Business owners have a number of entity choices when they form a new company to operate their business. But for most businesses, the best choice is a limited liability company. This post is part of a choice-of-entity series. The other posts cover S corporations, where we learned how S corporations can be a good choice for businesses that are required to operate as corporations but want to save on income taxes, and C corporations, which are often a good choice for high-growth startup companies and businesses that intend to go public.
When choosing a business entity, the two main considerations are protecting the business owners’ assets from the business’s liabilities, and reducing tax liability. For most small businesses, limited liability companies offer the best of both worlds.
Protecting business owners from liability
Practically all business structures where you create an entity by filing a document with the secretary of state provide a liability shield between business operations and the business owners. Traditionally, corporations were the preferred business entity because of their proven effectiveness in protecting their owners, but shareholders of traditional C corporations are subject to double-taxation, which significantly increases the business owners’ tax liability. For more, see Choice of Entity: C Corporations.
With the creation of S corporations in 1958, the double-taxation problem was fixed for smallish corporations. But rules governing eligibility of S corporation shareholders (most business entities and non-US residents don’t qualify) and the single class of stock rule (preferred distributions aren’t permitted) mean that S corporations don’t have the flexibility required in a lot of situations–particularly for high-growth startups, which need to provide preferred distributions to their investors and whose investors often do not qualify as S corporation shareholders. For more on the good and bad of S corporations, see Choice of Entity: S Corporations.
In most states, limited liability companies provide essentially the same liability shield as corporations, but LLC owners aren’t saddled with the burden of double taxation. LLCs were invented by Wyoming in 1977, and, after years of uncertainty, the availability of pass-through taxation for LLCs was formalized with the IRS’s adoption in 1997 of the “check-the-box rules,” which permit LLCs to choose their tax classification. See my post Limited Liability Tax Classifications for more on the various ways LLCs can be taxed. For more on the history of LLC tax classifications, see the American Bar Association’s 2004 article, LLCs: Is the Future Here?
Some people think that the liability shield of limited liability companies is less certain than that of corporations, but I haven’t been able to find any evidence of that. I’ve studied Missouri case law relating to “piercing the corporate veil,” and haven’t found any court bias against LLCs. Anecdotally, I’ve had a litigator tell me that courts are likely to disregard single-member LLCs and hold the member liable for the company’s liabilities, but, if that’s true, I haven’t found any evidence of that in reported cases. Such a result would also be contrary to Missouri’s LLC statute, which expressly provides for single-member LLCs and states that an LLC’s members are not responsible for the company’s liabilities (RSMo § 347.057, “A person who is a member, manager, or both, of a limited liability company is not liable, solely by reason of being a member or manager, or both, under a judgment, decree or order of a court, or in any other manner, for a debt, obligation or liability of the limited liability company, whether arising in contract, tort or otherwise or for the acts or omissions of any other member, manager, agent or employee of the limited liability company.”) It is true that you’re always responsible for your own actions, so business owners can create the risk of liability while they work for their companies. But that’s true regardless of the type of entity your company is.
Limited liability companies do have a couple of true advantages when it comes to limitation of liability. One advantage is that LLCs make it easier to preserve a company’s “corporate veil.” One of the factors courts consider when determining whether to “pierce the corporate veil” is whether the business owners observed required corporate formalities. With corporations, this usually involves holding annual meetings of shareholders and directors, board approval of important decisions, and the like. And it’s very common for small business owners to completely neglect these formalities after they have an attorney set up their company. Such formalities are usually less involved with LLCs.
Another advantage is what is known as charging order protection. I think of this (very loosely) as a corporate veil in reverse. Whereas the corporate veil protects business owners from the liabilities of their businesses, charging orders protect businesses from the liabilities of their owners. When a business owner’s judgment creditor executes a judgment against their ownership in an LLC, the creditor’s exclusive remedy is a charging order, which is essentially a lien on the owner’s distributions from the LLC. The creditor isn’t permitted to take the owner’s membership interest from the owner or take company assets from the LLC, but the creditor does have dibs on the business owner’s distributions from the LLC. This can permit the business owner to preserve the business to a certain extent in difficult situations. For a good explanation on charging order protection, its benefits, and its limits, see The Misunderstood Charging Order.
LLC tax flexibility
The second major consideration when a business owner chooses which type of entity to form is reducing tax liability. This usually means avoiding double-taxation, if possible, but can also involve reducing payroll taxes. The factors to consider in any given situation can be very complex and require the advice of a tax professional, but, generally speaking, LLCs are superior on this front because LLCs can choose their tax classification. So LLCs can choose to be taxed as C corporations or S corporations, single-member LLCs can choose to be taxed as sole proprietorships, and multi-member LLCs can choose to be taxed as partnerships. See my post about LLC tax classifications for a more in-depth discussion of this topic.
LLC operational flexibility
Operational flexibility is one of the most significant advantages of limited liability companies. Unlike corporations, which usually have a board of directors and officers and voting rights in proportion to stock ownership, LLCs have a tremendous amount of flexibility on how they are operated. If two people want to be 50/50 partners who are active managers of the business and have equal say on all decisions, they can do this through an LLC. If there are several owners, but only one of them will have an active role in the business, an LLC can accommodate this. If the passive investors want to have a say in significant decisions, this can be done. Whatever the specific situation, the LLC’s operating agreement can be drafted to accommodate the needs of the owners.
Bringing it all together
So, limited liability companies have “corporate veil” protection, advantageous and flexible tax treatment, and significant operational flexibility. What’s not to like? Although there are situations, such as high-growth startups and industries that require a business to be conducted through a corporation, where a different entity is the best choice, there’s a reason that the vast majority of new companies today are LLCs. If you’re starting a traditional main-street business, your company should probably be an LLC.