Category: Choice of entity – non-tax

USING SINGLE-MEMBER LLCs TO CREATE PARENT/SUBSIDIARY STRUCTURES

By , November 27, 2010 4:17 pm

Protecting business assets through parent/subsidiary structures—overview. As a general rule, business entities that own valuable business assets and conduct business operations that could lead to third-party claims should not conduct these operations directly.

Rather, unless there are significant considerations to the contrary, it should hold these assets directly but should conduct its operations through a wholly owned subsidiary entity, and it should lease, lend or license its assets to this subsidiary. Under a properly structured parent/subsidiary structure of this kind, if the subsidiary’s operations give rise to a third-party claim, the parent, if it has not participated in the subsidiary’s operations, should not be subject to the claim and its assets should not be at risk for the claim.

Companies that decide to create parent/subsidiary structures must choose between two types of entities as their subsidiaries—namely, single-member LLCs and single-shareholder corporations. In most cases, the better choice is single-member LLCs. These entities, like single-shareholder corporations, can provide their parents with a strong statutory liability shield. However, because single-member LLCs are subject to no significant statutory formalities, they are simpler to manage than single-shareholder corporations (which are subject to numerous such formalities) and they face a lesser risk of veil-piercing than single-shareholder corporations.

In addition, under applicable default statutory rules, the very simple management structures that can be provided for in the operating agreements of single-member LLCs owned by entities is generally much more user-friendly than the default statutory management structure of single-shareholder corporations.
Illustration. To illustrate the parent/subsidiary structure outlined above:

XYZ, Inc. manufactures and sells widgets. Its annual gross sales receipts are $20 million. It owns tools, vehicles and equipment (its “Hard Assets”) worth $5 million; it owns valuable patents, trademarks, copyrights and trade secrets (its “Intellectual Property”); it has average receivables during its fiscal year of about $ 1million; and it maintains in its bank account about $1 million as operating capital.

As long as XYZ’s board is willing to accept the modest additional complexities involved in operating through a subsidiary rather than through XYZ as a single unitary entity, XYZ should restructure itself as follows:

• It should create a single-member LLC (“XYZ Operations”—
which I’ll refer to here simply as “Operations”) to conduct
all of its product design, manufacturing and sales
operations.

• It should lease its hard assets to Operations.

• It should license its Intellectual property to Operations.

• It should lend to Operations the operating cash that
Operations needs.

Finally, in order to document its separateness from Operations and thus to minimize the risk of claims from business activities of Operations, XYZ should formalize all of its significant relations with Operations in written agreements that contain arm’s-length terms. These agreements should include a lease agreement; a licensing agreement; a loan and security agreement; a licensing agreement; and, last but not least, an operating agreement governing the relationship between XYZ as the parent of Operations and Operations as its subsidiary.

The operating agreements of single-member LLCs owned by entities. What should be the goals of the operating agreement between XYZ and XYZ Operations? I will address this question in my next post in this blog.

WHICH IS BETTER FOR YOUR NEW LLC – A CORPORATION OR AN LLC?

By , September 24, 2010 1:33 pm

CHOOSING BETWEEN STATE-LAW BUSINESS CORPORATIONS AND LLCs ON NON-TAX GROUNDS

Dear readers:

I recently published an article in a New Hampshire newspaper on some key issues in choosing between corporations and LLCs on non-tax grounds.  In case it’s of any interest to readers of this blog, here’s the article (in quotes)

“WHICH IS BETTER FOR YOUR NEW BUSINESS—
A CORPORATION OR AN LLC?

If you’re starting a new business, a basic question you have to address is whether to conduct it as a sole proprietorship or through an entity—which, in New Hampshire, usually means a corporation or an LLC.  Since every business is different, you should discuss this question with an experienced business lawyer.  But I’ll set forth below some basic guidelines I think you and your lawyer should consider with regard to the legal issues relevant to your decision.  (Tax is a whole different world, and I won’t discuss it here.)

