Entity Formation Series :: Part 3A - Why a Limited Liability Company is (usually) the Best Entity Vehicle for Most Business Models

There are many different entity vehicles to choose from under Texas law. Although there are other options, the more commonly-utilized entities include:

1.     limited liability companies (LLCs);

2.     for-profit corporations;

3.     limited partnerships (LPs);

4.     general partnerships; and,

5.     sole proprietorships.

It is important to note that these entity forms are creations of Texas state law, not federal law. When it comes to how entities are categorized for federal tax purposes, the IRS has its own, distinct entity categories. The IRS’s categorization of a business for tax purposes does not necessarily coincide with state-level entity classifications. The following are the most common tax categories that entities will be classified as under federal tax law:

1.     disregarded entities;

2.     partnerships;

3.     C corporations; or,

4.     S corporations.

So, if you want to form an S corporation, what that likely means is that you want to form a Texas for-profit corporation, and then elect to be taxed as an S corporation for federal tax purposes. “S corporations” do not exist under Texas law and, conversely, LLCs and other entities created by state law do not exist as their own separate tax classifications in the eyes of the IRS. When it comes to how a state-level entity will be classified by the IRS, the state-level entity usually has several options, which vary based on the type of entity in question, and the business can usually choose between the several available categorization options. Although entity types created by state law and IRS tax classifications are distinct, all entities will be formed as a single type of state entity and will also be classified under a single, specific IRS classification, so both aspects of an entity are relevant when determining which type of vehicle to utilize.

Now that the distinction between entities created by state law and IRS tax classifications has been addressed, I am going to provide the top five reasons why an LLC is the generally the best option for the vast majority of businesses (with one of the only clear exceptions being startups that have a market-disrupting business model; for a discussion on the entity vehicle that should be utilized for these types of businesses, see my Post: Entity Formation Series Part III(b) - Why a C Corporation is (usually) the Best Entity Vehicle for those Businesses with a Market-Disrupting Business Model. However, please keep in mind that each business is unique, and no absolute rule can be created to determine the best entity choice for any particular business without examining the specific facts and circumstances surrounding the business.

1. The LLC Provides a Liability Shield that Protects the Personal Assets of its Members.

The liability shield created by filing a Certificate of Formation is the greatest benefit of forming any entity that requires such a filing. The filing of a Certificate of Formation, alone, creates this liability shield, which protects the personal assets of business owners from any debts or obligations of the business. Meaning, business owners generally can only lose as much money through their business as they put into it (or as much as they commit to putting into it in the governing documents of the business).

Of the Texas entities being considered in this Post, LLCs and corporations are the only two entity vehicles that create complete liability protection for their owners simply by having a Certificate of Formation filed with the Texas Secretary of State. As addressed in Section Two below, LPs can also provide a complete liability shield for their owners but doing so requires more than just filing a Certificate of Formation.

One the other end of the protection spectrum, general partnerships and sole proprietorships are the two entity types that can exist without filing a Certificate of Formation (and can exist even if the owners do not intend for them to exist), so they do not provide any liability protection for any owners’ personal assets.

Due to the lack of personal liability protection they provide, sole proprietorships and general partnerships create such significant personal risk for owners that they should not be considered as legitimate entity forms to be used by a business. Removing these two entity vehicles from contention, the options that remain in consideration are LLCs, for-profit corporations, and LPs.

2. The LLC only Requires a Single Filing to Protect the Personal Assets its Members.

As long the owners and managers of a business operate their company in the way they should (i.e. do not use the entity to perpetuate fraud, keep accurate accounting records, etc.), LLCs and for-profit corporations create complete liability shields for the personal assets of their owners as soon as the Texas Secretary of State files the respective entity’s Certificate of Formation. LPs, on the other hand, require additional filings to achieve liability protection for all of their owners. For an LP to exist, the partnership must have at least one limited partner and at least one general partner. Often, there is a single general partner that manages and operates the partnership and a number of limited partners that act only as investors and have no direct involvement in the partnership’s operations.

Unless the general partner of an LP is, itself, an entity that provides personal liability protection (such as a corporation or LLC), then the general partner, which may consist of one or more persons, exists as a general partnership; meaning, an LP provides no liability shield for the assets of its general partners. Further, this means that each partner of an LP’s general partnership is jointly and severally liable for the obligations of the general partnership. If a company is going to use an LP as the entity vehicle for its business, it is possible to provide a liability shield for the LP’s general partner; however, doing so requires further action.

