101 Series: Entity Selection: Limited Liability Companies - Daniel Ross & Associates

Millions of entrepreneurs choose to start their new business as a limited liability company. Without being hyperbolic, LLCs are generally the superior entity form for most for-profit small businesses in terms of flexibility and functionality.

LLC laws really do cherry pick from the best of other business formations; the limited liability status of a corporation coupled with the relaxed formalities and tax benefits of a partnership make it next-to-ideal for owners who want to work in the business rather than on it. The trade-off for operational agility is in sometimes-limited investment and valuation capabilities, which we’ll delve into.

This dynamic between easy function and accessible funding highlights the different priorities of an LLC and a corporation. It also illustrates an important lesson in the company lifecycle: you can outgrow your business form! And no, that’s not a bad thing; limited liability companies can be converted to corporations (but not the other way around) when the time is right. So it’s important to develop an intelligent business model and grow in a sustainable way. Choosing the right business formation is just the first step.

The Benefits Of A Limited Liability Company

Whether you’re a first-time business owner or a serial entrepreneur, money is likely tight, staff is likely sparse, and time is at a premium. Statutory LLC rules address each of these stressors.

Tax Benefits

Limited liability companies borrow a page from partnership tax law. Like partnerships, LLCs employ what is known as “pass-through taxation,” which allows you to declare your share of LLC profits on your personal tax statement – as well as deduct any losses that may incur.

Not only does this streamline the tax preparation process and cut down on forms (and accounting fees), it saves business owners from the alternative: double taxation. This tax structure is typical of corporations, where income is taxed once at the entity level when the company profits and once at the personal level when the owner claims his or her share of those profits.

Now, unless your company plans to distribute dividends at a high clip (which means you anticipate rapid growth or none at all), the difference between double taxation and pass-through taxation may be negligible. This is especially true considering that profits from an LLC are generally subject to self-employment tax.

Function Over Formality

Formality requirements were established for corporations in order to set a minimum standard for claiming limited liability status. The strictures of corporate formalities reflect the complexity of corporate law – necessarily so because corporate ownership interest may be publicly traded and must be highly regulated.

The need for formalities diminishes significantly when your company is – and can only be – privately owned, as with an LLC. LLC members (i.e. owners) are accountable only to their private business partners and clients, not the public at large. For this reason, LLC formalities have been reined in significantly. There are some surviving LLC formalities which we will discuss at length in a forthcoming post – but suffice to say, LLCs afford far more freedom to their owners.

This freedom begins in the establishment and rule-drafting process. There are very few public filing requirements to register an LLC. Noticeably exempt from this requirements list is the company’s operating agreement – essentially its “rulebook.” Where a corporation’s public bylaws are inundated with compliance measures, private operating agreements can be crafted with expedience and functionality in mind.

And unlike corporate ownership (shareholders) and management (directors, officers, and employees), which ideally must be separated, LLC members are free to both manage the business and own interest. Roles in an LLC are more fluid and allow for greater oversight by the people most invested in the company, which can be integral in the start-up phase.

The Veil Of Limited Liability

Now to the heart of LLC appeal. It would not be an overstatement to say that without limited liability those involved in a business – even passive investors – put their financial lives at risk. This is true because there is no barrier between company assets and personal assets when a company debt is owed or liability is incurred.

Limited liability is a risk management tool; it allows owners and investors to define their level of exposure – to limit their liability to the amount they invest in the company. If the business tanks, their investment vanishes but their personal assets remain intact, unreachable by creditors and claimants. It’s very much like gambling: you risk the chips you bet, but the house can never take what’s tucked in your wallet.

But limited liability is not an absolute right; in fact it’s very much a privilege. Formalities are given due attention because they are necessary for maintaining limited liability status. When a company fails to adhere to legal formalities, the limited liability veil may be pierced, exposing the violating actor(s)’s personal assets and potentially exempting business insurance coverage. So although LLCs enjoy reduced formality requirements, it is imperative to observe those that apply. We’ll talk more about this in our formalities checklist article.

The Drawbacks Of A Limited Liability Company

We’ve touched on several minor drawbacks as they came up in our benefits discussion above. The remaining disadvantage of a limited liability company in comparison to a corporation is its investment limitation, and it’s quite a glaring one.

Problems With Ownership Interest

To be clear: there is no public market for LLC shares. That doesn’t mean that LLC ownership isn’t saleable, just that equity transfers are more difficult to achieve. Without a public trade platform like the New York Stock Exchange and the meticulous regulations that come with public trade, finding investors takes substantial effort, and so does valuation.

Valuation in particular presents an issue when LLC members are given equity options or there is a buyout clause in the operating agreement. These situations may require an independent audit to value the company as a whole in order to assign individual value to the shares that will be transferred. It’s time-consuming and expensive – even more so if the company fails to keep good financial records.

Affecting Investors

So we can see that public trading is a simpler option for investors. Not only is there objective pricing, there’s an active market for shares if and when an investor decides to sell. Because of this, an LLC can be riskier; investors are more often “married” to a private company than a public one. So if an investor does decide to play, he or she will likely ask for a more favorable return.

When an LLC conducts interstate commerce (business in multiple states), sometimes investors become subject to income tax in multiple states. This obviously varies by state, but if your LLC operates an online store, you should take special note of this nuance; income tax and accounting fees can add up for an investor.

And sometimes, investors simply can’t invest in LLCs in good conscience. Any investment group with a tax-exempt partner will inevitably shy from a company with pass-through taxation because the business income may affect their tax-exempt status. These investors won’t – nor should they – risk such a thing.

There are many considerations, even when there is a clear winner for your business. So be thoughtful, folks!

Keep an eye out for our next post discussing C and S Corporations; and if you haven’t yet, consider subscribing to DR&A updates.

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