Choosing the Right Business
Entity
One day, Raj and Shanty Patel quit their stressful
jobs as IT consultants and decided to attend Land
Grant University. Three years later, their hard work
paid off when they graduated with honors.
Upon graduation, they decided to form their own firm.
Even though they did take a class in Business Organizations,
they assumed that the trendy business form Limited
Liability Company (LLC) was the right choice, which
permits limited liability for the members and flow-through
taxes so to avoid double taxation.
In addition, like many business owners, they too were
starting out on a shoestring budget since they had
already spent their life-savings on tuition and living
expenses. Even though they invested some money to
form the company, Raj and Shanty soon discovered that
the LLC could not even pay for necessities such as
Westlaw a subscription or a paralegal’s salary.
Raj was forced to borrow ten-thousand dollars with
a personal guarantee to pay for the foreseeable expenses.
Unfortunately, for Raja and Shanty, Raj suffered a
heart attack a year later.
When tending to Raj and the practice became too much
for Shanty, she delegated the accounting and banking
functions to Deep Chopra, the paralegal. With only
one of the partners working, the practice began to
show signs of trouble because it could no longer afford
the monthly rent. On behalf of the LLC, Deep applied
for a fifty-thousand dollar line of credit. This kept
the business afloat for a while.
Unfortunately, to make matters worse, one evening
when Shanty forgot to turn off the curling iron in
the bathroom, the office burned to ground. Without
business interruption insurance, the LLC did not have
the funds to replace the equipment lost in the fire.
In addition, there was very little income as Shanty
was devoting all of her time to Raj’s health issues,
addressing the needs of clients whose files had been
lost in the fire, and similar business matters. She
was horrified to discover that dissolving the LLC
would not relieve her from the ten-thousand dollars
obligation because they had personally guaranteed
the debt. More importantly, she discovered that mingling
the LLC funds to pay for Raj’s medical bills would
help the banks pierce the corporate veil for the fifty-thousand
dollars line of credit. Consequently, the only way
to avoid the liability was to file for bankruptcy.
Since no one type of entity fits all, Raj and Shanty
should have compared the Limited Liability Company
(LLC) form with more traditional forms such as sole
proprietorship, a partnership, or a corporation. The
choice of entity comes down to evaluating many factors,
such as who the owners are (foreign person), where
they plan to operate the business (multi-state transaction),
and do they plan to transfer their interest (equity
capital) to find an entity that fits their business
goals. On some level, LLC appears to have eliminated
the task of choosing a business organization; however,
there are significant differences that could sway
the decision to choose another form of entity. Some
of those significant differences are as follows:
1. Comparison between a Sole Proprietorship and
a Partnership (general partnership and limited partnership)
and LLC:
With the exception of sole proprietorship or general
partnership, all other business forms require public
notice in the form of articles of organization or
a corporate charter with a state agency and obtaining
a business license or certificate if using an assumed
name. The advantage of operating as a general partnership
or as an LLC is that the general partners or the members
of an LLC can manipulate the management structure
in a variety of ways, e.g., all members or some members
may manage the entity.
An advantage of operating, as a sole proprietor is
that taxes “flow-through,” and the sole proprietor
pays ordinary income taxes on profits of the business,
and losses are offset against other income. Under
Revised Uniform Partnership Act (RUPA), a partnership,
on the other hand, is a separate entity, but a partnership
also is a “flow-through” entity, which means partners
report the income on their individual returns. Thus,
partners must file an informational return, which
shows the proportionate share of partnership profits
or losses allocated to each partner, but partners
pay taxes on “allocated” profits, not just “distributed”
profits.
Whether an LLC is a “flow-through” depends on its
federal tax classification. An LLC that has a single-member
can choose its classification as a disregarded entity
or as a corporation. Alternatively, a multiple-member
LLC also can choose its classification as a partnership
or as a corporation. If an LLC were classified as
a single-member LLC, a , or as an S corporation, it
too would be a “flow-through” entity. While simplicity
and flexibility of operating a sole proprietorship
are attractive features, they loose their attractiveness
if the owner needs equity capital or debt financing
to grow.
To some extent, a partnership can be riskier than
a sole proprietorship, since partners are liable for
the debts and obligations of the entire partnership.
In addition, each partner has the statutory apparent
agency authority to bind the partnership for the partnership’s
debts incurred in the ordinary course of the partnership’s
business. However, in a manager-managed company, members
can modify the statutory authority. More importantly,
liability is not proportionate to capital contributions
unless it is a limited partnership in a general partnership
where partners are not subject to the obligations
of the partnership beyond their respective capital
contributions. In fact, the amount of capital contribution
is irrelevant to the share of profits, losses, or
distributions allocated because the partners are personally
liable for the debts and obligations of the partnership
without regard to their capital contributions for
debts and obligations incurred in the ordinary course
of business.
However, as contrasted with each of the partnership
and the limited partnership options, which expose
either some or all of the owners to personal liability
for the debts and obligations of business organization,
a highly attractive feature of the LLC is that no
owner, as an owner, is exposed to personal liability
for the debts and obligations of the LLC. The limited
liability protection is not absolute, however. Members
of an LLC are liable for their own tortious acts,
omissions, or contract guarantees undertaken on behalf
of the entity.
Another critical factor to consider is the level of
liability protection in a foreign jurisdiction. Even
though most states have enacted LLC statutes, the
liability protection may differ. Experts speculate
that a foreign jurisdiction would grant the foreign
LLC at least the same liability protection in multi-state
transactions that it permits a domestic LLC, which
makes the LLC structure more attractive than any other
form of entity, such as an LLP (limited liability
partnership). Because the LLP is a form of general
partnership that, by means of making an election with
the state, modifies the traditional rule of joint
and several liability amongst the partners for partnership
debts and obligations, substituting in place thereof
a rule of either partial or full limited liability.