There are several ways that an LP can create a liability shield for the personal assets of its general partner. One option is to have an LLC or corporation act as the general partner. Either of these entity forms will protect the personal assets of the general partner. The other option that an LP has for providing liability protection for the personal assets of its general partner is to register the LP as a limited liability partnership (LLP), which does not create a new partnership or entity; rather, it basically provides the general partner(s) of an already existing partnership with a liability shield for obligations of the partnership that are incurred during the period that the partnership exists as an LLP.[1] Regardless of which option an LP uses to provide its general partner with a liability shield, the key takeaway is that a second filing of some sort is going to be required, resulting in additional costs and complexity.

The LP entity structure may be good for specific situations, such as real estate investment companies that also manage the properties they own, but - outside of specific industries - it is not an ideal organizational structure simply because of the need to complete a second filing. An LLC can be built to have all of the same flexibilities and benefits as an LP and can do so by taking a single action, which clearly makes it more favorable than an LP in general situations. As such, the LP (and its evolved form - the LLP) should be removed from consideration as to the type of entity that should be formed in most situations. However, I will continue to include the LP (and anytime I mention the LP in the remainder of this post, the same rules apply to an LLP except for the liability protection provided for general partners in an LLP) in some of the remaining sections of this post in order to provide a more robust analysis.

3. The LLC Allows for Pass-Through Taxation from the IRS.

Of the two main entity types that should remain in consideration, each can be treated as pass-through entities for federal tax purposes. By “pass-through” entities, I mean that the IRS will only tax the business income once (at whatever tax rate is applicable to the owners of the business). The business itself is not taxed on its income. The alternative, which is how the IRS taxes businesses classified as C corporations, is double taxation, under which the business itself is taxed, and then the owners of the business are taxed again on the income that they receive from the business. A business taxed as C corporation must complete its own, separate tax return and each owner would also need to fill out additional schedules on their personal tax returns. The total percentage of income that is taxed, which is referred to as the “effective tax rate” of a business, of a C corporation can be extremely high because of the two layers of tax, especially when a business and/or its owners are in a high tax bracket. Generally, for obvious reasons, it is going to be better to have the income of a business only taxed once, which disfavors the C corporation tax classification.

While all of the entity types remaining in consideration may be taxed as pass-through entities by the IRS, a for-profit corporation’s only option for receiving pass-through tax treatment is if the corporation elects to be taxed as an S corporation. To be treated as an S corporation, a corporation must meet some specific requirements that are often not realistic if the business is looking to follow a market-disrupting business plan and, as such, is the type of company that should probably be formed as a C corporation, regardless.[2]

For a business with more than a few owners, meeting and maintaining the requirements necessary to receive S-corporation tax treatment can be difficult. If, at any point in time, a company that is being taxed as an S corporation fails to meet all the IRS requirements necessary to be taxed in this manner, the IRS (whenever it finds out that the S corporation requirements were no longer being met) will retroactively treat the business as a C corporation from the moment the S corporation requirements were no longer met. The IRS will retroactively apply the C corporation taxation rules to the business from the date on which the business stopped meeting the requirements, even if the business was unaware of the fact that it was no longer in compliance with the S corporation requirements. Meaning, a corporation could unknowingly begin to face double-taxation obligations and fail to adjust its accounting and budgeting accordingly because it is unaware that its tax status has changed. Then, at some point down the road, when the IRS determines that the S corporation requirements were busted, the corporation and its shareholders could be subject to large tax obligations that were not budgeted for or expected.

LLCs and LPs can also achieve pass-through taxation by electing to be treated as S corporations, but they additionally each have alternative options for achieving pass-through tax treatment, which do not require the entities to meet S-corporation taxation requirements.

The default tax rule for a single-member LLC[3] is for the business to be treated as a “disregarded entity” for tax purposes. Meaning, the LLC’s income is essentially treated as income made directly by its member. If a single-member LLC is treated as a disregarded entity, and the single member is an individual, the person will need to fill out some additional schedules on his or her personal income tax return but will not have to file a separate return for the LLC. If the single member is an entity, then it will also not be required to file a separate return for the LLC, but it will need to fill out some additional schedules on the member entity’s tax return (if applicable). While disregarded-entity status is the default rule, a single-member LLC can also elect to be taxed as a C corporation or an S corporation.

The default tax rule for a multi-member LLC is to treat the business as a “partnership” for tax purposes. Partnership tax treatment still allows for pass-through taxation, but it does require a separate tax return to be filed for the business itself. An LLC taxed as a partnership, can also elect to be taxed as an C corporation or S corporation if it so chooses.

