Strictly Business

One of the benefits to using a limited liability company is the flexibility of being able to choose how the entity is taxed.  After a new LLC is formed, its owners must decide the method by which they would like their business taxed.  By default, an LLC is treated as a pass-through entity, which means that it does not pay federal taxes directly, but its income or loss is allocated to the owners, who then pay taxes on that income.  If the LLC has only one member, it files no tax return and all transactions of the LLC are treated as transactions of the owner for tax purposes.  If the LLC has more than one member, the LLC files a partnership tax return, which reports the LLC’s income and how that income is to be allocated to each owner.  Partnership style taxation is governed by Subchapter K of the Internal Revenue Code.  However, the owner(s) of an LLC, whether the LLC has a single member or multiple members, may choose to have their LLC taxed as a corporation.  In this case, the LLC can be taxed as a so-called “C Corporation,” which is governed under Subchapter C of the Internal Revenue Code, or an “S Corporation,” which is governed by Subchapter S.  This ability of LLC owners to elect the company’s means of taxation is called the “check the box” regulations. Below are summaries of the four methods of taxation of an LLC:

• Disregarded Entity – This is the default rule for any LLC that has only one member.  A single member LLC is treated as though it does not exist for tax purposes and thus the owner is treated as if he were running a sole proprietorship.  All transactions — income and expenses — are included on the owner’s tax return.  Therefore, no separate tax return need be filed for the LLC.
• Subchapter K (aka partnership taxation) – This is the most flexible form of taxation for a multi-member LLC.  All income and losses of the LLC are allocated to the owners, who pay taxes on that income regardless of the amount of cash they received from the company.  A distribution of cash to owners is itself a tax-free event.  The owners of the LLC can be compensated for service to the company (called “guaranteed payments”) in which case the payments are treated as an expense to the partnership and income to the owner.  Subchapter K is quite flexible, and allows the owners to allocate the income between themselves in a variety of ways, sometimes in quite complex formulas (subject to certain limited restrictions in the Internal Revenue Code).  One downside to using a partnership taxation structure is that the income of the partners is generally subject to the self-employment tax.
• Subchapter C – If an LLC elects to be taxed under Subchapter C, it is treated for tax purposes, as if it were a corporation.  The company must file a corporate tax return (regardless of whether there is one member or multiple members) and the LLC itself pays taxes.  Any income that is paid to owners in the form of dividends is also taxable income to the owner (so-called “double taxation”), though the dividends are taxed to the owner at the capital gains rate.  Because of this, many C Corporation owners pay themselves a salary or bonus.  Such income is deductible to the corporation, though the compensation must be “reasonable.”  If the IRS were to deem the salaries paid to an owner as higher than what would be reasonable if the owner were just an ordinary employee, it could reclassify part of the salary as a constructive dividend, subjecting the company to additional taxes and potential penalties.
• Subchapter S – If an LLC elects to be taxed under Subchapter S, it is treated for tax purposes, as if it were a corporation that had elected to be treated as an S Corporation.  In this form, the company will still file a corporate tax return but does not itself pay taxes.  Instead, each owner is allocated a portion of profits or losses based on the percentage interest that they each own.  As in a partnership, the owners must then pay the taxes themselves, regardless of whether any cash has been distributed to them.  Any cash payments to owners (called distributions or dividends) are tax-free.  Active owners are considered employees of the company and can also be paid for their services to the company in the form of a salary or other payments, in which case, the payment will be deductible to the company and will be taxable wage income to the owner.  The benefit of taxing an LLC as an S Corporation is that income that is not paid out as a salary is not subject to self-employment taxes.  However, the IRS can scrutinize the salaries paid to owners and if it deems that the owners have been underpaid, it may reclassify some of the LLC’s income as wages, subjecting the LLC and the owners to additional payroll taxes and potential penalties.  Another disadvantage to using Subchapter S is that the designation is very “fragile.” There are a number of requirements the company must adhere to (such as having only one class of stock and no more than 100 owners).  If the company fails to adhere to these requirements, it will automatically be converted to a C-Corp and face double taxation.  The single class of stock requirement is especially easy to violate inadvertently.  If the LLC gives any owners preferred distributions or distributes distributions in any way except through a straight pro rata method, it could be deemed as having more than one class of stock.  In addition, many of the default provisions in LLC statutes violate the single class of stock requirement, which means that the operating agreement of an LLC taxed under Subchapter S must be carefully written to override the default provisions.

