Choosing a Business Entity

08/02/2021

Business Entities. In the world of business there are numerous  entities or business structures which can be used to form and administer  a business or commercial enterprise. While there are aspects of business  which are common to all commercial enterprises, there is not one entity  or structure that is appropriate for all. Each business will have its own  set of priorities, capitalization and expense issues, owners and investors,  and even differing personalities between members and management  that must be considered. All of those factors are relevant in considering  which business entity to use.

For some, the need for a simple structure is a priority, in which  case a sole proprietorship or a single member LLC can be effective. For  other, more sophisticated businesses, the need to structure a business  based on tax planning can be of primary importance. Partnerships,  limited liability companies and small business corporation (or S Corps)  give business owners a variety of options for tax planning. For large  operations, despite apparent negative tax implications, sometimes the good old fashioned corporation (also known as a C Corp) is the best  option. Often more than one type of entity will be appropriate for a  given business. In order to determine which entity is best it is necessary  to undergo a detailed analysis of numerous applicable factors and  weighing of priorities.

Many professionals feel that tax benefits and liability protections  are the primary forces to consider when determining what form of  business structure is appropriate for the particular business needs. While  the authors agree that these are two very important considerations,  there are at least twenty (20) other factors that should reviewed as well.  Many of these factors are beyond the scope of this chapter, but you are  encouraged to consider such things as, marketing, branding, business  succession and exit strategies, compartmentalization of risk, future  financing and investment criteria, to name just a few.

This article is written to briefly outline the various business entities  that are available to business owners and to provide details regarding  the factors that weigh for or against use of each. It is not meant to be  an exhaustive list of the entity types that are available and certainly not  a complete dialogue of all factors to consider. Additionally, most of the  focus of this chapter will be regarding entity structures appropriate for  “for profit” entities. Non-profit or low profit enity planning is an animal  all to it’s own.

While tax issues are not always the guiding factor, proper tax  structure for a business can often have a significant impact on the  profitability of a business or on the attractiveness of a business to potential  investors. Therefore in addition to exploration of the fundamentals  regarding various business options, substantial reference is included to  tax structuring and tax based operations.

Sole Proprietorship. A sole proprietorship (“SP”) is not a formal  business entity. It is the oldest form of doing business and has existed since  long before state recognized entities. Simply stated, a SP is fancy way of  saying “doing business on your own.” It is owned by an individual and  is the simplest form of business entity, though again it is not technically  an entity. All of the income of the SP is taxable to the proprietor and all  assets are likewise owned by the proprietor.

The owner of a SP can operate the business that is the subject of  the SP in his or her own name or the SP can use a formal business name  registration commonly referred to as Doing Business As or “DBA.” A SP  can obtain a DBA typically by registering with the county or counties  where doing business. The SP then has a formal business name registration,  which is protectable intellectual property, but that is the extent of any  protections afforded to the owner of the SP. Although a SP can own  property and assets, as well as enter into contracts and conduct business,  the SP has no separation from the owner, and therefore the owner has no  liability protection from the creditors and liabilities of the SP.

The only real advantage to operating a SP as opposed to any other  business structure is the simplicity with which the SP can be organized and  can conduct business. Unlike a corporation or limited liability company,  there are no annual filings to be completed with the state where doing  business, and tax reporting for the SP is done simply by reporting business  income on Schedule C of the SP owner’s personal income tax return.

In addition to concern for no limited liability protection, the SP has  the other disadvantages of income still being subject to self-employment  tax and fringe benefits are generally not deductible. The owner of the SP  is not eligible for any fringe benefit that an employee may enjoy in other  business structures.

General Partnership. It is common under the laws of the various  states of the United States for a partnership to exist anytime there are two  or more individuals who join or work together in a common commercial  enterprise. If there is no formal written partnership agreement then state  law regarding partnerships will govern the rules of administration and  the duties of the partners involved.

A partnership exists as a separate entity from its partners. This  means that the assets and property used in the partnership is deemed  to be the property of the partnership rather than of the individual  partners. Typically, partners will contribute cash, tangible property and  even securities to the partnership as initial and ongoing capitalization.  The individual partners’ percentage of ownership in the partnership  is determined by the amount of capital and property contributed in  relation to the other partners.

