As any business owner knows (and as any business lawyer will advise) one of the first steps to getting your business up and running is to form a legal entity from which the business shall operate. As part of that step, the business owner must determine which type of business entity best suits their needs from a legal, tax, and operations perspective.
Though many people are familiar with corporations and partnerships, all entrepreneurs and small business owners should be aware of the limited liability company, commonly referred to as an LLC, as a legal business entity. Because it fuses some of the more attractive features of a corporation with that of a partnership, an LLC often is the ideal entity for closely-held businesses.
The owners of a properly established LLC (called “members”) will generally not be held personally liable for the debts or obligations of the LLC. Instead, similar to stockholders in a corporation, the maximum liability exposure that the members will have is the risk of losing their individual investments in the LLC.
Ensuring that the owners of a business are afforded limited liability protection is a critical aspect of the business formation process, and is one of the main reasons why businesses choose to be formed as an LLC or corporation as opposed to a general partnership or sole proprietorship that carries unlimited liability.
One of the most disadvantageous aspects of some corporations is that they are generally subject to two levels of income taxation: the corporation is taxed on the income it earns during a given tax year and the stockholders of the corporation are taxed when the corporation elects to pay out dividends.
In contrast, LLCs are treated as “pass-through” entities for tax purposes, and are therefore subject only to a single level of income taxation. Like a partnership, the tax liability arising from income earned by the LLC in a given tax year is paid by its members in proportion to their percentage ownership of the LLC. The members are not later taxed when that income earned by the LLC is later distributed to the members.
Though a corporation can opt to be subject only to a single layer of income tax similar to an LLC or partnership (by electing to be treated as an “S-corporation” by the Internal Revenue Service (IRS)), the IRS restricts the number of stockholders, no more than 100, the type of stockholders (individuals only), and the classes of stock (one and only one) that an S-corporation can have in order to receive the benefit of single-level taxation. LLCs benefit from single-level income taxation without any such restrictions on ownership.
Minimal Administrative Formalities
Corporations are required by law to maintain a board of directors to manage the corporation and to oversee the actions of the officers through board meetings. LLCs, on the other hand, may be managed by one or more managers who are often the member-owners too.
Because LLCs are a creature of contract (i.e., they are governed almost exclusively by the LLC’s operating agreement), a well-crafted operating agreement can eliminate the requirements of formal meetings between the same person wearing “two hats”.
In addition to the need to hold meetings of the board of directors, corporations are required by statute to (a) hold annual meetings of the stockholders, (b) issue proper notice to each stockholder of stockholder meetings, (c) issue stock certificates to stockholders, (d) maintain a corporate ledger book and (e) adhere to numerous other formalities that can be onerous in terms of time and impractical for small businesses.
Furthermore, directors of a corporation are subject to fiduciary duties that can be altered and, in some cases, eliminated entirely with respect to the managers of an LLC. Thus, LLCs have far fewer administrative formalities to keep track of and are not required to hold formal meetings of the members or to deliver certificates to the members representing their respective LLC interests.
Granting Equity to Key Employees
Many small businesses seek to grant equity to key employees as both a retention and performance incentive. When properly structured LLCs, unlike corporations, allow for the issuance of profits interests, or the right to the future profits of the company, on a tax-free basis.
This can be done without the employee having to make a cash payment, the LLC or the employee realizing immediate tax liabilities or the LLC relinquishing voting or ownership control of the business. In fact, an LLC’s ability to grant profits interest to its key employees on a tax-free, cashless basis with all of its other characteristics makes it the entity of choice for most closely-held entrepreneurial operating ventures.
Lastly, while most venture capitalists prefer their portfolio investments to be formed as corporations, LLCs are no longer viewed with as much trepidation by most institutional investors who appreciate LLCs’ benefits and also acknowledge that substantial case law involving LLCs has developed over the past 25 years since LLCs were first codified into the law.
The items discussed above are only some of the reasons why an entrepreneur should consider forming a small business as an LLC. However, each small business owner should consult with a business attorney to determine the best path for his or her business.
Related CLE Course: Negotiating and Drafting LLC Agreements in the District of Columbia, 3.0 Credit Hours. Click here to register!