There are changes coming to any business operation that is currently taxed as a partnership in the United States. The concept of the “tax matters partner” is being done away with in favor of what is called a “partnership representative.” Read more
I’m going to be posting a number of posts on the ins and outs of electing and operating a corporation which elects to be taxed as a small business corporation (an “S Corp”) with the IRS. There are many benefits to such an election, but there are also pitfalls that many owners run into that could jeopardize the election.
The first post in this series is simply how to make the election. Read more
If you are one of those people who is tired of having to form seperate entities (LLCs or corporations) for each type of business you operate, or for each piece of real estate that you own, a Series LLC may be useful to you. Nearly a decade ago, the state of Delaware introduced a legal entity that would become known as the Series LLC. Despite its origins in Delaware, several other states have now started to permit the usage of Series LLCs. Read more
There are a lot of small businesses out there operating as sole proprietorships, that is they operate the business through the individual(s), and there is no formal entity. Many sole proprietors tell me that they’ve filed a d/b/a with the local county (here, the counties of Onondaga, Tompkins or Monroe), and therefore believe that is all they need to ensure that they are not personally liable, but this is not correct.
The main reason people incorporate or organize LLCs is to limit liability. Debts and contractual obligations are not something that you want to owe personally if you can avoid it. Setting up an LLC will create a seperate legal entity from yourself that you will operate the business through, own business assets, and contract through. Not much has to change when you form a single member LLC. LLC’s are also useful because the IRS will let you choose how you want the LLC taxed (either as a disregarded entity, S corp or C corp).
There are many reasons why LLCs can be great for business owners. For those types of businesses that have revenue and don’t need outside investors or to issue stock options (although LLC profits interests can work), LLCs are a good choice.
For a lot of startup companies, a corporation may be the right choice, especially if it will be seeking investors, plans to be acquired by a larger player in the industry at some point, or would like to have an IPO or other offering. The choice for a lot of companies especially in the high tech sector is the corporation. But if those aren’t your goals, if you have a business plan, target market, product and are ready to sell and make revenue then an LLC may be the right choice for you. Whatever industry you are in, an LLC can be a beneficial entity to use. LLCs can do complex and sophisticated things with respect to splitting profits, can have interesting classes and structures, require less paperwork than would a corporation, and are by far more flexible. (I’ve kind of beat the LLC v. Corp. horse to death earlier so will get to the point now). One of the other great advantages of the LLC form is that it can elect (i.e. choose) to be taxed as either disregarded entity (if one member then a sole proprietorship, and if multiple members than a partnership), an S-corporation or a C-corporation.
Both drag along rights and tag along rights can be very beneficial in an LLC Operating Agreement or a corporation’s Shareholder Agreement. They both relate generally to when an owner (or a group of owners) holding a certain percentage of the equity of a company (usually a majority) wish to sell their interests in the company to a third party. Tag along rights are beneficial to minority owners, while drag along rights are beneficial to majority owners.
In a startup company, its common for certain employees to be compensated with some form of equity. When you incorporate, you would adopt a stock option plan and then issue options to the corporation’s employees to compensate them for their past services and to incentivize them to stay and keep up the hard work – make sure you vest!
With LLCs becoming ever more common, the owners of a startup organized as an LLC want to be able to compensate and motivate their employees and contractors in the same manner. They can do so by granting employees LLC profits interests.
This is one of the earliest questions that comes up when an entreprenuer or group of founders want to formalize their company or business relationship. The usual advice is that if you have current income and are not looking for investors and will not have to bring on other owners in the near future, an LLC is usually a good choice. They are flexible, light on required paperwork and are similar to doing business as a sole proprietor, assuming you continue to have the LLC disregarded for tax purposes. Sole member LLC’s are inherently flexible. Multi-member LLC’s are also flexible, but will require a carefully crafted Operating Agreement to cover certain actions each member can take, breakdown of membership interests, profits, and exit options. LLC’s are great vehicles to hold real estate.
Now if your company is seeking investors, especially institutional investors of either angel or VC level, it goes without saying that you will need to be set up as a corporation. Usually the investors will want a Delaware corporation. This will allow the corporation to issue preferred shares with various beneficial provisions in favor of the investors; right to convert to common, liquidation rights, registration rights, anti-dilution provisions, etc. While all of these are technically possible to do in an LLC format, they are not as commonly used. Investors feel more comfortable with the corporation form, notably c-corps, and they are the ones putting up the money so they usually get their way. Also, and more importantly, most investment funds have prohibitions in their organizational documents prohibiting investments in LLC’s to ensure that the fund does not receive any unrelated business income tax (UBIT). While you will hear some buzz around the internet, and maybe directly from some startups that institutional investors invested in their LLC, this is most likely through a “blocker” corporation, which is essentially a sole purpose corporation owned by the fund which holds the interest in the LLC. Most investors do not like this structure as it has its drawbacks, but it is done. Honestly, if you are running a startup, you would rather be negotiating investment terms and trying to get the best deal that you can, so you don’t want to already have one foot in a hole with respect to your entity situation.
Of course, no matter which entity you choose, you can always later either convert (depending on what state your company was formed in) or merge the existing LLC or corporation into another that you have formed. This will of course, require legal assistance, and is not always an easy process, especially if your company has signed certain non-assignable contracts or has other liabilities. But, as with most things, there is a way that it can be done.