In a general partnership all of the partners are deemed to be general  partners, and as such they are jointly and severally liable for all of the  liabilities of the partnership. Also, each partner of a general partnership  has the authority to bind the partnership when the partner acts in the  normal course of business. Common law rules and various state laws,  including the Uniform Partnership Act (UPA) in states where it has been  adopted govern the administration of partnerships.

Partnerships are also commonly referred to as a type of pass through entity because all of the income and losses flow through from  the partnership level to the individual partners. Upon formation each  partner will have a capital account that is a reflection of the amount  of capital or the value of any assets contributed to the partnership. A  partner’s capital account increases whenever the partner is allocated a  portion of profits or revenue and the capital account decreases when a  distribution is made to the partner. Taxation of a partnership is governed  by subchapter K of the Internal Revenue Code, which is one of the more  complex sections of the U.S tax code.

Limited Partnership. Limited partnerships are statutorily created  entities. A limited partnership is typically formed by filing with the  state a certificate of limited partnership. A limited partnership can  also be formed by filing articles of conversion to convert an existing  entity into a limited partnership. Similar to a general partnership  there must be at least two partners, but in the limited partnership  one or more partners may be the general partner with the remaining  partners known as limited partners. The general partners have  unlimited liability and typically manage or actively participate in the  business of the limited partnership as well have full authority over all  of the assets of the partnership. Because a general partner is subject to  unlimited liability a general partner is often organized as a corporation  or limited liability company in order to shield liability away from  the individual general partner. However, it is this characteristic of the  general partner being personally subject to the liabilities and debts of  the general partnership which makes this entity choice less popular.  This is especially true with the advent of the limited liability company  as an entity option.

General partners typically have a small percentage of ownership  anywhere from 1-10% of ownership. The general partnership interest  is also often granted by the partnership in exchange for a promise to  provide services to the partnership rather than in exchange for a capital  contribution of assets or cash.

Limited partners do not actively participate in the general  partnership and have no management control. Rather their involvement  is intended and even required to be limited, essentially leaving the limited  partner as only a passive investor. Because of this lack of management  and active participation in the business of the partnership the limited  partner has the protections of limited liability. This means that in the  event of a lawsuit or other liability against the limited partnership, the  limited partner’s loss potential is limited only to the limited partner’s  contribution to the partnership.

The tax laws and regulations for partnerships under Subchapter  K of the Internal Revenue Code apply equally to general and limited  partnerships. Subchapter K provides the benefit of the partnership not  being subject to double taxation because all income flows through to  the partners in proportion to their respective percentage of ownership.  The partnership also enjoys tax-free status on formation, meaning that  all contributions to the partnership by the forming or later contributing  partners are deemed tax free to the partner.

One characteristic that is unique to the partnership is the ability  of partners to take tax-free distributions of property or assets from the  partnership. There is no such thing as a tax-free distribution of property  in a corporation. All distributions of property, including any property  which has been originally contributed by a shareholder to a corporation,  is deemed to be a dividend and is therefore subject to tax as such.  Whereas with a partnership, partners have the flexibility to contribute to  and receive liquidating distributions from a partnership without being  taxed.

One of the primary tax benefits of a partnership is the ability to  enter into qualified non-recourse finance to acquire assets such as real  estate. When a partner contributes capital or assets to a partnership  the partner receives a tax basis for the partnership interest. For tax  purposes basis is an important tool because in a partnership a partner can deduct losses of the partnership up to the amount of the partner’s  basis in the partnership. Qualified non-recourse financing is a loan  taken to acquire real property and there is no personal liability to the  partners for repayment of the loan. A loan taken by the partnership that  is qualified non-recourse is allocated to all of the partners, which results  in an increase in the individual partners’ basis in the partnership. Thus  giving the partners greater basis from which losses of the partnership can  be deducted.

