Choice of Business Entity Considerations (Part I)
By Michael D. Cross, Jr., J.D.
It is very important for business owners to operate their business through some form of business entity. Whenever an owner simply operates a business in her own name or in the name of a general partnership, she subjects herself to tremendous, unnecessary risks. In particular, she subjects all assets she holds in her name or in the partnership’s name to liability for any breach of contract, debt, accident, or injury related to the business.
For example, suppose a business owner opens her office to visits by clients and/or customers. Let us further suppose that one of the customers and/or clients accidentally falls while visiting. The accident victim then brings a lawsuit against the business for the injuries he sustained and wins. Let us further assume that the business owner’s insurance is insufficient to pay the judgment awarded to the former customer. If the business owner owns and operates the business in her own name rather then through some legally recognized business entity, the customer may collect his judgment by foreclosing on the owner’s house, car, or other personal assets.
If, however, the owner operates her business through an entity such as a corporation or limited liability company, the customer could only sue the entity. Moreover, the customer, if successful in the lawsuit, could only recover the judgment from the entity. The owner’s personal assets would be safe from liabilities of the business.
This concern regarding liability is the reason why business owners incorporate or organize a limited liability company. The law recognizes that an entrepreneur’s personal assets should not be subject to business liabilities.
So now that we have identified why business owners often should seek the limited liability afforded by incorporating or organizing a limited liability company, we must talk about the differences between them and the facts business owners use to determine which they should use.
Corporations have been the primary legal entity used to operate a business for more than one hundred years. A corporation is formed by filing articles of incorporation with the Secretary of State. A person known as an incorporator files the articles. The incorporator may be anyone, and it often is the attorney hired by the business to incorporate it. The required contents of the articles of incorporation vary from state to stare, but generally include the state the name of the corporation, the business purpose of the corporation, the number of the shares the corporation may issue, the initial principal place of business of the corporation, and the registered agent of the corporation. Upon filing with the Secretary of State, the corporation becomes a separate legal entity apart from its owners. For most purposes, the corporation is a legal “person”.
The owners of a corporation are known as “shareholders”. As shareholders, the owners generally have no right to participate in the day-to-day management of the business. As shareholders, the owners have no right to be paid. Rather, the shareholders do have the right to choose the directors of the corporation. Shareholders also have the right to receive dividends from the corporation, if and when the directors decide to issue dividends. Finally, shareholders have the right to vote on certain major actions. Shareholders must hold a meeting each year to elect the directors of the corporation. Shareholders may call additional special meetings to determine other matters.
Directors, on the other hand, are responsible for the full and entire management of the affairs and business of the corporation. Directors set corporate policy, decide whether to issue dividends, and determine when to recommend mergers, acquisitions, and sales of business assets. Directors also choose officers to manage the day-to-day operations of the corporation and carry out corporate policy. Directors must hold at least one annual meeting at which they elect the officers of the corporation.
The officers generally consist of a president, a secretary and a treasurer. The directors may appoint one person to serve as more than one office. The directors may also establish additional officers, such as chief executive officer, chief financial officer, chief technical officer, chief operating officer, or any number of vice-presidents. Each officer serves for the term of office for which she is elected until she is replaced by a vote of the directors.
While most basic corporate requirements are contained in the state law of the state in which the business was incorporated, the founders of the corporation often add additional requirements in the corporation’s bylaws or in a shareholder agreement. Generally, the bylaws set forth the guidelines that will govern the corporation. The bylaws include specific guidelines as to timing of meetings, quorum requirements, the duties of directors and officers, and the nature of the certificates showing the capital stock. Generally, all corporations have bylaws.
The shareholders of privately held corporations, including smaller companies and startup companies, often also enter into a shareholder agreement. One of the purposes of the shareholder agreement is to provide for disposition of shares upon the departure of a shareholder from the company (i.e., retirement, disability, or termination of employment). Generally, the shareholders of privately held companies are also actively involved in the conduct of the business and serve as an officer and/or director of the company. Obviously, it is very important for a small corporation, particularly one that has taken its “S” election (as will be discussed later), to limit the individuals who may become shareholders to those who are actively involved in the business. It is also important to make certain that existing shareholders remain active in the business, as the company’s ability to succeed is largely dependent on the work of its shareholders in their separate roles as employees. Accordingly, the shareholder agreement often provides that when a shareholder leaves, the shareholder must sell his or her shares to the company or to the other shareholders.
Since the shares of privately held corporations are not traded on the open market and may not have a readily ascertainable value, the shareholder agreement also provides a formula for determining the value of the shares. The formula may vary depending upon the reason for which the shareholder leaves the business. For example, the shareholder agreement generally provides a higher price for retiring shareholders then for shareholders who are fired for cause. The nature of the precise formulas used depends upon the agreement reached by the shareholder inconsideration of the type of business in which the company is engaged.
The shareholder agreement also limits the transfer of shares to individuals or entities approved by the existing shareholders of the corporation. As mentioned above, the shareholders of a privately held company often are actively involved in the operation of the company in their separate roles as employees of the company. Generally, founding shareholders do not want a new shareholder to enter the business and begin taking an active role in it without their approval, as the success of a small or startup business is largely dependent upon the ability of the individuals involved to work together.
Finally, the shareholder agreement often also includes an agreement between the shareholders as to how votes will be cast. For example, the shareholders may agree that they will vote their shares so that shareholders X, Y, and Z will be directors of the company, and that X will be president, Y will be treasurer, and Z will be secretary. It is very important for the shareholders of a privately held corporation to agree on these matters early in the corporation’s existence, before any conflict or disagreement exists regarding these matters. This allows the founders of the corporation to focus their efforts on growing the company rather then on internal matters.
