As discussed in our articles on engaging in business in the United States, it is usually wise to create an entity that can limit the liability the owners face if things go wrong. See our article Business Startups While Protecting Your Assets and Basic Summary of Characteristics of Various Types of Business Entities as well as The American System of Business-Limited Liability Entities. As discussed in those articles, the types of limited liability entities normally available are corporations, limited partnerships and limited liability companies.
Limited partnerships are often used in real estate developments and other limited business ventures, such as owning and maintaining certain real estate. They are seldom appropriate for long term business operations. The two entities normally utilized for broader business operations are corporations and limited liability companies. For corporations, please see our article, Why Use The Corporate Structure. This article shall discuss the basic characteristics and some of the benefits and detriments of utilizing a limited liability company rather than a corporation for your business needs.
The Basic Characteristics of a Limited Liability Company (“LLC”) in California:
Since the 1990s, individuals who wish to form businesses have seen a significant increase in the types of business entities that may be formed. Laws governing these newer forms of businesses limit the liability that business owners may face. In general, a person who invests in a limited liability entity is only liable for an amount equivalent to the investment made by the investor.
Some limited liability entities resemble general partnerships, except for the limitations in liability. Other entities, especially limited liability companies, are akin to corporations in their structure. Although some entities are taxed in a manner similar to partnerships, other forms of limited liability entities may be taxed as corporations are.
It is important to recall that engaging in business using structures other than the three above does not allow limited liability. Owners of sole proprietorships and/or partnerships are not protected by the limited liability that the other business forms offer. An owner of such a business is personally liable for the debts incurred by the business. The unlimited liability entites include general partnerships, joint ventures, and sole proprietorships. General partnerships are formed when two or more agree to engage in a business for profit. A joint venture is similar to a general partnership, except that two or more people form a venture for a particular business project. A sole proprietorship is a business that is simply owned and operated by an individual. The law traditionally has not treated these types of business as independent and distinct from the owners either in terms of liability or tax exposure. Owners of these types of business also do not need to follow the formalities that owners of other forms of businesses, such as corporations, must follow. Such informality attracts many entrepreneurs who, after creation of the business do not even think again about the structure absent sale, removal of a member, or dissolution. The problem is that unlimited liability puts all of their assets on the line if things go wrong and tax planning, which is critical if things go well, is made much more difficult without a separate taxable entity, such as a C corporation.
Although limitations on liability provide considerable incentive to form a limited liability entity, other factors may lead business owners to form an entity that does not enjoy limited liability. The most usual factor is that new business owners put the issue of potential liability aside and concentrate on the mechanics and numerous obligations that commencing a business requires. The decision to create a limited liability entity is put off to a day when the owners feel they can afford the legal and tax costs more easily…and often one is never formed before it is needed.
This writer had one restaurant owner client who worked fifteen hours days for two years establishing a restaurant that finally prospered and had called to make an appointment to consider incorporating when one of his delivery vans hit a pedestrian while has employee was intoxicated. He had insurance…one million dollars worth. Sadly, the injuries cost far more than that and without a limited liability entity to limit his exposure, the client faced utter ruin. We were able to settle the case for the insurance limits (the injured party was contributory negligent) but the client thereafter immediately formed a corporation and put a sign on his desk which read, “The Time to Begin to Protect Your Assets Is Before You Have Them.” The United States is a nation famous for its love of litigation. Most litigation involves businesses. If you are moving into that world, protect yourself. Get sufficient insurance and form a limited liability entity. The sooner…the better.
Limited Liability Companies (“LLC”) as the name implies have the limited liability that a corporation has but are usually far less formal in the creation and use of the documents concerning operations. While this is discussed further below, the critical factor to understand is the benefit of such limit to the risk the entrepreneur and owner undertakes if the limited liability structure is used.
The distinguishing feature of limited liability entitles is the limited liability to the owners. Many entrepreneurs opt for a limited liability model of enterprise for greater protection of personal assets while still taking the risk of being in business. If they can avoid granting personal guaranties for the debts of the limited liability entity, they may retain the security of knowing their own assets are not subject to the vagaries of the business. In certain instances, a lending institution or vendor may ask the members, or the head of the company to personally guarantee the loan or account in the absence of any financial history or major assets in the company. Such an act eliminates for that debt the protection of limited personal liability for the guarantor. But note that the personal liability would be only to the guaranteed party, in this case the bank or particular vendor, and the limited liability would apply to all other creditors who do not have the guaranty.
Tax Treatment:
While both corporations and limited liability companies have limited liability, the tax treatment of the two entities can differ if the owners elect.
Corporations are taxed in one of two ways, depending on the type of corporation that has been structured. A “C Corporation,” also known as a standard business corporation, is an entity that is taxed separately from its owners. Dividends that are passed on to shareholders of the corporation are often also taxable, thus that income received by a corporation may be taxed twice. Another type of corporation, known as an “S Corporation” is considered to be a “pass-through” entity with respect to taxation. The corporation itself is not taxed, and profits and losses are passed down as income or losses to the owners of the corporation. An S Corporation is taxed in a manner similar to a partnership, which is also treated as a pass-through entity.