Partnerships are notorious for one characteristic which can be  financially burdensome, especially to limited partners. A partnership is  generally not required to issue a distribution of profit to the partners.  However, because the partnership is a flow-through entity with all  partnership income being allocated or attributable to the individual  partners on a pro-rata basis (unless a special allocation of income or  loss is made – see below) each partner must pay tax on his or her share  of partnership income regardless of whether a distribution of profit is  distributed to the partners. This scenario is referred to as “Phantom  Income.” If a partnership is profitable then at the end of the year, the  general or managing partner is required to issue a K-1 to each partner,  which shows the partner’s share of partnership income. A K-1is also  provided to the IRS similar to how a W-2 is issued by employers. Upon  receipt of the K-1 each partner is required to report his or her share of  the partnership income with the partner’s annual 1040 tax return. If the  partnership does not distribute the revenue from the partnership and if  the partner does not have sufficient outside revenue or capital sources  available to pay the tax on the partner’s share of partnership income it  can leave the partner in a difficult situation with the IRS. This problem  can be avoided by proper drafting of the partnership agreement.

Another special tax rule that exists in the partnership world is the  ability of partners to make special allocations of income and loss. In  general the partnership agreement governs how items of income, gain,  loss or deduction will be allocated among the partners. If there is no  partnership agreement or if the agreement does not provide guidance  as to how those items are to be allocated then each partner’s share of  income, gain, loss or deduction will be determined according to the  partner’s percentage of ownership in the partnership. However, tax law governing partnerships gives flexibility for a partnership to allocate  income or loss disproportionately as long as the allocation has what is  referred as “substantial economic effect.”7 This ability to make special  allocations gives the partnership the ability to return cash or assets to  a partner before distributing income or other items of loss to other  partners. This can allow the partnership to allocate income to partners  in a lower income tax bracket or may allow the partnership to pass on  losses of the partnership to partners with higher outside income.

The general partner manages the business of the partnership. As  a result of that active participation in the business the general partner’s  income or share of the profits of the partnership is subject to self employment tax.8 Active participation is key concept in partnership law.  If a limited partner participates in the operation of the partnership up  to 500 or more hours per year then the limited partner will be deemed  to have actively participated and his income or share of income from the  partnership will be subject to self-employment tax.

General partners have a responsibility to the limited partners.  General partners have sole control of the business of the partnership  and have the ability to act for and contractually bind the partnership.  The general partner is therefore accountable to the limited partners  as a fiduciary. A general partner may breach such fiduciary duties by  failing to notify the limited partners of the sale of a partnership asset.  As a general rule a general partner may not take a business opportunity  which should be shared with the partnership away from the partnership.  Although a general partner does have the right to participate in similar  business ventures to the extent that there is no conflict of interest, there  is tension there between the general partners’ duty to the partnership  and the limited partnership and the general partners’ freedom to pursue  his or her own interest. One of the general partners’ primary duties  is disclosure of all information that is pertinent to the interests of the  limited partners.

General partners may not exceed the authority granted to them  in the partnership agreement to use partnership funds and assets for anything other than the business and pursuits of the partnership. For  example, if a general partner obtains a loan on behalf of the partnership  from a creditor or lender who has knowledge that the loan will render  the partnership insolvent or which is contrary to the terms of the  partnership agreement, the lender may not then rely on the authority of  the general partner to pursue a claim of default against the partnership.

Corporations. Corporations have long been used by business  owners and investors as one of the most common business structures. A  corporation is a separate business person with a separate identity from its  shareholders. A corporation is formed by filing with the state articles of  incorporation. Once articles are filed and accepted, the state will typically  issue a corporate charter declaring the existence of the corporation and  authorizing it to do business in that state.

Corporations have several important characteristics which are  attractive to business owners and investors. First shareholders of a  corporation enjoy limited liability, which means the shareholders are not  personally subject to the debts and liabilities of the corporation and are  not personally responsible for the corporation’s activities. A corporation  has centralized management where ownership through shareholders is  distinct from the management operations provided by the management  team or group customarily referred to as the board of directors. A  corporation will typically also have officers who conduct the day to day  operations of the corporation.

Shareholders of a corporation are its owners. They have the  collective financial interest in the corporation and the power to elect  the management of the corporation. The shareholders have borne the  financial risk associated with forming and operating the corporation and  are therefore granted power to dictate the terms by which the corporation  will operate. Subject to federal and state securities laws, shareholders can  freely sell or transfer their interests or shares in the corporation. It is  often the ease with which one can acquire shares or stock in a company  that makes investing in a corporation so attractive to investors. This is  particularly true with regard to investing in large corporations whose  shares are openly traded on one or more of the formal stock exchanges.  Corporations also enjoy indefinite existence, subject to state law. Typically the state statute governing formation and operation of  a corporation provides that corporation duly formed in the state will  exist for an indefinite period of time. Of course a corporation can cease  operations and the shareholders elect to have the corporation dissolved  with the assets distributed to the shareholders on pro rata basis.