Limited Liability Companies
Limited liability companies, or LLCs, are organized in a manner similar to corporations. LLCs are formed upon the filing of articles of organization with the Secretary of State. The articles are filed by an organizer, and the articles vary from state to state )just like with corporation), but generally include the name of the LLC, the business purpose of the LLC, the principal place of business of the LLC, and the duration of the LLC (i.e., perpetual or for a limited time). The articles may also state whether the LLC shall be managed by its members or by managers, as will be described later.
LLCs are somewhat new, having become prominent only in the past decade. While the LLC laws of the various states are often similar, it is important to consult with an attorney regarding the specific provisions of the state in which the LLC is organized. This is extremely important if the LLC is to have only one owner. Only about one half of the states recognize single member LLCs, although many state legislatures are changing their LLC laws to allow single member LLCs. It is absolutely critical to make certain the state in which the LLC is to be organized allows single member LLCs before creating one.
Conceptually, an LLC with multiple members can be very similar to a partnership. The owners of the LLC are known as “members”. If the LLC is “member-managed”, then each of the members has an equal right to participate in the management of the company, unless the members otherwise agree. For example, the members may agree that the value of each member’s vote is related to that member’s percentage ownership interest in the LLC. Often, the members appoint one of the members to serve as the managing member, and delegate to the managing member certain administrative duties. These duties may include hiring employees, maintaining bank accounts, maintaining the LLC’s financial records, preparing and filing tax returns, and filing any reports required by the Secretary of State.
The members of an LLC may also be employees of the LLC and receive compensation for the services they provide. Once all expenses have been determined, the members of the LLC then share in the company’s profits. The default rule is that the members share in the profits and losses of the LLC in accordance with their ownership interest in the LLC. For example, under the default provision, if members X, Y, and Z all contribute $10,000 to the LLC, then each would be entitled to 1/3 of the profits and losses of the LLC. In the above example, the members may agree to accept the $10,000 contributions in any form. Member X may contribute $10,000 in cash, Member Y may contribute $10,000 in real property, and Member Z may contribute $10,000 in equipment.
The members may also agree to contribute varying amounts toward the initial capital of the company. X may contribute $5,000, Y may contribute $10,000, and Z may contribute $15,000, in which case under the default rule they would have ownership interests of 1/6, 1/3, and 1/2, respectively. The members may also agree that despite unequal contributions, they wish to allocate the LLC’s profits and losses equally. Members sometimes do this when the members expect each other to contribute varying amounts of services to the company.
Generally, members may also allocate profits in one manner and losses in another. This is often done when one member contributes depreciable property to the LLC as her initial capital contribution. For example, the members may agree that they will allocate to Member Z all depreciation deductions associated with the capital asset she contributed. Though the IRS does impose some restrictions on such allocations for tax purposes, generally the members may agree to allocate and distribute profits and losses in any manner they wish so long as the allocation has substantial economic effect, as defined in the Internal Revenue Code and tax regulations. The above paragraphs generally describe a member-managed LLC, however, the members may also agree that the LLC will be “manager-managed”. Such an arrangement is very similar to operating a business in the corporate form. In such a situation, the members of the LLC elect managers to tend to the day-to-day operation of the LLC. Essentially, if compared to a corporation, the members’ role and duties in such a situation would include both those of shareholders and of directors. The managers’ duties would be very similar to those of corporate officers.
The managers in a manager-managed LLC may be members or may be outsiders. For example, suppose a group of investors form an LLC to own a hotel, and they enter into a franchise agreement with a large hotel chain. The members of the LLC may not have sufficient knowledge as to how to run the hotel from day to day. Accordingly, the LLC may enter into an agreement with the hotel chain whereby the hotel’s management company manages the hotel in accordance with the members’ instructions and the contract between the LLC and the hotel chain.
Members sometimes choose to operate as a manager-managed LLC for other reasons. Investors often become members of an LLC to invest in a certain type of investment, relying largely on the talents of one or more members. Such an arrangement is very similar to the notion of a limited partnership, where one or more general partners run the business, and one or more limited partners simply supply capital without the right to participate in the management of the company.
The above examples illustrate one of the primary attributes of the LLC – flexibility. The members may decide how to treat the above issues by entering into an operating agreement. The operating agreement sets forth how the members will vote, how the LLC will allocate profits and losses, when the LLC will distribute money to its members, and the process by which a member may transfer his or her ownership interest and receive compensation for it. The LLC’s operating agreement serves the purposes of a corporation’s bylaws and shareholder agreement, but it does so in one document. The above examples, however, address only organizational and operating aspects of the LLC form without addressing the impact of tax issues, which are discussed in a separate article.
The above discussion is merely an overview of the factors to be considered when determining the appropriate legal form for a new business and is not meant to provide legal advice to anyone regarding the proper form of business entity, although almost every business owner should operate his or her business as either a corporation or limited liability company. Regardless, the above discussion does not provide sufficient information upon which to base the choice of appropriate legal form. The discussion is meant only to supply an overview of the types of factors to be considered, and it does not take into account the specific laws of any state, nor does it address state and local tax issues. Choice as to the proper entity should not be made without discussing the business’ specific objectives and method of operation with legal, tax, and accounting professionals.
The information you obtain at this site is not, nor is it intended to be, legal advice. You should consult an attorney for individual advice regarding your own situation.