The default tax rule for LPs is for the business to receive “partnership” taxation treatment, which means that LPs basically have the same tax filing requirements as LLCs that are being taxed as partnerships. An LP can also elect to be taxed as an C corporation or S corporation if it so chooses.

While all three entity types have methods available for receiving pass-through tax treatment - when there is a single owner - an LLC certainly provides the simplest means of achieving this tax classification. If there are two or more owners, then an LLC and an LP each are able to equally utilize the simplest means of achieving pass-through taxation. Even if an LLC or LP elects to be taxed as an S corporation, the size and operations of the companies utilizing these entity forms tend to be less complex than a corporation electing S corporation tax status, so this is just another factor that makes the for-profit corporation less favorable than the LLC. We will not eliminate for-profit corporations entirely yet, though, because they can operate with relatively few owners and easily fall within the requirements for S corporation taxation; thus, receiving pass through taxation just like an LLC or an LP. In fact, many LLCs and LPs elect to be treated as S corporations anyways for certain other tax purposes, so all three business forms should still at least be considered, despite the fact that the LP and for-profit corporation have strikes against them.

The simplicity of completing tax filings and goals based on filing the fewest number of tax returns are certainly not the only factors that should be considered when determining the best tax-planning strategies for a business, but – from a realistic perspective - they can often be the deciding factors when people are operating a small business with a tight budget. The more complex your business is and the loftier your business goals are, the less these factors should be weighed when considering the tax or overall aspects of your business. Regardless of the size or complexity of your business, an accountant should be consulted regarding all tax aspects of your company.

4. The LLC is not Required to Follow Extensive Formalities.

Generally, corporations (both C corporations and S corporations) are legally required to follow certain legal formalities for their meetings, record keeping, and other aspects of their operations. For example, corporations are generally required to have annual meetings of both their shareholders and their board of directors, with certain quorum requirements, meeting notice requirements, etc. LLCs, on the other hand, are free to dictate in their governing documents how almost every aspect of the business will be run. In other words, corporations generally must operate in accordance with more laws that must be followed (mandatory laws) rather than default rules that can be changed by the entity’s internal governance docuemnts. Simply put, corporations do not necessarily have the same freedom in choosing how to operate that is available to LLCs. More of the laws concerning LLCs tend to be default rules, which will only be applied if an LLC does not address the issue in question in its governing documents, rather than mandatory laws that must be followed. Therefore, LLCs have much more freedom to dictate how they will operate and do not need to comply with as many formalities as corporations. All the benefits of LLCs that have been covered in this section, also generally apply to partnerships (both LPs and general partnerships).

Even if a corporation elects S corporation status and receives pass-through taxation, the formality requirements that must be followed by a for-profit corporation, make that entity type less appealing than the LLC or LP.  The alternative is that the for-profit corporation is a bigger enterprise, and, then, in addition to requirements to comply with additional formalities, the corporation is likely to face double taxation because it may not be possible or wise for it to seek S-corporation tax status because of the size or complexity of the business. So, whether a for-profit corporation is small or is a larger enterprise, the for-profit corporation is generally going to be less attractive than the LLC due to the additional formality requirements.

5. The LLC’s Ownership Interests are Better Protected from Judgment Creditors than Other Entities if an Owner becomes a Judgment Debtor.

One of the benefits of forming an LLC rather than a corporation only becomes apparent when one of the owners of a business becomes a judgment debtor and the owner faces the possibility of having his/her/its individual assets seized.

The best way to demonstrate this benefit is by way of an example. Imagine Bill and Sarah are the only two owners of a company. Bill, on a personal basis, loses a lawsuit and owes millions of dollars to the plaintiff in his case, and Bill is unable to pay the judgment using his available personal funds. In such a case, Bill becomes a judgment debtor, and the judgment creditor (formerly the plaintiff) can seize some of Bill’s assets to satisfy the judgment against Bill. Ownership interests in a company are assets, and – in a situation like this – Bill’s ownership interest in the company could potentially be seized. In such a situation, whether Bill and Sarah are co-owners of a corporation or an LLC can make a huge difference.

If Bill and Sarah own a corporation, then Bill’s shares in the corporation can be seized and sold at auction, and all rights associated with the shares, including applicable voting rights, will now be held by the buyer of the shares at auction. The rights associated with any shares can vary widely by class, but if the seized stock is common stock and Bill owns more than 50% of the corporation’s common stock, then the purchaser of the shares, who could be anyone, now pretty much controls the corporation without Sarah being able to do anything about it.