In addition to the state law which governs corporate operations,  a corporation is generally governed by bylaws of operations commonly  known simply as the bylaws. The bylaws are typically written by an  attorney or a qualified business advisor of the corporation and are  accepted by resolution of the shareholders. The bylaws outline the rules of  operation for the corporation as previously determined by the shareholders  or as recommended by legal counsel. Once the bylaws are in place the  shareholders, directors and officers are bound to act according to its terms.  Of course bylaws can be modified but a majority or sometimes even a  unanimous vote of the shareholders is required to do so.

The management structure of a corporation is one of its primary  characteristics which makes the corporation unique and in many cases  complex. As mentioned above, shareholders assumed the financial risk  to form and capitalize the corporation. As a result the board of directors  and officers owe the shareholders certain duties, such as the duty of care  and the duty of loyalty. These duties are akin to fiduciary duties and  the members of the board in particular are expected to act in the best  interest of the shareholders.

It is important to understand the relationship between ownership of  a corporation through its shareholders and the management conducted  through its board of directors and officers. The shareholders are the  owners, but at least in the case of large corporations with numerous  shareholders, the shareholders are not able or inclined to manage the  business of the corporation. The shareholders elect a board of directors,  which generally consists of an odd number of directors somewhere  between three and nine members. The board of directors often is made up  of various individuals with specific knowledge and experience regarding  the operations of the corporation and its business, or the board will  include individuals with specialized training, such as business lawyers or  CPAs, whose experience and expertise is useful in determining what is  best for the corporation.

The procedure and timing for election of the members of the board  of directors is usually outlined in the corporation bylaws. Board of  directors elections generally occur every year or every other year and will  often include staggered director elections, meaning that only a certain  number of directors will stand for reelection each year. The practice  of staggered elections is seen as beneficial to a corporation as a way to  maintain continuity among the board. Staggered board elections ensures  that every time there is an election at least some number of directors  will remain, and therefore the process of overseeing the business of the  corporation will always include at least some directors who have been  involved from the prior year.

The board of directors will typically meet at least once per year  but in many cases the board will meet on a bi-annual, quarterly or even  monthly basis depending upon the frequency with which the board is  directed to meet pursuant to the bylaws of the corporation. Typically  the bylaws of the corporation will enable the board to meet as often as  the members board, or some minimum required number, may feel is  necessary.

The day to day operations of a corporation are conducted by the  officers of the corporation. The officers are generally the president, vice president, treasurer and secretary. Other titles of corporate officers are  chief executive officer, chief operating officer, chief financial officer and  even chief legal counsel. These terms are often used interchangeably with  the positions of president, vice-president, treasurer and secretary. The  duties and titles of such officers are generally outlined in the bylaws.

One of the benefits to operating a corporation is that corporations  have been used in business for many years. Most states have a long legal  history of corporate operations, which includes statutes and existing  case law that in some states goes back literally hundreds of years. The  existence of long-standing statutes and case law makes operations of a  corporation predictable. Delaware is a state that is often recognized as  having very good corporate statutes and case law. Many other states have  enacted statutes governing corporate operations that are either modeled  on or largely influenced by Delaware’s corporate statutes.

State laws governing corporate operations often require various  formalities. As noted, formation requires the filing of articles of incorporation. Typically a corporation is also required to file with the  state an annual list of officers and to renew its charter. This is usually to  be accompanied by a filing fee seen by the state as a reasonable fee paid  in exchange for state recognition of the corporation and for privilege  of operating under the laws and protections of that state. Additional  formalities that are generally required include annual shareholder  meetings, annual directors meetings, annual accounting and report to  shareholder, annual shareholder election of directors and probably most  important maintaining proper separation between the shareholders and  the company. Small corporations sometimes run into trouble when  shareholders also occupy positions on the board and as officers, and in  doing so comingle the assets or funds of the corporation with their own  funds and assets. Such a breakdown can often lead to what is referred  to as “piercing the corporate veil” by creditors of the shareholders of  the corporation. When the corporate veil is pierced the corporation is  disregarded, the limited liability protection for with the corporation  exists is set aside and the shareholders can be personally liable for the  debts and liabilities of the corporation. In order to maintain the integrity  of the corporation, proper working and economic formalities must be  maintained.