As you can see, there are many factors to consider in choosing how to have an LLC taxed.  Your final choice should be based on your own specific situation.  Therefore, before making any decisions on your form of business, you should speak with your attorney or accountant.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Entrepreneur magazine recently posted an article on their blog describing five overlooked legal mistakes that entrepreneurs often make.  It’s a good worthwhile read.  The mistakes mentioned are:

1. Making handshake deals (i.e. not in writing) with clients and vendors.
2. Choosing the wrong business structure (i.e. sole proprietorship, LLC, Corporation).
3. Entering into a partnership without a detailed written agreement.
4. Entering into a 50-50 partnership.
5. Filing a trademark without doing a detailed and extensive search before hand.

I wholeheartedly agree with four out of the five common mistakes.  Perhaps the one I may partially disagree with is mistake number 4: entering into a 50-50 partnership.  50-50 partnerships can certainly present challenges when it comes to governing a company and general decision-making when there is a deadlock between the partners.  However, I think categorically ruling out such an arrangement is a mistake.  Rather, if the partners desire to establish a 50-50 partnership and that relationship is important to them, they should plan ahead and consider adding detailed provisions in their partnership agreement which deals with deadlocks.  In addition, the company buy-sell provisions will have to be carefully considered as well.

Article Referenced: Five Overlooked Legal Mistakes Entrepreneurs Make

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© 2011 Alexander J. Davie – This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Previously, I have written about the advantages and disadvantages of incorporating in Delaware or Nevada as a small business owner.  With regards to Delaware, my conclusion was that, for most small companies, the disadvantages outweigh any advantages.  With regards to Nevada, my view was that it is highly uncertain that many of the advertised benefits of incorporation in Nevada, such as greater asset protection and greater liability protection, would actually materialize.  In this piece, I’ll cover my thoughts on another state that is frequently pitched as a good place for forming your business: Wyoming.

Wyoming limited liability companies are heavily marketed on the internet as a great option to form a new business.  Wyoming has the distinction of being the first state to have a limited liability company statute, which apparently was created as special interest legislation for an oil company.  Because of Wyoming’s long history with LLCs, Wyoming LLCs are highly promoted as being superior to the LLCs of other states (usually by companies that offer to do the formation for you…for a fee).  The fact that Wyoming was the first state to have an LLC statute doesn’t really benefit a business owner, of course.  The three major substantive selling points that are used to promote Wyoming LLCs are: (1) superior asset protection, (2) lower taxes, and (3) lower fees.  For the reasons described below, it is highly unlikely that a business owner would actually realize any of these benefits if they were to organize their business as a Wyoming LLC.

