Selecting the Legal Form of Your Company
When a business plan is developed, consideration must
be given to the form in which the business is to be conducted.
There are several possibilities, which are described below.
A special subtype of the incorporated entity is called
the "S Corporation" (formerly "Subchapter
S" Corporation), the name taken from the location
of the governing provisions in the Code. For most purposes,
S Corporations are garden-variety corporations under state
law, the distinguishing factor being that if they configure
themselves to meet special rules of the Internal Revenue
Code, no corporate tax is assessed, thereby passing through
corporate income and losses directly to the shareholders.
Under the Tax Reform Act of 1986, S Corporations became
increasingly popular because, for the first time since
1916, personal tax rates were lower than the corporate
tax rates, thereby putting a premium on the ability of
a business entity to pass through its income to its shareholders
without the imposition of tax. Moreover, while losses
from passive activities may not be offset against income
other than from passive activity under the Tax Reform
Act of 1986, losses garnered by an S Corporation and allocable
to a shareholder who materially participates - as an officer,
for example - in the S Corporation's business may elude
the "passive activity" trap and thus be more
widely useful. However, such losses are generally limited
to the shareholder's tax basis in his stock and any loans
he has made to the corporation.
When contemplating tax issues, keep in mind that the
treatment of S Corporations for local tax purposes can
complicate the issue, since New York City and some states
refuse to recognize S Corporations as "flow-through
entities". Moreover, a large element of any individual
or corporate tax strategy has to do with the treatment
of fringe benefits. A person owning 2 percent or more
of the voting stock of an S Corporation is a "partner"
for certain fringe-benefit purposes, such as group term
life insurance and medical insurance, and a partner fares
less well with fringe-benefit than does a stockholder/employee
of a C Corporation.
The good news is that S Corporation status is relatively
easy to achieve and, when necessary, to surrender; a timely
election approved by the shareholders and filed with the
IRS is all that is required. However, if a C Corporation
builds up unrealized appreciation in its assets and then
switches to S status prior to a sale of those assets in
order to avoid double tax, the IRS has statutory weapons.
Limited Liability Companies (LLCs)
The limited liability company, in effect an incorporated
partnership, has gained considerable momentum since 1988,
when the Internal Revenue Service ruled that a corporation
organized under a special Wyoming statute qualified for
pass-through tax treatment as a partnership even though
the entity possessed the corporate characteristic of limited
liability. The following discussion of a limited liability
company is oriented toward the Delaware statute (the Act).
In the following discussion, it should be assumed that
unless otherwise indicated or unless the context suggests
otherwise (i.e., fundamental rules on how the entity is
to be organized), any provision of the Act can be modified
by agreement of the parties.
Under the law in some states, a limited liability company
must have at least two "members" (i.e., owners),
an inheritance from the underlying concept of liability
company which implies two or more participants. As a structuring
issue, if only two partners are involved, the agreement
between them should not name a mutually acceptable third
party to become a member if one member dies or withdraws,
if only for purposes of liquidating the entity.
The members may directly manage the company or they may
delegate all or a portion of that task to "managers"
(an equivalent of directors or general partners). Limited
liability companies can be organized in Delaware for any
purpose other than banking or insurance.
A limited liability company is formed by filing a certificate
of formation with the secretary of state. The certificate
must set forth the name of the company (which shall contain
the words "Limited Liability Company" or "LLC"),
the address of its registered office, and the name and
address of its registered agent for service of process.
The certificate need not identify the names and business
addresses of the initial members or managers, nor the
purposes for which the LLC was organized. The omission
of members' and/or managers' names is the better practice.
The list of limited partners required in the certificate
by outdated versions of the Uniform Limited Partnership
Act only served to identify prospects for salesmen pushing
The Act contemplates that the affairs and conduct of
the business of a limited liability company will be governed
by a written operating agreement (the Agreement). There
is no requirement that the Agreement be made public; some
practitioners may, however, wish to publicize portions
of the Agreement, by incorporating the same in the Certificate
of Formation, in hopes that constructive notice to, say,
creditors and vendors, will prove helpful at some point
down the road. If an LLC is to be used as a special-purpose,
bankruptcy-remote vehicle, for example, the sponsors might
want a purpose clause on the public record indicating
to all the world that the company is not authorized to
borrow money or run up bills except in certain specified
The Agreement may contain any provisions for the regulation
and management of the company which are not inconsistent
with the Act. The entity may be governed like a general
partnership, all members voting on all matters in proportion
to their profits' interests, with no delegation to managers.
However, the norm is expected to be delegation of management
functions to managers (a.k.a. directors). The Act does
not mention officers specifically; but there is no reason
not to appoint the same if deemed useful, much as partnerships
appoint officers from time to time.
