In his book, Essentials of Corporate and Capital Formation, David H. Fater identifies the corporate structures traditionally used by entrepreneurs and helps them understand which is best for their particular situation. This is part-two of a two-part article. Read the first part here.
Limited Liability Companies
A limited liability company or LLC is a legal form of business providing limited liability to its owners. Evolving from the limited partnership structure, a LLC is a hybrid structure with both the limited liability of a corporation and the pass-through taxation of a partnership. As such, it provides owners with limited liability for both the debts and the actions of the company, and it is suitable for single owner entities.
LLC owners are called members. They may be persons, corporations, partnerships, or other LLCs. Like corporate shareholders, a member's liability and distribution rights are limited to his/her capital contribution. Member ownership is referred to as membership interest, which is a portion of shares or units. Membership interests and membership rights are regulated by state law.
The day-to-day operations of LLCs may be managed by members, or a manager or board of managers, according to the LLC operating agreement. Managers are either elected or appointed, and removed by members. A member who is also a manager is called a managing member. Member-managed LLCs are governed by a single class of members - similar to a partnership - or by multiple classes - similar to a limited partnership. Manager-managed LLCs have a two-tiered management structure that more closely resembles that of a corporation, with managers having powers similar to those held by corporate officers and directors.
All LLCs are required to file evidence of their existence with the state in which they choose to organize. Additionally, LLCs create an operating agreement which determines, defines, and apportions the rights of the members and managers (if any).
LLCs are the most flexible corporate structure, making them preferable for many businesses. Their advantages include:
- LLCs may elect to be taxed as a proprietor, partnership, or corporation (either S or C).
- Members have limited liability for both the acts and debts of the LLC.
- An LLC has significantly less paperwork and bookkeeping than a corporation.
- An LLC has pass-through taxation, unless it's structured to be taxed as a C corporation.
- LLCs have a default tax classification; profits are taxed personally at the member, versus the LLC, level.
- In most states, LLCs are treated as entities separate from their members.
- In some states, LLCs may be formed with only a single individual
- LLC membership interests - and attendant economic benefits -- can be assigned without a transfer of title.
- LLC income retains its character - as capital gains or foreign-sourced income - in the hands of its members; unless the LLC has elected to be taxed as a corporation.
Disadvantages of the LLC structure include:
- Members operating an LLC without an operating agreement may run into problems
- Raising capital may be more difficult.
- Many states levy a franchise tax or capital value tax on LLCs; generally this tax is nominal compared with the tax imposed on corporations.
- Creditors may require members of new LLCs to personally guarantee LLC loans.
- The management structure of an LLC may be unfamiliar.
- The LLC structure is relatively new and many states treat LLCs as disregarded entities, which may disable the limited liability benefit of the LLC.
The corporation is the most common corporate structure and, in depending on your goals, the most logical choice.
By law, corporations have the same rights as individuals. Here are five common characteristics of the modern corporation:
- delegated management
- limited liability for shareholders
- investor/shareholder ownership
- independent legal "personality"
- transferrable shares
As a legal personality, the corporation is treated as a fictional, legal, or moral - versus natural - person. As such, corporate statutes enable corporations to own property, sign binding contracts, and pay taxes separate from those of its shareholders.
The legal personality has two economic implications:
- Creditors have priority over corporate assets upon liquidation.
- Corporate assets may not be withdrawn by shareholders or the creditors of shareholders.
- The advantages of the corporate structure include:
- Limited liability - shareholders have limited liability for the corporation's debts and obligations.
- Perpetual life - corporations live beyond the lifetime of their shareholders, bondholders, and/or employees.
- Ownership and control - individuals and other legal entities are able to exercise control by voting on corporate matters and share in the profits of the corporation.
Two types of corporations - S and C - are typically used.
- are taxed like a partnership in that they don't pay taxes; earnings/losses flow through to the owner's individual tax returns
- have restrictions regarding the number and type of shareholders
- provide limited liability for shareholders
- may have adverse tax consequences upon their termination
- are the most common form of corporation
- afford shareholders limited liability
- are the most flexible to operate and for raising capital
Of the two corporate structures available, a C corporations is the best choice for those with the goal of:
- minimizing personal risk ignoring the minimum consequences of corporate and individual taxation raising capital.
- having a structure with an easily-executable exit strategy
As may now be obvious, Fater's preferred structure for conducting a meaningful business is the C corporation, especially if outside capital will be required.