The first major substantive selling point is that Wyoming LLCs supposedly have superior asset protections.  Wyoming law provides that the sole remedy available to creditors of owners of LLCs is a charging order.  A charging order is an order by the court directed to the company ordering the company to send all distributions that would have gone to the owner/debtor to the judgment holder instead.  This limitation can make it more difficult for a creditor to collect on their judgment because the creditor will not be able to force the debtor to sell his ownership interest in the company. Usually, after a creditor obtains a judgment against a debtor, the creditor is entitled to sell the debtor’s personal property to satisfy that judgment.  However, if the creditor’s sole remedy is a charging order, then the creditor is entitled to whatever distributions are produced from the ownership interest (if any at all), but the creditor cannot transfer or sell that ownership interest.  Having this protection can give a debtor more leverage in negotiating a settlement. However, the charging order limitation is not unique to Wyoming.  Most states’ LLC statutes provide that the sole remedy to a creditor of a member is a charging order.  It is true that Wyoming has extended the charging order limitation to single member LLCs, whereas many other states do not provide such a protection in the case where an LLC has only one owner.  However, it is important to note that if a lawsuit takes place in your home state or in some other state besides Wyoming, conflicts of laws principles may cause the law of a state other than Wyoming to control whether a creditor may be able to obtain a lien on or a forced sale of a debtor’s interest in a Wyoming single member LLC.  In other words, judges often have a lot of discretion as to which state’s laws apply in multi-state cases and often begin with the assumption that the law of the forum applies, unless a party can show that another state’s laws have greater contacts or interests in the case.  Therefore, you cannot be sure that your own home state won’t go ahead and apply its own law to the situation, notwithstanding whatever Wyoming law states.  Therefore, for people interested in asset protection, I’d recommend taking steps other than forming a Wyoming LLC.  See my post on Nevada corporations and LLCs for links to more information on what steps your should take for asset protection.

Another major selling point that is used in promoting Wyoming LLCs is that Wyoming has no income tax.  Unfortunately, since most LLCs are pass through entities, which pay no taxes themselves, this is of limited benefit.  For instance, if you live in another state that has a personal income tax, and form a Wyoming LLC, all the income would be passed through to you and you would still end up paying state income taxes.  Therefore, forming an LLC in Wyoming is not an effective tax avoidance method.  In addition, if your state does impose an income tax on LLCs at the entity level (which for instance my own state of Tennessee does), and your LLC operates a business in your state, then your LLC would still end up paying the state income tax regardless of Wyoming’s income tax, because it is the entity’s presence in a state which controls whether it is taxed there, not its state of incorporation.

The final major selling point that is used to promote Wyoming LLCs is that the fees to organize them and the ongoing annual fees are lower than other states.  This is certainly true.  But if you live outside of Wyoming, and organize your business as a Wyoming LLC, your business will almost certainly be doing business in your home state.   In that case, your LLC will be required to qualify to do business in your state, which usually involves paying a fee equal to what your company would have paid had it simply been organized in your own home state.  Therefore, you are unlikely to realize any cost savings from organizing your LLC in Wyoming (Nevada and Delaware entities present this same issue as well).

As with Delaware and Nevada entities, I don’t think there is much advantage to using a Wyoming LLC, as opposed to an entity formed in your home state (unless of course, your home state is Wyoming).  You will end up incurring double the fees, because you will have to pay Wyoming’s fees and then pay your own state’s fees to obtain authorization for your Wyoming LLC to do business in your own state.  Despite this additional cost and complication, it is uncertain whether you will see any of the benefits, such as greater asset protection, that are often promised in connection with incorporation in Wyoming, nor are you likely to see any tax savings.  In addition, if there were ever litigation among the owners, you may be forced to conduct that litigation in Wyoming, which could end up being highly inconvenient and expensive.  Therefore, unless there is some specific reason to set up your company in Wyoming, I’d avoid using a Wyoming LLC.

As always, your final choice in entity selection should be based on your own specific situation.  Therefore, before making any final decisions on your form of business, you should speak with your attorney.

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© 2011 Alexander J. Davie – This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Previously, I wrote about the pros and cons of incorporating in Delaware as a small business owner.  My conclusion was that, for most small companies, the disadvantages outweigh any advantages.  In this piece, I’ll cover my thoughts on another state that is frequently pitched as a good place for incorporation: Nevada.

Like Delaware, Nevada has a special court system for litigating business disputes.  Nevada promotes its so-called “Business Court” as efficient and fast in its case management.  However, Nevada’s Business Court doesn’t issue written opinions or binding precedent, so it does not provide the predictability that Delaware provides.  In addition, as with being incorporated in Delaware, if your business is physically located in a state other than Nevada, the supposed efficiencies are probably outweighed by the hassle of having to litigate cases in a far away state.  Therefore, for most business owners, I do not see Nevada’s Business Court as being a major benefit.