The Agreement will generally specify how profits and
losses will be allocated and distributions made. An important
query at this point is if the Agreement should be like
a typical partnership agreement in providing for such
items as adjustments to keep the system in sync with the
Treasury Regulations under I.R.C. §704, the appropriate
profit allocation upon a distribution in-kind, and the
Once a Delaware limited liability company has creditors,
no distributions or returns of capital can be made if
that action would cause the fair value of its net assets
to be less than zero. Indeed, under applicable fraudulent-conveyance
statutes, the constraint on distributions extends to those
which might make the firm insolvent or leave it unreasonably
short of capital. Other than that restriction, however,
distributions by a limited liability company can be structured
in any way the members or managers choose. If no allocation
is specified in the Agreement, the Act specifies that
distributions and profits and losses will be allocated
by proportionate share of the "agreed value"
of membership interests. But discriminatory distributions
are allowed if the governing documents so provide. If
a member resigns, he is entitled to receive within a reasonable
time the fair value of his membership interest based on
his right to share in distributions. (As stated above,
this and most other rights can be modified or curtailed
by the Agreement.)
This Act also clarifies relationships between members
and the company. It is, for example, acceptable for a
member to transact business with the company. In such
a role, the member has the same rights as any nonmember.
And, to the extent members have a right to distributions,
they have creditor status.
The Act specifies that new members may be admitted only
with the unanimous consent of the existing members unless
the Agreement otherwise provides. The Agreement may provide
any admission procedure imaginable; for example, under
the Act, one can become a member by orally agreeing to
become a member. Stock or other certificates are not specifically
mentioned. Moreover, unlike corporations in some states,
membership interests can be issued for whatever consideration
the members choose, including a promissory note or future
services. At this point, careful counsel will consider
creating formalities in the Agreement so that, for example,
when the time rolls around for an opinion to issue on,
say, the status of certain issues, the lawyer concerned
will have something to go on.
The Act has established a procedure whereby limited liability
companies organized in other jurisdictions can qualify
to do business in Delaware. And, the Act is specific on
such issues as the LLC's ability to merge with LLCs and
C Corporations (foreign and domestic). The Act provides
for partnership-type rights of members to look at the
books and lists of members, subject only to "reasonable"
Limitation of liability for members is a cornerstone
of the Act. Members of limited liability companies are
not risking their personal assets; they are not liable
to creditors "solely by reason of being a member
or acting as a manager." Members are, on the other
hand, liable for any contributions they agreed in writing
to make and the obligation survives death or disability;
if required property or services are not contributed,
the company may require a cash contribution of equal value.
The Act also recognizes that there are contractual elements
to the relationship of the members. For example, the Act
allows for the resignation of a member or manager unless
the Agreement provides he may not, in which case the company
may recover damages for breach from the manager and offset
those damages from other distributions. The Act imposes
liability on managers and members to return improper distributions,
but, in the case of members, only if the member knew at
the time the distribution was improper.
In the event of bankruptcy of an LLC, the rules pertaining
to corporations (versus liability company) apply. Most
states (Florida being a prominent exception) treat LLCs
as liability companies for tax purposes.
One major drawback is the risk that a court outside Delaware
considering an action against a Delaware LLC may hold
the members and/or managers liable as general partners.
The risk is reduced since all states have adopted limited
liability company legislation. Moreover, if the sponsors
of the LLC observe the customary and usual rules to avoid
the corporate veil being pierced, the risk of an LLC being
treated as a general partnership should be manageable.
Corporation Versus Limited Liability Company
There are a number of alternatives not discussed in this
text, including general and limited partnerships, business
trusts, sole proprietorships, etc. In the final analysis,
the choice usually comes down to an S or C corporation
or a limited liability company. The following summary
of certain important issues is intended to help you make
the final decision.
Most practitioners perceive public trading in shares
of corporate stock as more efficiently accomplished than
trading in limited liability company interests. Corporate
shares were designed to be liquid; not so limited liability
Flexibility versus Formality
Except to the extent the general corporation law of a
given state provides relief, corporate existence entails
a higher degree of formality and expense) than life under
a limited liability company. Corporations require a formally
elected board of directors, statutory officers, stockholders
meetings, class votes on certain issues, and records of
meetings. These formalities are often neglected, but at
some peril; if there is no evidence of formal directors'
meetings, plaintiffs can contend the board was negligent
in carrying out its fiduciary duties to the stockholders
because one of the functions of a board is to hold formal
Corporate law has been more thoroughly developed than
limited liability company law in the litigated cases.
There is more predictability from a legal standpoint.