However, if Bill and Sarah own an LLC, a court will only issue something called a “Charging Order,” which governs the extent to which the judgment creditor can reach Bill’s membership interest in the LLC. The Charging Order only entitles the judgment creditor to receive distributions that are made to Bill when any such distributions occur. It is therefore essentially a lien only on Bill’s right to distributions (a lien that, under Texas law, cannot be foreclosed), is not a lien on Bill’s membership interest itself, and does not allow for the seizure of Bill’s membership interest. Therefore, Sarah and Bill would still have all management rights in the LLC, and Sarah would not be forced to have an unknown third party take control of their company without any consent or compensation.[4] The same Charging Order process applies to partnership interests (in both general and limited partnerships).

Corporations can try to address this by issuing varying types of stock, but - once again - this is just another layer of complexity that most small businesses should not worry about at the point of formation. The corporation is going to have to issue some form of common stock and any stock that is issued with voting rights leaves open the door that the personal debts of a shareholder could result in a third party taking over those voting rights without the corporation or other shareholders being able to do anything.

For Texas LLCs (and partnerships), the Charging Order is the exclusive remedy for a judgment creditor seeking to reach an LLC member’s membership interest. This is much more preferable than the possibility of corporate shares being seized and sold at auction.

Conclusion.

For all the reasons listed above, I believe the LLC is the best entity-vehicle option available for the clear majority of businesses. Here is a quick recap of these reasons:

An LLC provides full-liability protection for its owners’ personal assets, unlike a general partnership or sole proprietorship;

An LLC provides said full-liability protection for its owners’ personal assets by completing a single filing, unlike an LP;

An LLC has multiple options for pass-through taxation, including the simpler and less burdensome options of “disregarded entity” or “partnership” tax treatment (depending on the number of owners) as compared to S corporation tax treatment, which is the only available pass-through taxation status that can be achieved by a Corporation;

An LLC is not required to comply with as many stringent formalities as a corporation; and,

Finally, unlike a corporation, any personal judgments against an LLC member will only grant a judgment creditor a lien on the debtor member’s distributions when distributions are made by the LLC. If the same situation occurred to a corporation’s shareholder, then the shares of the corporation could be seized and sold at auction, allowing a third-party to have all the corporate rights of the original shareholder, which could include voting rights.

Footnotes [1] A general partnership - existing as a stand-alone entity rather than as the general partner of an LP - can also register as an LLP in order to create a liability shield for its partners’ personal assets. In some other states, a general partnership that completes this registration is called an LLP, while a limited partnership that completes this registration is called a Limited Liability Limited Partnership (LLLP). Texas, however, does not make such a distinction in terms of nomenclature and refers to both entities as LLPs, post-registration. [2]For the requirements that must be met in order to retain S corporation tax treatment from the IRS, check out: https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations [3] For Texas LLCs that only have two members, and those two members are married, the LLC, generally, can choose whether to be treated as a disregarded entity or a partnership as the “default” option for the LLC, and then can also make elections to be treated as a C corporation or S corporation if desired. This option is only available in community-property states, like Texas. [4] There have been a few recent cases in which Texas courts have granted judgment creditors additional means of effectuating the exclusive remedy of Charging Orders, but these have occurred in specific situations and, generally, Charging Orders, will serve as an exclusive remedy and protect an LLC or partnership from the debts of its respective members or partners. For a discussion on the specific cases that seem to have extended judgment creditors additional remedies, see pages 59 – 61 of http://www.baylor.edu/law/facultystaff/doc.php/290275.pdf

Footnotes

[1] A general partnership - existing as a stand-alone entity rather than as the general partner of an LP - can also register as an LLP in order to create a liability shield for its partners’ personal assets. In some other states, a general partnership that completes this registration is called an LLP, while a limited partnership that completes this registration is called a Limited Liability Limited Partnership (LLLP). Texas, however, does not make such a distinction in terms of nomenclature and refers to both entities as LLPs, post-registration.

[2]For the requirements that must be met in order to retain S corporation tax treatment from the IRS, check out: https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations

[3] For Texas LLCs that only have two members, and those two members are married, the LLC, generally, can choose whether to be treated as a disregarded entity or a partnership as the “default” option for the LLC, and then can also make elections to be treated as a C corporation or S corporation if desired. This option is only available in community-property states, like Texas.

[4] There have been a few recent cases in which Texas courts have granted judgment creditors additional means of effectuating the exclusive remedy of Charging Orders, but these have occurred in specific situations and, generally, Charging Orders, will serve as an exclusive remedy and protect an LLC or partnership from the debts of its respective members or partners. For a discussion on the specific cases that seem to have extended judgment creditors additional remedies, see pages 59 – 61 of http://www.baylor.edu/law/facultystaff/doc.php/290275.pdf