  1. Doing business through an entity involves modest annual expenses and administrative tasks.  The main reason for using an entity is to get “limited liability”—i.e., legal protection for your personal assets if your business gets sued.  However, if you won’t have any employees or other persons with whom you work closely in your business, limited liability may not be useful to you, since no statutory liability shield will protect you from the consequences of your personal misconduct.  Why spend time and money on an entity if it won’t do you any good?
  2. About seven out of every eight entities formed these days in New Hampshire are LLCs.  Assuming that entity limited liability might be useful to you, there are three main reasons why you should probably form an LLC to conduct your business rather than a corporation.
  • First, LLCs have a very informal, user-friendly management structure.  The corporate management structure is much more complex and involves substantial statutory formalities.
  • Second, if you fail to comply with these formalities, your corporate liability shield may be at risk.  This risk is arguably less for LLCs.
  • Third, multi-member LLCs (i.e., those with two or more members) provide a special set of business asset protections called “charging order protections.”  Corporations don’t provide these protections.
  1. What are “charging order protections”?  Here’s an illustration:

Assume that you and a friend form a 50/50 two-member company to manufacture and sell widgets.  One day, while driving your car on an errand unrelated to your business, you accidentally strike and seriously injure a pedestrian.  The pedestrian gets a negligence judgment against you that exceeds your auto insurance coverage.  The pedestrian’s lawyer seeks a court order requiring you to transfer your personal assets to the pedestrian to satisfy the judgment.

If your company is a corporation, the lawyer might well get this order, and you’ll lose your interest in your company.  If your company is an LLC, all the lawyer will probably get will be a “charging order”—i.e., an order that any dividends your company would have distributed to you must be distributed instead to the pedestrian until the judgment is satisfied.

The fact that charging order protections are available to LLC members but not to corporate shareholders is the single biggest reason why, at least for multi-owner businesses, LLCs are better as business entities than corporations.

  1. Do corporations have any legal advantages over LLCs?  Some lawyers say yes, and they cite two main advantages.  Personally, I disagree with these lawyers.
  • First, these lawyers argue that the rules in the New Hampshire corporate statute governing decision-making, although they are complex, provide much more certainty that those in the New Hampshire LLC act.  I agree that our corporate statute contains excellent governance rules; but in my experience, these rules are too complex for most small businesses.  As a result, these businesses simply ignore them.  So when there are disputes among the shareholders of small New Hampshire corporations, the corporate rules often don’t help and can sometimes be a serious hindrance.
  • Second, these lawyers argue that because corporations have shares, share certificates, and share and shareholder registries that keep track of corporation ownership, while LLCs don’t, corporations are better able to document changes of ownership over the years.  In my view, this is a good argument—but only in theory.  The problem is that, in my experience, very few small New Hampshire corporations keep track of their share certificates and most don’t have up-to-date share registries or shareholder registries.  So, in practice, the supposed greater clarity of corporate ownership is, for many small businesses, illusory.  Furthermore, there are simple and effective ways that LLCs can track changes in ownership without any need for share certificates and complicated registries.

To sum up:  Every business is different, so before you decide whether to form your business as a corporation or an LLC, you should talk to an expert.  But the expert should probably tell you to go with an LLC.”

WHAT LLC BUSINESS ORGANIZATION LAW DO YOU NEED TO KNOW IN ORDER TO BE COMPETENT TO FORM LLCs?

By , August 19, 2010 6:45 am

For the past several weeks I’ve been hard at work writing a law journal article that seeks to answer the above question under the Massachusetts LLC Act. 

I’ve concluded that in order to be able to form LLCs competently under that act, you need to possess a rather shockingly large amount of business organization law knowledge. 

Specifically, I’ve concluded that in order to handle non-tax choice of entity for your LLC formation clients, you need to know (i) the chief business organization law features of LLCs under the Massachusetts LLC Act and (ii) the similarities and differences among these features and those of all other types of Massachusetts business organizations. 

And I’ve concluded that in order to competently plan, negotiate and draft operating agreements for your clients you need to know:

  • The provisions of the Massachusetts LLC Act that are relevant to LLC formation practice (which, by my count, comprise 152 provisions);
  • Whether each of these provisions should be characterized as definitional, mandatory, default, non-self-enabling permissive or self-enabling permissive;
  • The tactical significance of these characterizations in forming Massachusetts LLCs;
  • Massachusetts LLC case law relevant to LLC formations;
  • The “gap issues” in Massachusetts LLC law—i.e., the issues on which this law is silent or ambiguous (so that, in the operating agreement, you won’t overlook any of these issues);
  • The principal business organization law issues relevant in Massachusetts LLC formations (so that you won’t overlook any of these issues) and the various alternative methods of resolving each of these issues in your clients’ best interest;
  • The rules of Massachusetts LLC law that govern Massachusetts LLCs that lack operating agreements (so that you can explain to your clients why they absolutely need to have these agreements); and
  • The potential adverse impact of these rules on Massachusetts LLCs and their members.

If the above question is one that you yourself have thought about, I’d be very grateful for your reactions to the above list.  In putting the list together, have I gotten just a bit carried away?