When new forms of business entities such as LLCs began to emerge in the 1990s, taxation of the entity was a major consideration. Limited partnerships and limited liability partnerships were classified as pass through entities. However, the Internal Revenue Service (IRS) had some difficulty in determining how an LLC should be taxed. Under regulations that existed prior to 1997, if an LLC was operated in a manner akin to a C Corporation, then the LLC was taxed as a corporation. However, the IRS changed its regulations in 1997 to allow an LLC to select how it should be taxed. Since the passage of those regulations, LLCs have been free to operate in a manner similar to corporations, but these LLCs may elect to be taxed like partnerships. This is a major advantage for LLCs and with the right tax advice, that structure is attractive to many business owners. Before electing that option, good advice from a qualified CPA is highly recommended.
Formalities:
The formal corporation normally must create annual minutes of meetings and place them in a minute book for future reference. It has a formal structure created in the bylaws, normally shareholders, a board of directors and officers. Its bylaws are adopted for rules as to how the entity runs, a board of directors makes strategic decisions and elect the officers who run operations and all of whom are ultimately controlled by the shareholders. Annual meetings are normally held in which the shareholders elect the directors and the directors elect the officers who operate the company day to day. Share certificates are formally issued and delivered to the owners.
An LLC need not have any of those characteristics. Instead, the LLC creates an Operating Agreement that is executed by the Members who own interests in the entity. The Operating Agreement can vary widely in its terms and most of them provide for a manager who runs the day to day operation of the company, determine how profits and losses are to be disbursed and provide for how interests may be transferred. The Operating Agreement takes the place of the bylaws and often does not provide for formal elections, issuance of shares, etc. etc.
Any experienced law office will have its own forms for various types of LLCs that can be created and that will be in conformity with the law of the State of their creation. It is the freedom, within specified limits, to create the formality or informality of the LLC structure that appeals to many business people and which leads to the LLC being a popular form of business structure today.
Piercing the Limited Liability Entity:
Under the law governing corporations, where an owner or owners of a corporation use the corporate form of business to engage in fraud while hiding behind the shield of limited liability, a court may hold the owners of the corporation personally liable to a third party. This is referred to as piercing the corporate veil. Since partners in a general partnership or sole proprietorship owner are personally liable for the debts of the partnership, this theory of liability did not apply to entities other than corporations.
Because these new limited liability entities shield owners of businesses from personal liability, courts have ruled that the piercing-the-veil theory can apply to LLCs and LLPs. This theory would apply only in narrow circumstances, such as where owners of an LLC or LLP fail to follow proper formalities in forming or running the business, or where the business entity is being used to perpetuate fraud. The typical situation is “looting” the assets of the corporation or LLC. See our article on Piercing the Corporate Veil.
If one commingles corporate or LLC assets with one’s personal assets or treats the entity as merely an adjunct to one’s own personal assets, one risks a creditor which is unpaid seeking to pierce the veil. Such cases go before a Trier of fact, a judge or a jury, with the burden of proof being on the claimant.
Owners and managers of limited liability entities are never necessarily completely shielded from personal liability. For instance, laws that govern these types of entities do not generally shield owners or managers from liability for torts (fraud; embezzlement; violation of various hazardous materials statutes, etc.) that are committed while the person is acting on behalf of the business. Whether a business owner or manager is shielded from liability with respect to his or her involvement in the business depends on the type of limited liability entity and the individual state law that governs that type of entity. Note that in California, the state adopted the 1997 version of the Uniform Partnership Act, including provisions governing limited liability partnerships.
Practicalities:
Most business people believe that the simpler a process is the better and they are usually correct. Most want a structure with limited liability and do not want to have to think about the structure again unless the entity is sold or needs to be dissolved. Thus, LLCs which do not need minutes, elections, etc. strike them as an excellent choice. That is often the case.
But our office has discovered that the “trouble” of an annual meeting of owners occurring once a year takes perhaps three hours a year to accomplish, including drafting the minutes, and is an excellent way to force the owners to meet and confer as to long range goals and accomplishments. Such meetings can occur over the telephone and need not be very formal affairs.
There is also a tremendous advantage in having formal meeting minutes and a minute book. If anyone ever does try to pierce the corporate veil, alleging that no one treated the entity seriously and that it was a nullity, having ten years of minutes in a minute book, with minutes signed by the officers years before the creditor was owed money, is a very powerful piece of evidence to put before a judge or jury.
Thus, we normally advise clients that the corporate form is an excellent choice unless one wants pass through taxation. Sub S corporations also have pass through taxation but the IRS has placed numerous restrictions on Sub S corporations in terms of structure and ownership. The LLC provides that tax treatment without those restrictions and is an attractive alternative to seriously consider.