Counsel can forecast with a higher degree of confidence
what the Chancery and Supreme Courts in Delaware will
do on a given state of facts. Indeed, for every case construing
a Limited Liability Company Act, there are hundreds construing
the general corporation laws.
Organizational tax issues will revolve principally around
the fact that earnings by a business operated in corporate
form generate federal and state income tax on the corporate
level. When those earnings are distributed (if they are)
by way of dividends (or in liquidation), they ordinarily
generate additional tax again, this time levied upon the
shareholders, and such dividends are not deductible corporate
expenses. Avoidance of "double taxation" will
drive the preference of planners toward the liability
company format. There are ways to avoid double taxation,
but the gate is substantially narrower than it was before
January 1, 1987.
Starting one's business in noncorporate form will prove
to be popular for yet another reason. Upward pressure
on corporate rates, plus the post-1986 difficulty in extracting
profits from corporate solution without paying double
tax, puts a premium on avoiding corporate tax altogether.
Partners do pay tax on revenue whether it is distributed
or not and it may be necessary to retain earnings in the
entity to expand the business. That is not, however, a
major problem in most instances. The limited liability
company simply distributes enough cash to the partners
to pay tax at an assumed rate (28 to 34 percent, plus
something for state taxes) and retains the rest, the danger
being that the limited liability company will have taxable
income but no cash, in a year of large principal payments
on debt, for example.
Migration from one form of organization to another is
a one-way street. A limited liability company can organize
a corporation and transfer its assets thereto without
tax, assuming that the partners contributing cash and/or
the property hold 80 percent or more of the resultant
voting stock and the liabilities of the limited liability
company do not exceed the fair value of its assets; if
a corporation wants to organize itself as a limited liability
company, however, there is a double tax under the new
tax law. Appreciated assets are taxed at the corporate
level and the shareholders taxed on the liquidation distributions.
Further, election of the limited liability company structure
allows somewhat greater flexibility in allocating items
of income and loss among the partners. The dream of the
organizers of a business is to be able to strike a deal
between the suppliers of capital and the managers in a
tax-neutral setting. The founder and the investors want
to be able to arrange the split between them of calls
on the company's future income (in the person of shares
of capital stock or interests in limited liability company
profits) without worrying about the consequences of that
allocation as a taxable event to either party. In a limited
liability company, interests in profits can be allocated
and reallocated more or less as the parties agree, without
regard to the respective contributions of capital. The
allocation must have "substantial economic effect,"
which means not much more than that a scheme directly
keyed to the tax status of the partners is questionable.
A corporation can distribute stock disproportionate to
paid-in capital but only within certain limits.
On the other hand, limited liability companies are not
eligible to participate in tax-postponed reorganizations
under I.R.C. §368. Because a limited liability company
can be incorporated without tax, that problem may not
be insuperable, but attempts to incorporate a limited
liability company on the eve of a statutory merger could
run afoul of the "step transaction" test. Moreover,
venture funds usually do not invest in LLCs because such
investments create intractable tax problems for some of
their own investors.
Finally, one of the most significant disadvantages of
a LLC is associated with the issuance of membership interests
to employees of a LLC upon exercise of employee options.
Generally, the grant of an option to purchase LLC equity
to an employee does not have an immediate taxable consequence
for the LLC or the employee. However, upon the exercise
of such an option by an employee, who then becomes a holder
of LLC equity, several significant tax consequences appear
likely. Although the issue is not free from doubt, once
an employee acquires LLC equity, he or she is likely to
be treated as a partner for tax purposes.
One straightforward solution is to forestall option exercises
until after the date the LLC converts to a C corporation
in anticipation of an IPO or acquisition or merger. Options
would "vest" under a schedule to be determined,
but would not be exercisable until the "first exercise
date." For option holders who leave employment prior
to this first exercise date, the post-termination exercise
period would continue until the conversion of the LLC.
By extending the post-termination exercise period, no
departing employee will feel compelled to exercise the
option that would otherwise expire due to termination
of employment. Preventing option exercises also will save
the LLC the costs associated with accounting and reporting
obligations to a holder of a relatively small interest
in the LLC. It also simplifies the management of the LLC
when membership votes are required.
The complexity of the choice - corporation versus limited
liability company - is multiplied by the fact that there
are issues other than federal income tax to take into
account, such as the impact of state taxes, medical insurance,
and other expenses. There is one way in which to decide
the most intelligent election between the corporate and
the limited liability company form. Take the business
forecast and run two scenarios: limited liability company
versus corporation. Compare the after-tax wealth of the
shareholders assuming a sale of their shares in Year 5
at a multiple of ten times earnings. Look at the difference
Source: VC Experts, Inc.