A corporation can be taxed either as a C Corporation or as an S  Corporation or sub-chapter S small business corporation (also colloquially  referred to as an S Corp). It is not uncommon for the shareholder of a  corporation taxed as an S Corp to state he or she owns an S Corp. The  reality is there is no such thing as an S Corp for formation purposes.  Rather corporations exist due to formation at the state level due to  filing of articles of incorporation. How the corporation will be taxed  is function of what type of tax structure the shareholders elect for the  corporation. The default tax structure of a corporation upon formation  is for it to be taxed as C Corporation. If the shareholders or management  team of the corporation elect for the corporation to be taxed as an S  Corporation they will file a Form 2553 with the IRS thereby informing  the IRS that the corporation has elected to be taxed accordingly.

To further complicate the issue; it is important to note that when an  entity is formed, it is formed at the given state level. If a Utah corporation  is formed, the state of Utah does not care what type of corporation you are (i.e. “C” corp or “S” corp), it is the IRS that is concerned with the  form of taxation. This is an important distinction as other entity types,  LLCs for example, can also “elect” to be treated as S Corporations with  the IRS while maintaining their status as an LLC with the given state  of their formation. This can result in confusion and should be done  carefully as when an LLC elects to be treated as an S Corporation, the  specific rules to be qualified as an S Corporation must now be met by  the LLC. For example; the LLC will now have to make sure there are less  than 100 owners (or owner groups) of the LLC, all members of the LLC  are qualified shareholders of an S Corporation and the LLC can have  only one class of ownership. Preferred and common interests in the LLC  will no longer be allowed. These are all issues that are not present with an  LLC that does not make an S Election as the IRS will assume the LLC  is to be taxed as a partnership. The authors advise caution in proceeding  this way in creating an LLC that will be taxed in a different manner.

The benefits of existing as a C Corporation include the ability  to take large deductions for providing numerous fringe benefits for  employees. However, the downside of operating as a C Corporation is  that the corporation is subject to double taxation. This means that the  corporation will pay tax on its revenue as earned, and the shareholders  will be taxed on their individual share of profits distributed as dividends.  In order to ameliorate the effect of double taxation large corporations  often seek to pay as much in fringe benefits and executive compensation  as possible to mitigate the corporate level tax. If a corporation requires  numerous employees to maintain the operations of the corporation then  a C Corporation structure may be the best structure in order to provide  fringe benefits which are attractive to potential employees.

When a corporation elects to be taxed as an S Corp it will then  become a flow-through entity somewhat similar to a partnership, but  an S Corp is much more than an incorporated partnership and there are  key differences between the two. Under the current Internal Revenue  Code an S Corp has no more than 100 shareholders. Shareholders may  only be taxpaying U.S. resident individuals and there can only be one  class of stock. This means that shareholders of an S Corp must receive  distributions based upon percentage of ownership, and there cannot be  any preferred class of shareholders.

Non-Profit Corporations. As previously mentioned, only a brief  discussion will take place regarding Non-Profit Corporations. Non profit planning, including not just Non-Profit Corporations, but private  foundations, trusts and low profit corporations and LLCs all have very  strict rules and guidelines that should be fully investigated.

A non-profit organization is typically a non-profit corporation  and is organized at the state level similar to any other corporation. Its  existence is generally for the purpose of benefit some specific social  cause, such as a charity, school, sporting event or other enterprise  which exists to benefit a cause rather than to generate a profit. A non

profit organization is formed at the state level but only obtains federal  tax benefits (for itself and contributors) after it applies to the Internal  Revenue Service to be recognized as a tax-exempt organization such as  a 501(c)(3) organization. The Internal Revenue Code allows for certain  entities to be tax-exempt for certain social purposes, these include  organizing to be a private foundation with a charitable purpose or to be  a charitable supporting organization. The moniker of 501(c)(3) refers to  the Internal Revenue Tax Code Section 501(c)(3). There are numerous  other Tax Code Sections under which a non-profit organization can seek  tax exempt status.

