CHOOSING A BUSINESS ENTITY: THE LLC

By Jeff Wolfe

jeff2One of our key practice areas at the Forrest Firm is helping entrepreneurs and executives with matters of business entity formation or transition. Business leaders have a lot of options at their disposal when choosing a corporate entity type, from corporations (S-corp and C-corp) to partnerships, proprietorships, and perhaps the most flexible entity type of all, the limited liability company (LLC).

Today, we’re launching a new series on the Forrest Firm blog, where we’ll discuss considerations for choosing each major entity type. In our first installment, let’s look at the popular choice for many small businesses, both solely owned and many structured with multiple owners—the LLC.

LLCs are known for their flexibility, and this attribute immediately translates with regard to the number of owners in a business. These entities may be structured for individual ownership, known as a single-member LLC, or with multiple members of the ownership group (a multi-member LLC).

In terms of formation documents, LLCs require articles of organization (or certificate of organization in Delaware) filed with the secretary of state in the state of formation. Members of the LLC must also execute a limited liability company agreement (also called an operating agreement), which governs multiple aspects of ownership and management of the business.

From a taxation standpoint, LLCs are by default disregarded entities by taxing authorities, meaning that single-member organizations file at the individual level. Multi-member LLCs by default have the same tax filing requirements as a partnership.  However, LLCs can also elect to be taxed as an S corporation or a C corporation, which may be recommended depending on the circumstances.

Adding to the flexibility of the LLC is the ability to structure the percentage of membership interests among multiple owners. It’s permissible to designate membership interests into different classes (akin to common and preferred stock) with different rights and preferences. Also, income distributions do not need to be proportionate to LLC ownership. Distribution, liquidation, and voting preferences can be specified in the operating agreement.

With regard to management structure, the management of the LLC is flexible in that members can delegate management authority to managing member(s) or non-member manager(s). The manager(s) may also designate officers to manage specific aspects of the day-to-day operations of the company. Certain major decisions, however, may require approval of the members.  Once again, preferences of the organizing members with regard to management structure may be customized in the operating agreement.

One of the difficulties with operating an LLC is structuring employee incentives. Profits interests or non-qualified options can be granted to employees, but these alternatives are less familiar than traditional stock options (awarded by corporations) and may result in an employee being treated as a partner for tax and employee benefit purposes.

With regard to funding, LLCs raise capital through the issuance of equity (membership interests) and the incurrence of debt. Membership interests are typically issued in private placements. Members can create membership interests that mirror the properties of different types of stock. LLCs are not limited by a preset number of authorized interests, but may be restricted from diluting the interests of its current members by provisions in the operating agreement.  Due to unfamiliarity and other concerns, investors, especially venture capital funds, are often hesitant to invest in an LLC.

The bottom line is that LLCs have many features that are favorable and flexible for many lifestyle businesses, but may not be a good vehicle if the business anticipates raising outside capital or incentivizing employees with equity compensation.

If you have questions regarding choosing an appropriate entity type for your business, the attorneys of the Forrest Firm are here to help. Contact us today to receive advice and counsel that will tailor your entity selection to optimal risk management and growth-oriented business development.