Probably the most common conversation I have with a new client goes something like this:
Client: “I need create an LLC.”
Me: “How do you know?”
Client: “Know what?”
Me: “That you need to create an LLC.”
Client: “Because I’m starting a business, and I need an LLC.”
Me: “I understand that you are starting a business, and you are wise to create an entity of some sort, but how do you know you need an LLC?”
Client: “I don’t know. I just thought that’s what I needed,” or “Because my friend so-and-so [insert the non-lawyer advisor of your choice] told me I need an LLC.” I’ve even heard, “Because my accountant has an LLC, so it must be what I need” (never mind that my client isn’t opening an accounting business).
For some reason nowadays, everyone thinks they need an LLC. Many do. Many don’t.
Selection of the right business entity for your particular business is a crucial decision, and it must be made right at the start, with the counsel and guidance of a knowledgeable business attorney. This one decision will determine ownership of the business, how it is managed, what the business can and cannot do, the potential liabilities and liability protection of the business, and the legal requirements for formation and maintenance of the business, among other things.
For instance, LLCs are owned by its members, who typically also operate the business (though an LLC can be operated by designated managers), and can have very flexible ownership and operating structures. However, they are more difficult to work with if you are looking for periodic venture capital infusions. On the other hand, corporations are owned by shareholders, who may or may not also run the company, and the stock structure is typically much friendlier to venture capitalists.
Members of an LLC risk (and can lose) their capital investment, but usually not much else. They are protected from company obligations and liabilities of other members. However, they can of course be liable for their own personal misconduct. Similarly, shareholders of a corporation risk only their investment in the company – what they paid for their stock. They are typically not liable for the debts of the corporation. However, directors have a heavier burden in terms of their duties and loyalty to the company than members of an LLC.
There are tax differences as well. An LLC is automatically taxed as a partnership, unless it qualifies and elects to receive what is usually the more favorable tax treatment of an S-Corp. In contrast, a corporation is automatically taxed as a C-Corp, which means that all income is taxed at the corporate level, and then taxed again when salaries and distributions are paid out to employees and shareholders (double taxation). However, a corporation, like an LLC, can choose the pass-through taxation of an S-Corp, provided it qualifies. Also, some particular types of business activities can receive greater tax benefits from certain types of entities (for example, some businesses that deal in real estate can, under certain circumstances, receive greater benefit from being formed as an LLC).
An LLC is typically much easier to maintain on a year-to-year basis. There are essentially no ongoing company formalities that must be complied with from a legal standpoint. A single-member LLC may not even have to file a tax return for the business! This is very different from a corporation, which will always have to file a tax return (even if it elects to be taxed as an S-Corp and therefore has only pass-through taxation), as well as annual minutes for both its shareholders and its board of directors. Neglecting these formalities can not only increase legal liability, but can create due diligence problems if you ever try to sell the business.
As an aside, I should also mention here that whether you are creating an LLC or a corporation, at least a cursory trademark search should be conducted before you file any organizational documents to make sure that the name you so lovingly and carefully chose for your business after weeks of agonizing consideration, does not infringe on somebody else’s trademark. Just because the Secretary of State says that your chosen name is available in Alabama does not mean that somebody else in the state – or anywhere else in the country – doesn’t already have a trademark interest in that name, which you are about to infringe. A good business attorney will know how to conduct this type of search, and hopefully keep you from getting nasty letters and having to change your business name.
All of which is to say that choosing the right kind of business entity is a complicated and important decision. It is important that you consult a knowledgeable business attorney during the process. It may cost you a little more on the front end, but will likely save you a great deal of money and hassle during the life of your business. Having said all of the foregoing, the worst thing a business owner can do is operate without the protection of any legal entity structure at all. The potential liability and tax consequences of non-organized businesses (called “sole proprietorships”) are the kinds of things that keep me up at night – the stuff of nightmares for business attorneys. Don’t give me nightmares.