Limited Liability Company. For many years the partnership  structure was the fundamental business entity for start-up enterprises.  However, due to the susceptibility of personal liability by the general  partners, and even limited partners who were deemed to actively  participate in the business, as well as due to strict partnership rules  regarding administration and taxation, business owners began to seek  other options with which to operate small businesses. Prior to the advent  of the limited liability company the only option available to business  owners for limited liability protection was to form a corporation.  However, due to the formalities required in maintaining a corporation  coupled often with disadvantageous corporate tax laws, business owners  sought for another entity type to run small businesses. The answer  came when Wyoming enacted the first limited liability company statute  in 1977, interestingly created similarly in some respects to the 1892  German GmbH Code and the Panamanian LLC.

A limited liability company, or LLC, is formed by an organizer  who files articles of organization, or in some states by filing a certificate  of organization. LLCs have numerous characteristics which make them  attractive to small business owners and investors. The first of which  is limited liability for all members. In a corporation the investors  are referred to as shareholders who receive shares for their respective  investment. In the LLC a contributing person becomes a member and  typically receives units and/or a percentage of ownership in the LLC.  The limited liability protection provided to LLC members allows both  the passive investment members and those members taking an active  role in the administration and management of the business to enjoy  limited liability protection. The LLC member’s liability is limited to his  or her interest or investment in the company. Although a member can  be found personally liable in the event of any personal guarantee made  by the member or in the event of actions that allow for claims against the  member on the grounds of laws governing tort, fraud or illegal actions.

The LLC provides great flexibility for its members. State laws  governing LLCs generally provide wide latitude for members of an  LLC to dictate the terms of operation and to reduce those terms to  an operating agreement. Of course in the absence of an operating  agreement state laws generally provide default rules for administration,  but the members can often contract around or out of those default rules.  This makes for large opportunity for various types of investors, whether  passive, active, preferred or a combination of investment options.

An LLC is a pass-through entity just like a partnership, and the  default tax structure is for the LLC to be taxed as a partnership subject  to Subchapter K of the Internal Revenue Code. However, as previously  mentioned, an LLC can also be taxed as an S Corp which is preferable  for LLCs that provide professional services or that are in the business  of selling goods. An LLC can even be a C Corp if so desired by the  members. Many states allow for single member LLCs, in which case the  LLC will be taxed as a sole proprietorship in the absence of any other tax  structure designation by the single member.

One disadvantage to operating an LLC is lack of uniformity  between the states. Therefore when a business is operating in more than  one state it may face unexpected rules or consequences by doing business in a particular state. Various states treat LLC activities and taxation  differently, such as differences with minimum capital taxes, fees issued  on the number of K-1s issued to members and potential taxes when  assets are transferred to the LLC. Some states require a franchise tax or a  minimum fee payable to the state for the benefit of operating as an LLC  in that state. Some states such as Illinois, New Hampshire, Tennessee  and Wisconsin subject LLCs to an income tax based on percentages.  Other states impose taxes based on capital accounts or the number  of members. California is well known as one of the most aggressively  taxing states of LLCs with its annual fee and additional tax based on  profitability.

The LLC is managed either by members or by managers elected  by the members. A person does not typically have to be a member  to be a manager, unless required by the members in the operating  agreement. The LLC management structure can be simple with as  little as one manager, or it can be as complex as a corporation with a  board of managers (or board of directors) with company officers such  as president, secretary and treasurer. Again the flexibility allowed by  most LLC statutes gives the members the ability to determine rules of  administration and management that meet the needs and circumstances  of the LLC as they arise. It is not uncommon for the members of an LLC  to amend the terms of the company operating agreement multiple times  as circumstances change and as the number of members and investors  increase.

