What usually follows is a court intervention and dissolution to ensure creditors receive fair compensation and to prevent further financial damages.

• Breach of fiduciary duty: LLC members have a fiduciary duty to act in the business's best interests. If a member prioritizes personal gain over the LLC's well-being, like entering into self-dealing transactions, a court might order a dissolution as a consequence.

• Violating safety regulations: In some cases, repeated violations of safety regulations, especially those leading to accidents or injuries, can result in court-ordered dissolution. This protects the public from further risk.

Administrative Dissolution by the State

Every state requires LLCs to file annual reports and pay fees. Ignoring this duty for an extended period can prompt the state to administratively dissolve an LLC. Generally speaking, the process is reversible if the fees are paid and filings are made within a specific timeframe (varies by state).

Note: For a more in-depth explanation, check out this blog on voluntary vs. involuntary company dissolution.

Steps to Dissolve and Terminate an LLC

Doing justice to the topic of dissolving or terminating an LLC requires a separate blog (here’s one if you’re interested). But if you’re short on time and want a quick run-down, these are the steps you should follow:

• Review the operating agreement: This is crucial because the operating agreement outlines specific procedures or voting thresholds required for dissolution.

• Hold a vote among members: Unless the operating agreement states otherwise, a majority vote by members is needed to dissolve the company. 

• File articles of dissolution: This document, filed with the state where the LLC is registered, initiates the dissolution process.

• Notify creditors and settle debts: The LLC must notify creditors of the dissolution and settle any outstanding debts before distributing assets.

• Distribute remaining assets to members: After settling debts, any remaining assets are distributed to members according to the operating agreement or state law.

• File final tax returns and obtain tax clearance: The LLC needs to file final tax returns and obtain clearance from the IRS before termination.

• File articles of termination or certificate of cancellation: This final filing with the state officially terminates the LLC's legal existence.

While you're preparing to shut down your startup, it’s equally important to avoid common pitfalls.

Common Mistakes to Avoid During LLC Shutdown

Failing to Properly Notify Creditors

The consequences: Creditors you haven't notified can still come after your personal assets for unpaid debts, even after your LLC is dissolved. 

How to avoid it: Send certified mail notifications to all known creditors informing them of the dissolution and the last date to submit their claims.

Not Distributing Assets According to the Operating Agreement

The consequences: Members can sue if assets are not distributed as outlined in the operating agreement, which can lead to legal fees, delays, and bad blood.

How to avoid it: Review the operating agreement's provisions on asset distribution. If there's no clear provision (or an operating agreement to begin with), follow the state law that governs asset distribution to ensure compliance. 

Neglecting to File Necessary Paperwork with the State

The consequences: The LLC remains legally active even after dissolution if you don't file the proper paperwork (resulting in potential liabilities!).

How to avoid it: File the required articles of dissolution (sometimes called cancellation) or similar documents with the state where your LLC is registered. Each state has its own requirements, so research the specific process.

Skipping the Tax Clearance Process

The consequences: The IRS may stop you from closing your LLC's tax account and impose penalties if final tax returns aren't filed or outstanding taxes remain unpaid. This can prevent you from obtaining a Certificate of Good Standing, which is crucial to carry out certain business actions.

How to avoid it: File final tax returns for the LLC and settle any tax liabilities. Obtain clearance from the IRS before going ahead with the termination.

A Recap & How SimpleClosure Can Help

Distinguishing between LLC termination and dissolution is vital to protect your assets and reputation, steer clear of legal and financial complications, and make the best of a stressful situation.

As you prepare to shut down your LLC, why not consider a more streamlined approach, one that’s considerably more affordable and faster than traditional service providers? 

SimpleClosure leverages AI, legal tech, and years of experience to expedite the startup closure process with little to no effort on your behalf. 

Reach out today and let’s talk.