Corporations Don't Work: Here’s Why You Should Form an LLC Instead
What’s the big deal with an LLC? Why should I prefer it over a corporation?
With any US-based business, the IRS serves as a silent partner, eagerly waiting for its cut of any business earnings. Accordingly, most small businesses and startups prefer a limited liability company (also known as an LLC) over a corporation because it offers them the most favorable tax treatment. This began on January 1, 1997, when the IRS issued the so-called Check-the-Box regulations, which made it easy for multi-member LLCs (LLCs with two or more owners) to qualify for partnership taxation and for single-member LLCs (LLCs with only one owner) to qualify for the highly favorable “disregarded entity” federal income tax treatment. The tax burden passes through (with two or more owners) or even bypasses (with one owner) the LLC and you deal with the taxes on your personal tax return.
Before 1997, the corporation was the dominant form for business formation. By default, a corporation is taxed under Subchapter C of the Internal Revenue Code (IRC), as an C Corporation. This means double taxation. The corporation pays income taxes on its profits (also known as earnings) and then the shareholders separately pay taxes on any disbursements of cash received (also called dividends). The same dollar is taxed twice – not the best result for a small business owner eager to retain as much of her hard-earned money as possible!
The Check-the-Box regulations also permitted LLCs to elect treatment under Subchapter S of the IRC (aka “S Corporation”), assuming the LLC met certain eligibility and election requirements. Under the right circumstances, the S Corporation designation offers a small business owner additional tax savings in social security and Medicare taxes.
The LLC also offers some practical advantages over a corporation.
ADVANTAGE 1: Contractual Freedom
As a fundamental principle, an LLC offers “freedom of contract.” This is based on a free-market philosophy, namely, business owners should be free to structure their businesses as they see fit. This is contrary to the policy behind corporations, which favors making owners fiduciaries for the actions of their companies. As a result, LLC members can transact business with anyone (as opposed to being held to a duty of loyalty under corporation law). The LLC can also provide unlimited indemnification under most state LLC laws. Thirdly, the LLC agreement can carve out specific classes of owners with no voting rights.
This contractual freedom gives business owners nearly unlimited flexibility and creativity to tailor their LLC agreements to meet their specific business goals. Although an LLC Act contains provisions for handling the LLC’s business and management activities, these are mostly default provisions (meaning the terms only apply if you don’t directly deal with such activities in your written operating agreement). Having properly drafted written operating agreement in place is critical.
The Delaware Limited Liability Act (DLLC Act), for example, expressly states: “it is the policy . . . to give the maximum effect to the principle of freedom of contract and to the enforceability of [LLC] agreements.” See DLLC Act § 18-1101(b). See also Elf Atochem North America, Inc. v. Jaffari, 727 A.2d 286 (Del. 1999) (affirmed maximum freedom of contract). Other state LLC Acts mirror this language.
It’s important to note the “maximum freedom” does not mean “absolute freedom.” All LLC Acts still contain certain mandatory provisions. Except for Illinois, an LLC must have at least one member to be a valid LLC. An LLC must also use a business name not nearly identical to other business names in the formation state’s database. Additionally, LLC agreements cannot override federal bankruptcy law. Contract law also has limits. A contract, for example, is not valid if executed based on a misrepresentation or fraud. These contract limits also apply to LLC operating agreements (except for prohibiting contract penalties, which are allowed under LLC operating agreements for specific situations, like failing to make a promised contribution).
In contrast to a corporation, an LLC offers substantial freedom in customizing your business.
ADVANTAGE 2: More Asset Protection
The LLC Act also offers business asset protections not offered by corporations, namely “pick-your-partner” and “charging order” protections. These provisions help protect business assets and membership rights from third parties.
Pick-your-Partner. As implied by the term, you cannot force an LLC owner to be in business with someone else (i.e. a creditor). An LLC owner has the right to pick her partner under the default rules of most LLC Acts. These default rules recognize the success of any business venture depends on compatibility. Accordingly, although an LLC owner can freely transfer her economic rights, she cannot transfer her management rights without the consent of all the other members. This protects the other owners. It prevents them from having to make business decisions with partners they never picked. This prohibition also extends to the courts. Thus, a court cannot order another LLC owner to transfer her management rights to a third party.
In contrast, corporation law generally permits shareholders to freely transfer shares, including management rights. This helps corporations raise large amounts of capital (such as in a public offering). Small businesses, however, typically do not need to mobilize lots of cash, making the corporate form less valuable.
Charging Order provisions. A charging order provision protects the LLC’s business assets if a creditor obtains an unsatisfied judgement against one of the owners personally. This provision limits the creditors recourse to that owner’s economic rights, without impacting the economic rights of the other owners.
ADVANTAGE 3: Less Formalities
Corporations must comply with statutory formalities. This includes adopting bylaws, electing directors and officers, issuing share certificates, holding annual shareholder meetings, taking annual shareholder actions by consent, and documenting actions by corporate minutes. Many of these formalities are mandatory. Failure to follow these formalities can lead to veil-piercing and loss of any liability and asset protection.
In contrast, no LLC Act imposes these types of formalities. Owners can completely customize how they structure the management of their businesses. This allows owners to streamline decision-making and move faster.
Corporations are not all bad. They have advantages too. The LLC Acts of most states, however, incorporate many of these same advantages. Like a corporation, an LLC affords its members: (a) limited liability; (b) easy transfer of assets; and (c) continuity of management.
SIMILARITY 1: Limited Liability
In theory, the LLC remains solely liable for any claims brought against the LLC or any debts or obligations of the LLC. The members and managers are not personally liable for such claims, debts, or obligations. In short, the limited liability protections help safeguard your personal assets from claims brought by third parties against the LLC.
Importantly, the LLC remains 100% liable for all claims brought against the LLC and all the LLC’s business assets are at risk with such claims. Therefore, many of our clients will form multiple LLCs, sometimes structured as subsidiaries or sister companies, to isolate the liabilities of one LLC from the others. A restaurant group, for example, that owns multiple restaurant locations will often create a new LLC for each location. If one location becomes liable, then in theory, that liability does not extend to the other LLCs. We say “in theory” because it depends on how well you have structured the intercompany agreements, the sharing of resources and other business functions. Additionally, make sure you insure your LLC against claims by purchasing the proper business insurance.
SIMILARITY 2: Easy transfer of assets
Like a corporation, an LLC is a separate and an independent entity. This means the LLC can own property in its own name. The owners have no direct interest in the property owned. As the LLC owner, you will only indirectly own such assets (by holding membership interests). By selling membership interest (aka equity in the LLC) to third parties, the third parties also gain indirect ownership of the business assets. This avoids the complication often associated with transferring assets. Technically, you never transferred the assets because the LLC continues to own them, even with the change of ownership.
SIMILARITY 3: Continuity of Management
If properly structured, the LLC will continue to exist, even as owners become deceased, retired, or removed. Like the corporation form, this ensures continuity of management.
Corporations can work in certain circumstances, such as mobilizing large amounts of cash or making a public offering. The unfavorable tax treatment, inflexibility, and statutory formalities, however, make the corporate form burdensome and not effective for most small businesses and startups.
By the way, if you need an operating agreement (and you do), then go to contractsprint.com or reach out to us at email@example.com. Our operating agreements are fully customizable and can help you achieve more in business. This ain’t no Zoom baloney.