LLCs AND CHOICE OF ENTITY—THE BIG PICTURE

By , June 9, 2010 11:22 am

Every LLC lawyer will agree that the most important threshold task in forming LLCs is a task often referred to as “choice of entity.”  In the months and years to come, this blog will address dozens of choice-of entity issues.

But the key fact you have to realize before you undertake any choice-of-entity analysis is that there is, technically, no such thing. Rather, choice of entity requires three types of analyses, each of which is entirely different from the others. When you’re doing choice-of-entity, you should, to the extent of your competence, do all three analyses and then, if there are any conflicts among them, reconcile these conflicts.

To explain:

  • Non-tax choice of entity. The first type of choice-of-entity analysis is non-tax choice of entity. This is the process by which lawyers choose the best type of business organization for their clients on non-tax grounds—mainly on business organization law grounds. The key types of business organizations are sole proprietorships, divisions, general partnerships, limited partnerships, corporations and LLCs. The key issues are, for most clients, (1) Does the client need a liability shield? (2) If so, which type of organization will provide the client with the best shield? (3) Does the client need the special statutory business asset protections referred to by LLC lawyers as charging order protections? (4) If so, should the client obtain these protections through a general partnership, a limited partnership or an LLC? (Most corporate statutes don’t provide charging order protections.)
  • Choosing the right federal income tax regimen for federal income tax purposes. The second is choice of federal income tax regimen for federal income tax purposes. The relevant regimens are disregarded entity taxation and Subchapters C, K and S. Key issues include: (1) Which regimen will provide the client with the lowest tax rate? (2) Which will provide the client with the greatest flexibility in deploying and redeploying business assets?
  • Choosing the right federal income tax regimen for Social Security Tax purposes. The third is choice of federal income tax regimen for Social Security Tax purposes. The relevant regimens are those listed above, but the relevant issues are entirely different from federal income tax issues. In addition, you won’t find the key authority in this field in the Internal Revenue Code or even in a final regulation—it’s a little-known but remarkably powerful IRS proposed regulation designated Prop. Reg. § 1.1402(a)-2.

Understanding these three types of analyses in detail takes a lot of study and experience; but the best place to start in understanding them is with the Big Picture. The Big Picture is in the three bullet points above.

LLCS ARE THE KING OF THE HILL!—PROFESSOR CHRISMAN’S NEW ARTICLE

By , March 29, 2010 7:37 am

On April 9, 2010, Rodney Chrisman, a professor of law at Liberty University School of Law, will publish an article in the Fordham Journal of Corporate and Financial Law entitled “LLCs are the New King of the Hill:  An Empirical Study of the Number of New LLCs, Corporations and LPs Formed in the United States between 2004-2007 and How LLCs Were Taxed for Tax Years 2002-2006.”  You can access the article here.  A photo of Professor Chrisman is on the left.  You can access his bio here.

The central conclusions of the article are as follows:

  • LLC formations.  As of the end of calendar year 2007, more LLCs were being formed each year than corporations and limited partnerships in all U.S. jurisdictions except California, Florida, Illinois, and New York.  (Recent data appear to indicate that LLCs have overtaken corporations and other non-LLC entities in Florida.  However, because of taxes and other factors in California, filing fees in Illinois, and “publication” requirements in New York, corporate formations are likely to outnumber LLC formations in these three states until they change their laws.)
  • LLC taxation.  To date, only a relatively small number of LLCs have made elections to be subject to federal income taxation under Internal Revenue Code Subchapter S.  However, the annual rate of increase of these elections is phenomenal, and it suggests that eventually, Subchapter S will be as popular with LLCs and their members as with corporations and their shareholders.

Professor Chrisman’s article makes an important contribution to our understanding of the standing of LLCs stand vis à vis non-LLC entities in the American business and professional community.  It also provides critical data on a key issue of LLC taxation—namely; the use of Subchapter S by LLCs.  The article will be useful not only to LLC lawyers and accountants but also to business people who are considering forming LLCs or converting non-LLC entities to LLCs.  Professor Chrisman deserves thanks from us all.

If you’re wondering why LLCs are now “the king of the hill” as compared with corporations, here’s why:  (1) LLCs provide a stronger statutory liability shield than corporations.  (2) Unlike corporations, LLCs provide statutory charging order protections.  (3)  Under the relevant statutory default rules, the LLC management structure is far simpler, more flexible and more user-friendly than the corporate management structure.

If you’re wondering why ever-increasing numbers of LLCs are making S elections, it’s because these elections provide individuals who own single-member LLCs and many individuals who are members of multi-member LLCs with the only available means to avoid Social Security Taxes on their LLC income.