The second big selling point to incorporating in Nevada is that Nevada supposedly has greater protections for shareholders against a “piercing the corporate veil” action.  Piercing the corporate veil involves holding the owners of a corporation or limited liability company liable for the debts of the company. Generally, piercing the corporate veil can only be done in extreme situations such as when the shareholder commits fraud or when the corporation is deemed the “alter ego” of the shareholder.  The standard for successfully piercing the corporate veil in Nevada may be stricter than in your home state.  However, it is important to note that if a lawsuit takes place in your home state or in some other state besides Nevada, conflicts of laws principles may cause the law of a state other than Nevada to control whether a piercing the corporate veil action would be successful.  In other words, judges often have a lot of discretion as to which state’s laws apply in multi-state cases and often begin with the assumption that the law of the forum applies unless a party can show that another state’s laws have greater contacts or interests in the case.  In fact, while Nevada corporations are often promoted as being particularly useful to business owners in California, California has been one of the most aggressive states in applying its own corporate laws to businesses incorporated elsewhere but doing business in California.  Therefore, my recommendation is to use your own state’s incorporation statute and take effective precautions against liability, which includes observing all corporate formalities and making sure that you and your company have adequate liability insurance coverage.

Nevada corporations are also promoted for their asset protection abilities. Nevada law provides that the sole remedy available to creditors of owners of Nevada closely held corporations and LLCs is a charging order.  A charging order is an order by the court directed to the company ordering the company to send all distributions and dividends that would have gone to the shareholder/owner/debtor to the judgment holder instead.  This limitation can make it more difficult for a creditor to collect on their judgment because the creditor will not be able to force the debtor to sell his stock or ownership interest in the company. Usually, after a creditor obtains a judgment against a debtor, the creditor is entitled to sell the debtor’s personal property to satisfy that judgment.  However, if the creditor’s sole remedy is a charging order, then the creditor is entitled to whatever distributions or dividends are produced from the ownership interest (if any at all), but the creditor cannot transfer or sell that ownership interest.  Having this protection can give a debtor more leverage in negotiating a settlement. However, the charging order limitation is not unique to Nevada.  Most states’ LLC statutes provide that the sole remedy to a creditor of a member is a charging order.  It is true that Nevada has extended the charging order limitation to situations that other states have not, namely to closely held corporations and single member LLCs.  However, as in the case of piercing the corporate veil, you cannot be sure that your own home state won’t go ahead and apply its own law to the situation, notwithstanding whatever Nevada law states.  My colleague Jeff Vandrew wrote recently about this issue and has some suggestions for alternative asset protection precautions that can be taken using your own home state’s LLC statute.  These precautions are far more likely to accomplish your asset protection goals than simply incorporating in Nevada and hoping that the judge applies Nevada law.

As with Delaware, I don’t think there is much advantage for most businesses to incorporating in Nevada, as opposed to the business owner’s home state.  You will end up incurring double the fees, because you will have to pay Nevada’s fees and then pay your own states fees to obtain authorization for your Nevada entity to do business in your own state.  Despite this additional cost and complication, it is uncertain whether you will see any of the benefits, such as greater asset protection and liability protection, that are often promised in connection with incorporation in Nevada.  As always, your final choice in entity selection should be based on your own specific situation.  Therefore, before making any final decisions on your form of business, you should speak with your attorney.

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© 2011 Alexander J. Davie – This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

One question I frequently receive from people seeking to start a new business is whether they should incorporate that new business in Delaware.  They frequently hear vague notions of the benefits of incorporation in Delaware but haven’t heard any definitive statement on why they should or shouldn’t choose Delaware as their state of incorporation.  My advice most times is to incorporate in the home state of their business (usually the company’s headquarters).

