John Green and Mary Jones, our future coffee shop operators, have now heard my spiel on partnerships and corporations. They want to know the upside and downside of
limited liability companies (also known as LLCs). So I explain the strange animal known as an LLC.
LLCs have been in the USA for a number of years, but are relatively new to California. The state legislature birthed the California version in 1994. The LLC was
developed to give its owners both limited liability to the same extent enjoyed by corporate shareholders and a pass-through entity similar to that of an “S” corporation but
with more flexibility about how the company is run and who may own it.
An LLC can be run in one of three different ways: by all of its owners (also known as Members), by a manager who is also one of the LLC’s owners, or by an outside
third party. Regardless of which form is chosen, the members and managers enjoy liability protection much like the shareholders and directors of a corporation.
LLCs present significant benefits in certain situations. For instance, let’s say that John is a Canadian citizen who is a registered permanent resident. In other words, he’s
here legally but he is an alien. As such, could not own stock in an “S” corporation. Or consider the scenario where, after John and Mary’s business has started, another
corporation wanted to invest in it by buying some of Coffee Haus’ stock. While this is possible, Coffee Haus would lose its “S” status since corporations cannot own stock in
LLCs.
Another benefit is that the owners of LLCs can decide to split the profits and losses however they want (and not according to what their percentage of ownership is)
and still have the tax pass-through benefit. This can really help where some of the owners of the LLC are putting in most of the money and the other owners are contributing their
time and effort. The owners of the LLC can agree that the members who put in the money get paid back their investment before the sweat equity owners get any return. You
couldn’t do this with an “S” corporation.
A major attraction to LLCs is that they do not have to run as formally as corporations. They do not have to have regular meetings, they can structure management
in a variety of ways, and their recordkeeping is not as onerous. With a corporation, if you fail to keep records and have meetings and adopt resolutions, someone could use that
omission as a basis to hold the individual owners and directors liable. This is not the case
with LLCs.
However, there is at least one major negative with LLCs. Even though for federal tax purposes they are pass-through entities, the State of California imposes a high tax for
the privilege of being a California LLC. The state will charge all LLCs a fee based on their gross receipts (not net income). That fee can range from $800 to as much as
$11,790.
After all of this discussion, I again advise John and Mary to consult with an accountant. I tell them that I often recommend an LLC over a corporation because it is so
flexible, very informal, allows for a variety of types of investors and owners, and, with the preparation of a good Operating Agreement, the owners have the benefit of a
Buy/Sell Agreement and a Shareholders’ Agreement all in one document at a lower cost than preparing separate agreements.
If you are about to open a business and have questions about what type of organizational entity you should be, you should consult with a qualified business attorney
and an accountant with experience advising corporations and other types of businesses.©