The use of an LLC is excellent for holding passive investments,  such as rental real estate, investment in stock portfolios and other  interest or passive income generating investments. The LLC is attractive  in this scenario because of the ease by which the members can place  property and investments in and take out of the LLC. Also, because  of the limited liability protection afforded to members of the LLC, the  LLC is an effective device for asset protection by the member from his  or her personal creditors. In many states the sole remedy for the creditor  of a member of an LLC is for the creditor to obtain a “charging order”  against the member’s interest in the LLC. This means that if a creditor  obtains a personal judgment against the member, rather than being  able to get the member’s interest in the company, or worse attach the company’s assets, the creditor only obtains the charging order which is  essentially a lien against the member’s share of LLC distributions. The  assets of the company remain protected and the distributions remain  protected as well because generally the management of the company  will have discretion whether to make a distribution. Some states allow  for foreclosure of a charging order, but only after another lengthy legal  proceeding by which the creditor must show by a stringent legal standard  that a distribution is unlikely. Regardless, the structure provides the  member substantial asset protection and at worst will typically provide  the member with leverage in reaching a settlement that is favorable to  the member.

As with all entity types, LLCs are not without limitations. As  mentioned above the default tax structure of the LLC is for it to be  taxed as a partnership. This means that the same tax issues that exist with  a partnership, such as potential for phantom income, exist with LLCs as  well. Also, due to the ease at which an LLC can be formed and operated  often business partners and co-investors will form an LLC without taking  the time to fully understand the default state law governing the LLC or  to obtain a comprehensive operating agreement. In the absence of such  an agreement that clearly defines the intent of the parties, state law will  govern which can often lead to unintended consequences, particularly  with regard to determination of ownership percentages, distributions  of profits, taxation, succession of ownership, management power and  dispute resolution among members or managers.

Many state LLC statues include nuances which allow for the  creation of different types of LLCs such as a Series LLC, PLLC, L3C  and the Restricted LLC. The Series LLC allows for the creation of one  LLC but allows that each asset of the LLC will be treated separately  for liability protection purposes. In the authors’ opinion, series LLCs  are not as protective of a structure as another structure in which there  is a parent LLC or “holding company” that then owns 100% interest  in separate single member LLCs to compartmentalize risk. This is due  to numerous court cases that have attacked the efficacy of the series  LLC and the non-uniformity of series LLC statutes throughout the  Country. Not all states allow for series LLCs and although they had  been popular a few years ago, many planners are simply choosing not to use them anymore due to these issues. Although the series LLC  may contain numerous rental properties, in theory if there is a liability  attributable to one of the properties, the other properties are deemed  to be held in a separate LLC, thereby making the non-liability related  properties unavailable to the creditor of the LLC. In order to maintain  the limited liability between the assets it is generally recommended that  each separate income-producing asset be administered separately from  an accounting perspective. In essence, each series under the series LLC  must be run with it’s own books and accounting and therefore results  in similar complexities to just having the parent holding company with  single member LLCs underneath.

The PLLC or Professional Limited Liability Company is useful to  professional service providers such as physicians, attorneys, accountant  and architects. While no type of entity will protect a professional service  provider from personal liability attributable to the professional services  provided, it does create a formal structure from which the professional  can conduct business and any contractual or other business related  liabilities not attributable directly to the providing of professional  services will be subject to the limited liability structure available to all  LLCs.

The L3C or low-profit LLC provides the financial benefits of the  LLC for business administration but also gives social benefits enjoyed  by the non-profit corporation. The L3C is a for-profit company and  is generally engaged in a commercial enterprise, but the purpose of  the commercial enterprise is typically to benefit some social cause or  purpose. The L3C is also organized in conjunction with a non-profit  organization to provide a profit-generating format that will benefit the  non-profit but not subject the non-profit to taxation and cause the non profit to lose its tax exempt status. This is especially attractive for private  foundations. Each year private foundations are required to donate 5%  of average net assets for charitable purposes. This 5% can be contributed  to a L3C, which company can take higher risks and attract private sector  investment which might not ordinarily support a charity or socially  conscious enterprise.

To the author’s knowledge only Nevada allows for a Restricted LLC.  This rare entity was established in Nevada for advanced estate planning purposes to enable strategic gift giving that will allow for a potentially  higher discount on the value of a gift due to lack of marketability and  lack of control by the member. The Nevada law allows for a restriction  on distributions up to ten years which is designed to deflate the value of  partial ownership interests.

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