The one major significant benefit to being incorporated in Delaware is that Delaware has a highly developed body of corporate law.  The Delaware General Corporation Law is considered to be well-designed and flexible.  In addition, Delaware has established its own court system (called the Court of Chancery), which only hears corporate cases and is considered to be highly sophisticated and efficient.  As a result of the depth of Delaware’s body of corporate law decisions, boards of directors are able to better predict and understand their fiduciary duties to shareholders.  Delaware also has a reputation of being “management friendly” when it comes to disputes between owners and the company’s management, though whether this is actually true is subject to some debate.

Often when I explain these factors to an aspiring entrepreneur, they respond “that’s it?”  Yes, that is it.  There are little to no tangible or financial benefits for a small business to incorporate in Delaware.  It certainly is not a tax haven; it has some of the highest corporate state income taxes in the nation.  Even if it were a tax haven, this would be of little benefit to the company, because the company will still be required to pay the state income taxes of its home state and any other states it operates within.  In addition, incorporating in Delaware is often more expensive for the business.  It will be required to pay annual fees and franchise taxes to Delaware (which get pretty high for corporations) and it will also need to pay annual incorporation fees to its home state in order to qualify to do business in that state.  So in the end, if a business incorporates in Delaware, but operates in another state, it will be more expensive than if it had just incorporated in its home state.  The “management friendly” nature of Delaware corporate law usually is not of significant interest to a small business owner since small businesses rarely have a large division between ownership and control.

Who should incorporate in Delaware?  Certainly large corporations have a good reason to do so.  Since they have a significant division of ownership and control, the predictability of Delaware corporate law is helpful to directors, giving them clear guidance on what their duties to shareholders are.  In addition, hedge fund, private equity, and venture capital fund managers frequently use Delaware limited liability companies and limited partnerships.  They have good reason to do so because of the clear well-developed fiduciary duties of Delaware law.  Like large corporations, hedge funds have a significant separation of ownership and control.

One category of small business that should consider incorporating in Delaware is those businesses that anticipate unusually fast upward trajectories in their growth.  If a business expects to be receiving venture capital funding within the next couple of years, it may be a good idea to opt for a Delaware corporation, because chances are, when the company does receive funding, the VC fund will insist that it convert into a Delaware corporation.  However, if such funding is far off, be aware that it is not that difficult to change a company’s the state of incorporation (compared with the relative complexity of any corporate financing), so a business does not need to incorporate in Delaware because simply because it may at some point in the future seek outside financing.

As always, your final choice in entity selection should be based on your own specific situation.  Therefore, before making any final decisions on your form of business, you should speak with your attorney.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

One of the first decisions new business owners face is what type of entity they should use to form their new company. Most likely, this involves a choice between a limited liability company (LLC) or a corporation.  These two types of entities differ significantly in how they are governed.

Corporations

In a corporation, each owner owns shares of stock and is called a shareholder.  Each shareholder’s portion of ownership is measured in how many shares of stock each shareholder has.  The shareholders elect a board of directors, which has the ultimate management control over the company.  Shareholders may also be directors, but there is no requirement that they be.  In some states, the board of directors is permitted to have only one director, while in others, there must be more than one.   All major decisions of the company must be made by the board and approved by a vote.  These decisions are documented as formal resolutions and minutes of meetings of the board must be taken.  Boards delegate day-to-day management of the corporation to officers, who are responsible for carrying out the decisions of the board.  There is no requirement that someone be a shareholder or a director in order for them to be an officer.  Thus all three groups (shareholders, directors, and officers) could theoretically consist of completely different people, although in practice there is usually some degree of overlap.

Corporations are governed by a certificate of incorporation (sometimes also called a charter or articles of incorporation) and a set of bylaws, which set out board election and voting procedures.  In addition, there can be one or more shareholder agreements, which set forth the rights that shareholders have vis-a-vis each other (e.g. transfer restrictions, options, or rights of first refusal).   Usually, corporations are required to hold annual shareholder and/or board meetings, even if there is no significant business to discuss.

