Category: LLC Formation Process

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.”

DRAFTING PLANNING MEMOS FOR LLC FORMATION CLIENTS

By , September 14, 2010 4:30 pm

I’ve spent much of the last 17 years forming LLCs for clients.  If there are two things I’ve learned from this experience, they are as follows: 

  • First, it’s indispensable that clients understand at least the basic rules that will govern their LLCs, and especially those concerning contributions, allocations, distributions, events of dissociation, buy-sells, fiduciary rights and duties, and dispute resolution.  If they don’t understand these rules, then once their LLC is formed, they can unsuspectingly step into a lot of holes.  And if they do, they’ll blame you.
  • Second, most clients hate to learn LLC rules by reading drafts of LLC operating agreements.  Even in relatively simple deals involving multi-member LLCs, these agreements, if they are well-drafted, are likely to be 30 or 40 pages long and replete with unavoidable technical terms.  Even for lawyers, reading 30- or 40- page agreements can be a real pain.  And even operating agreements for single-member LLCs should normally run to 10 or 15 pages.

But I think there’s a very effective way to address the dislike most clients have for the demanding process of reviewing drafts of operating agreements.  It’s what I call planning memos.  I highly recommend you consider the use of these memos.

Planning memos should normally do the following:

  • They should explain the purpose of the operating agreement in question.
  • They should explain in plain English key LLC terms and concepts such as “allocation,” “distribution,” “event of dissociation,” “fiduciary rule,” and “charging order protections.”
  • They should identify all of the LLC business organization law issues, the other legal issues and the federal and state tax issues likely to be important to your clients.
  • They should identify the main alternatives available to your clients for resolving each of these issues.
  • They should recommend the alternatives you believe to be best for your clients and should state the reasons for your belief.

Needless to say, while planning memos are much easier for most LLC formation clients to review and digest than operating agreements, writing them is often a hard job; it’s time-consuming; and it adds significantly to the legal fees your clients will have to pay you.  But I find that at least half of my LLC formation clients are willing to pay these extra fees; and in my experience, once they’ve read your memo, these clients are glad they paid you to write it.

Here’s a final major benefit of planning memos:  In addition to providing a useful tool for clients and earning you some deserved additional income, you’ll almost always find that the very process of drafting them helps you identify legal and tax issues you’d otherwise have overlooked.