Over the past two decades Limited Liability Companies (LLCs) have become a preferred means of forming a business entity and with good reason. LLCs provide their owners with many of the benefits of other types of entities while limiting their detriments. In many instances, however, an LLC may not be appropriate, especially in early-stage technology or planned high-growth companies (often one in the same), who plan to go through several rounds of financing and, eventually cash out with a sale to a large company or an IPO. The following is a brief comparison of oft-quoted reasons for establishing an LLC followed by counterarguments suggesting reasons to not set up this type of entity.
- Formation is quick and simple. While Articles of Organization must be filed with the Illinois Secretary of State, the process is relatively painless. The business owner should be prepared to answer some questions prior to organizing, including who the registered agent will be and whether the business will be “member managed” or “manager managed.” The owner will also need names and addresses for the agent, the organizer, and the members/managers (in small LLCs, these can all be the same person). The cost to file the Articles is $500.00 and there is an additional $100.00 fee for expedited filing. In LLCs with 2 or more members, an operating agreement should be entered into, but this is not a requirement and is not filed with the state. When the Articles are filed and approved by the state (a process that only takes about a day with expedited filing), the LLC becomes an official entity.
1a. LLCs may be difficult to invest in. LLCs provide unique problems for investors that aren’t present in a corporate structure. A member of an LLC who receives no cash distributions can still be taxed on the business income. Venture funds often can’t (or won’t) invest in LLCs, especially if they have tax-exempt partners. Furthermore, the relative simplicity of investment in a corporation via stock purchase is the preferred means of investment for early-stage growth companies. Finally, LLCs are unable to perform some stock swaps that corporations can.
1b. Raising Funds. Obtaining additional rounds of financing with a corporate structure is substantially easier than doing the same with an LLC. Tax issues can complicate matters when raising additional capital for an LLC that are not applicable in the corporate realm.
- The administrative burdens are light. From a corporate governance standpoint, an LLC is not subject to nearly as many requirements as corporations. There is no necessity to have a board of directors and, therefore, resolutions and written consents are not necessary for company action. The only major on-going requirement is the filing of an annual report with the Secretary of State. This is an important step, however as a failure to timely file the report can be grounds for administrative dissolution.
2a. Difficult Agreements. Although LLCs are easy to form and have substantial flexibility in the way they may be operated, this freedom actually poses a problem when the entity becomes complex. While a small or self-funded LLC can get by with a basic operating agreement, a larger company (or one that plans to grow substantially) will need to spell out substantial terms in their agreements, making them unwieldy and a poor choice for a growing entity.
- Flexibility. Substantially fewer formalities are required to manage an LLC as opposed to a corporation. For example, an LLC can be managed by a “manager,” or by one or more “members.” It can provide for a board of directors and employ officers, similar to a corporation, or it can simply be run by its member(s) or manager(s). Distributions and allocations of profits and losses can be structured in different fashions in the operating agreement, as can the general operations of the business. There are also few restrictions placed on who may be an owner of the entity and owners may be active in the day-to-day operations of the business.
3a. Bias towards Corporations. LLCs are becoming more common and knowledge of them is gaining, but major investors do most of their work with corporations and have a level of familiarity with that structure. Therefore, even if the above issues are worked out, there is a good chance the documentation necessary for the LLC will be difficult for the investors and more time will be spent on due diligence prior to making an investment decision. In the world of high growth companies, this extra time can spell doom for a company that needs quick funds to stay afloat.
- Limited Liability. As the name implies, an LLC structure provides its owners with limited liability meaning that, while the company itself is liable for lawsuits and debts, the individual members (owners) are not personally liable. While there is a way to “pierce the corporate veil,” most LLC owners can rest assured that their personal assets are safe regardless of what happens with the LLC.
4a. No Argument. Corporations were the initial vehicle to provide limited liability for their owners. LLCs also have this benefit and, other than the veil piercing mentioned above, both entities are good choices for limiting personal liability.
- Tax Issues. Corporations are generally subject to what is known as “double taxation,” meaning they are taxed on the income they receive and then taxed, again, when paying dividends to shareholders. LLC’s, on the other hand, are considered “pass-through” entities, meaning that profits and losses are passed through to the owners and the LLC itself does not pay taxes on the gains, thereby avoiding double taxation. Of course, the owners pay taxes, but when their tax rates are lower than the corporate tax rate, they will enjoy tax savings. Furthermore, where the business expects to incur losses early in its existence, the members can claim the losses on their tax returns and obtain a personal tax benefit.
5a. Is Double Taxation Really a Problem? As discussed above, LLCs are not subject to double tax. However, this may not be an issue for many early-stage companies. Therefore, the actual effects of double taxation may be overblown, as many early-stage companies trying to raise capital and grow quickly do not plan to be immediately profitable and have no profits and/or distributions to worry about.
Care should be taken in choosing an appropriate business entity. While LLCs are a perfect choice for many start-up businesses, the particular plans of the company owners should be analyzed prior to making a commitment to business formation.