The overarching theme of the way corporations are governed is that they are formalistic and structured.  In some situations, this can be beneficial.  In a company with a significant number of owners or people involved in its governance, the corporate structure provides an established template for decision-making processes.  If the company were to be governed more like a partnership, where each owner is actively involved in making decisions and executing them, company governance and decision-making could get chaotic.  The disadvantages of the corporate form is that the formalities involved may be overkill for a small business with just one or a few active owners.

Limited Liability Companies

In an LLC, each owner is called a member.  Each member’s portion of ownership is often measured in percentage interests, although LLCs can emulate corporations by issuing units of ownership, which are similar to shares of stock.  An LLC may be governed directly by the members, similar to the way a partnership is often governed, in which case the members would vote to approve major decisions.  Generally, a member can act on behalf of an LLC and sign and execute contracts.  It is possible for the members to delegate authority to a non-member, but that is rarely done in a member-managed LLC.

LLCs can also elect to be manager-managed.  In this case, the members will have no governance rights over the company but have the power to elect one or more managers, who are given the ultimate decision-making authority over the company.  Some state LLC acts provide for board-managed LLCs, which approximate the governance structure of corporations.  In a board-managed LLC, the members elect a board of governors (sometimes also called directors or managers), which manages the company like a board of directors would manage a corporation. Even in those states that do not have board-managed LLCs, a corporation-like structure can still be approximated be having a group of managers who act as the board of the company.  The managers can delegate day-to-day authority to officers, just as a board would do in a corporation.

LLCs are governed by a certificate of formation (sometimes also called articles of organization) and an operating agreement.  The operating agreement is a comprehensive contract between the members (and sometimes the managers) which covers economic rights (i.e. division of profits, losses, and cash flow), governance issues such as manager election and voting procedures, and rights between the members such as restrictions on transferability.

The overarching theme of the way LLCs are governed is flexibility.  Generally, the parties can organize an LLC however they would like.  They can run it in the structured manner that a corporation is governed, run it informally, or operate some kind of hybrid of the two.  LLCs permit a high degree of creativity in structuring a company.

Some Rules of Thumb

Below are some general rules of thumb of follow in making your decision on whether to form your business as an LLC or a corporation.  Please note that these suggestions only take into account governance issues and there are other issues to consider, such as taxation and asset protection issues.

• For a company with a single owner, an LLC often is the easiest organization to manage. The owner can operate the business largely the same way as he did as a sole proprietor (except he should take care not to commingle assets and make sure all business is done in the name of the company).  No annual meetings are necessary nor are any formal resolutions.

• For a company with a small number of owners who are active in the business, an LLC is also an excellent option.  The small size of the group lends itself well to the informality of the LLC structure. Major decisions will need to be made at member meetings, but there are no requirements for annual meetings.

• For a company with multiple owners but where only one owner makes the decisions, an LLC is once again the best option.  The company would elect to be a manager-managed LLC and the members would either elect their manager or he or she would be appointed in the operating agreement.  This manager could also be a member (called a member-manager or a managing member).  This structure is very similar to a limited partnership, except that the manager would not be liable for the debts of the company like the general partner of a limited partnership would be.

• For a company with a large number of decision-makers or owners, a corporate structure is often best.  Once the number of “cooks in the kitchen” gets large enough, the structured nature of a corporation begins to make sense.  Please note, the owners may want to consider setting up a board-managed LLC or some other LLC structure that imitates a corporation if they desire that the entity to be taxed as a partnership (which a corporation cannot be) or if they want to take advanced of the asset protection benefits of an LLC.

Please note, your choice in entity selection should be based on your own specific situation.  Therefore, before making any final decisions on your form of business, you should speak with your attorney and/or accountant.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.