Corporation Versus Limited Liability Company
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
There are a number of alternatives not discussed in this text, including general and limited partnerships, business trusts, sole proprietorships, etc. In the final analysis, the choice of entity usually comes down to an election between a corporation, whether S corporation or C corporation, and a limited liability company. The following is a summary of certain important issues.
Liquidity
Most practitioners perceive public trading in shares of corporate stock as easier–that is, more efficiently accomplished–than trading in limited liability company interests. Corporate shares were designed to be liquid; not so with limited liability company interests.
Flexibility versus Formality
Except to the extent the general corporation law of a given state provides relief, corporate existence entails a higher degree of formality (and therefore, expense) than life under a limited liability company. Corporations require a formally elected board of directors, statutory officers, stockholders meetings, class votes on certain issues, and records of meetings. These formalities are often neglected, but at some peril; if there is no evidence of formal directors' meetings, plaintiffs can contend the board was ipso facto negligent in carrying out its fiduciary duties to the stockholders because one of the functions of a board is to hold formal meetings.
Familiarity
Corporate law has been more thoroughly developed than limited liability company law in the litigated cases. There is more predictability, accordingly, from a legal standpoint. Counsel can forecast with a higher degree of confidence what the leading oracles on corporate law–the Chancery and Supreme Courts in Delaware–will do on a given state of facts. Indeed, for every case construing a Limited Liability Company Act, there are hundreds construing the general corporation laws. The schizophrenic nature of a liability company–now an entity, now just a see-through label for an aggregate of individual partners–makes for potential confusion.
Tax Issues Influencing the Choice
Organizational tax issues will revolve principally around the fact that earnings by a business operated in corporate form generate federal and state income tax on the corporate level. When those earnings are distributed (if they are) by way of dividends (or in liquidation), they ordinarily generate additional tax again, this time levied upon the shareholders, and such dividends are not deductible corporate expenses. Avoidance of "double taxation" will drive the preference of planners toward the liability company format. There are, to be sure, ways to avoid double taxation, but the gate is substantially narrower than it was pre-January 1, 1987.
The tax issues are extremely complicated, and no attempt will be made to set them out in detail. Much depends on facts and circumstances in a given case interacting with special rules, such as the exclusion from taxable income of a large portion (70 percent, down from 85 percent) of corporate dividends paid to corporate shareholders. This discussion will outline only general principles, to be used as guides in analyzing particular cases. To get into the subject in detail a number of code provisions must be analyzed carefully. For example, the new rules restricting the ability of corporations to carry forward net operating losses and the application of alternative minimum tax to corporations.
Starting one's business in non-corporate form will prove to be popular for yet another reason. Upward pressure on corporate rates, plus the post-1986 difficulty in extracting profits from corporate solution without paying double tax, puts a premium on avoiding corporate tax altogether. It is true that partners pay tax on revenue whether it is distributed or not and it may be necessary to retain earnings in the entity to expand the business. That is not, however, a major problem in most instances. The limited liability company simply distributes enough cash to the partners to pay tax at an assumed rate (28 to 34 percent, plus something for state taxes) and retains the rest, the danger being that the limited liability company will have taxable income but no cash, in a year of large principal payments on debt, for example.
Migration from one form of organization to another is a one-way street. A limited liability company can organize a corporation and transfer its assets thereto without tax, assuming that the partners contributing cash and/or the property hold 80 percent or more of the resultant voting stock and the liabilities of the limited liability company do not exceed the fair value of its assets; if a corporation wants to organize itself as a limited liability company, however, there is a double tax under the new tax law. Appreciated assets are taxed at the corporate level and the shareholders taxed on the liquidation distributions.
Further, election of the limited liability company structure allows somewhat greater flexibility in allocating items of income and loss among the partners. The dream of the organizers of a business is to be able to strike a deal between the suppliers of capital and the managers in a tax-neutral setting. The founder and the investors want to be able to arrange the split between them of calls on the company's future income (in the person of shares of capital stock or interests in limited liability company profits) without worrying about the consequences of that allocation as a taxable event to either party. In a limited liability company, interests in profits can be allocated and reallocated more or less as the parties agree, without regard to the respective contributions of capital. The allocation must have "substantial economic effect," which means not much more than that a scheme directly keyed to the tax status of the partners is questionable. A corporation can distribute stock disproportionate to paid-in capital but only within certain limits.
On the other hand, limited liability companies are not eligible to participate in tax-postponed reorganizations under I.R.C. §368. Because a limited liability company can be incorporated without tax, that problem may not be insuperable, but attempts to incorporate a limited liability company on the eve of a statutory merger could run afoul of the "step transaction" test. Moreover, venture funds usually will not invest in LLCs because such investments create intractable tax problems for certain of their own investors, tax-exempt pension and endowment funds and offshore investors. Finally, one of the most significant disadvantages of a LLC is associated with the issuance of membership interests to employees of a LLC upon exercise of employee options. Generally, the grant of an option to purchase LLC equity to an employee does not have an immediate taxable consequence for the LLC or the employee. However, upon the exercise of such an option by an employee, who then becomes a holder of LLC equity, several significant tax consequences appear likely. Although the issue is not free from doubt, once an employee acquires LLC equity, he or she is likely to be treated as a partner for tax purposes.
One fairly straightforward solution is to forestall option exercises until after the date the LLC converts to a C corporation in anticipation of an IPO or acquisition or merger. Options would "vest" under a schedule to be determined, but would not be exercisable until the "first exercise date." For option holders who leave employment prior to this first exercise date, the post-termination exercise period would continue until the conversion of the LLC. By extending the post-termination exercise period, no departing employee will feel compelled to exercise the option that would otherwise expire due to termination of employment. Preventing option exercises also will save the LLC the costs associated with accounting and reporting obligations to a holder of a relatively small interest in the LLC. It also simplifies the management of the LLC when membership votes are required.
The complexity of the analysis is multiplied by the fact that there are issues other than federal income tax to take into account, including the impact of state taxes, medical insurance, and other nontrivial expenses. There is, in the final analysis, only one way in which to illuminate and decide the most intelligent election between the corporate and the limited liability company form. Take the business forecast and run two scenarios: limited liability company versus corporation. Compare the after-tax wealth of the shareholders assuming a sale of their shares in Year 5 at a multiple of ten times earnings. Look at the difference and decide.