2. Comparison between an LLC(if classified as a
partnership) and a subchapter C and S corporation:
All three types’ of entities have filing requirements
but organizing an S corporation requires an extra
step since the incorporators must first create a C
corporation and then shareholders must elect the S
corporation status. Like the members of an LLC, shareholders
of an S corporation can directly manage the entity
but shareholders of a C corporation cannot do the
same.
As previously mentioned, an LLC too can be “flow-through”
entity depending on its federal tax classification.
C corporation, on the other hand, is not a “flow-through”
entity, which means double taxation. Another difference
is that the shareholders of S corporation pay taxes
on proportionate share of income, deductions and credits
of the entity even if they do not actually receive
distributions. Conversely, shareholders of C corporation
pay no taxes on retained earnings since shareholders
of a C corporation cannot receive allocations of any
corporate profits or losses. In certain circumstances,
however, shareholders of C corporation might have
to pay additional taxes on accumulated earnings.
Another factor to consider while comparing these structures
is if the debt would increase or decrease the basis.
In certain LLC’s, members would be able to increase
their basis by a proportionate amount of the non-recourse
debt incurred by the entity, even though the members
will not be per se liable upon this debt. In addition,
members of LLC can include the business debt even
if members personally guaranteed the debt. In an S
corporation, shareholders cannot increase the basis
in their stock by guaranteeing corporate debt, while
in the case of a member of an LLC which is taxed under
Subchapter K, they may increase their basis to the
extent they guarantee debt of the LLC. The basis can
also increase or decrease depending on the profits
and losses allocated to each member.
The advantage of forming an S corporation, on the
other hand, is that shareholders of an S corporation
do not pay double taxes on profit distribution and
do not pay Social Security or Medicare taxes on non-wage
income. While LLC members do pay self-employment taxes
on all allocations of income and do pay self-employment
or Medicare taxes on those portions of company earnings
that are distributed.
Another factor to consider regarding an S corporation
is that it provides less flexibility in attracting
key employees than entities taxed under Subchapter
K (LLC) or Subchapter C because an S corporation can
only issue single class of stock. Another disadvantage
of forming an S corporation is that the shareholders
cannot raise capital through initial public offering
due to limitation on number of shareholders.
3. Comparison between an LLC, a PLLC (Professional
Limited Liability Company), and a PC (Professional
Corporation):
Although the benefit of forming an LLC over a PLLC
or PC is that the LLC organization is simpler. However,
forming an LLC is generally not an option for providing
professional services. Some states have additional
requirements for practicing a profession, such as
ethics guidelines. To form a PLLC or PC, for example,
members must obtain a license to practice the profession.
Examples are lawyers or accountants. In addition,
lawyers must receive approval from a state’s highest
court or a bar association before forming a PLLC or
a PC.
In some states, members of a PLLC can manipulate the
management structure so long as no one other than
a licensed professional is a member. The tax considerations
for a PLLC or a PC are like any other LLC or a corporation.
In some states, a PLLC or a PC dissolves when it no
longer has any members or shareholders who are licensed
professionals, such as lawyers. However, such restrictions
do not apply to all types of a PLLC or a PC, e.g.,
landscape services. As far as liability is concerned,
professionals are liable for their own malpractice
in a multi-member entity, even if the business was
incorporated.
Organizing a professional practice as a PLLC or a
PC has the benefit of affording each owner limited
liability from the debts and obligations of the company
that might otherwise be imposed upon them in their
capacity as owners. At the same time, it must be recognized
that no such organization will protect a professional
from personal liability for the consequences of their
own actions (including malpractice).
4. Comparison between an LLC and LLP (Limited Liability
Partnership):
Both entities require formal notice. The ease of organizing
one over the other depends on state-specific requirements.
Like members of an LLC, all partners of an LLP can
participate in the management of entity without losing
the liability shield. An important feature of an LLP
is that all partners avoid individual liability for
the debts and obligations of the entire partnership
including judgments that arise from errors, omissions,
or negligence committed in the course of a partnership.
Moreover, LLP partners cannot compel each other to
contribute in case the LLP does not have sufficient
funds to pay the judgment.
Still the extent of protection depends on whether
the jurisdiction has adopted a full-shield LLP Act
as opposed to a partial-shield LLP Act. In the former,
partners are not per se liable for the debts and obligations
of the partnership, irrespective of the legal theory
under which those claims are raised. By way of contrast,
a number of states have partial-shield LLP Acts, and
in those jurisdictions, partners, as partners, have
limited liability from certain claims made against
the partnership, but remain per se liable for other
claims made against the partnership. Exactly what
is the extent of the liability protection afforded
(or not) by a partial-shield jurisdiction must be
assessed based upon the statute in question.
The question arises of whether, when an LLP or an
LLC does business in a state outside that in which
it is organized, the foreign state will respect the
liability afforded in the jurisdiction of organization.
To determine an answer, it helps to understand that
a state treats organizational issues differently from
the internal affairs issues of a business.
Like Raj and Shanty, limited liability issue for the
business debts looms in every entrepreneur’s mind.
Most entrepreneurs borrow to some extent, and they
all want to know how to plan for catastrophe so they
do not have to sell their personal assets. However,
because no one form of entity provides protection
from liability from all sources, understanding investment
goals, the risk capacity of the investors, and the
characteristics of an entity could guide an entrepreneur
during the planning stages in how to minimize risk.
Even as entrepreneurs consider and take advantage
of the limited liability afforded by certain forms
of business organization, they will still need to
keep in mind other risk-shifting mechanisms, such
as professional malpractice insurance or borrowing
from only those trade creditors that do not require
personal guarantees.
