Many state legislatures have simplified the process of forming a business entity. In many jurisdictions the formation of a limited liability company or “LLC” can be completed either on-line or by filing a single page form along with the payment of a filing fee. Although the filing of the formation documents is quite easy there are many long-term considerations one should take into account during the organizational process.
Formation, Employees, and Tax Status – unless an organizer of an LLC makes an alternative election with the Internal Revenue Service to be taxed as a corporation, a new LLC will, like a partnership, be treated as a “pass through” entity for tax purposes, i.e., income or losses pass through to the LLC members. For new business owners the ability to deduct early losses may seem like a positive facet of the LLC but it can create problems.
- Membership, employee equity, and taxes – Many corporations offer employees stock options as part of their compensation package. When employees receive LLC equity (a “membership interest”) as compensation it entitles them to share in the value of the equity in the company. Unless the organizer of the LLC elected a different tax scheme, the LLC will file tax returns as a partnership, and everyone who is an equity holder will receive a K-1 tax schedule which will disclose a lot about the company’s finances. Many founders would probably not want to give company employees this kind of detailed information. Additionally, The Bipartisan Budget Act of 2015 changed the IRS partnership audit rules. Effective as of January 1, 2018 underpayment of taxes will be imputed at the partnership level, i.e., current partners owning interests in a partnership are liable for the underpayment of taxes even if the subject years of the audit occurred before their admission to the partnership.
- Restrictions on the sale of membership interest. Without sufficient provisions in an LLC’s operating agreement governing restrictions on the transfer of LLC membership interest, members may find themselves in business with someone they do not know or who might cause problems for the company. “Permitted Transfer” provisions will expressly permit certain transactions but disallow others. In addition, the operating agreement should include provisions on “Involuntary Transfers”. These are transfers that occur by operation of law such as those resulting from death, divorce, or bankruptcy.
- Difficulty raising equity Venture capital groups or “VC groups” may be hesitant to look at an LLC for investment. If a VC group is already structured as a pass-through entity itself, the group may be wary of investing in another “pass though” entity that could leave the VC stakeholders with an unwanted tax bill. Add employee/members to the mix along with inadequate or non-existent provisions regarding transfers of membership interest and many VC groups may walk away. Who wants to buy into a company where valuation is difficult to measure, and the full nature and extent of ownership cannot be documented?
It should be clear that the path that looks the easiest is not without consequences. If you are organizing a start-up or considering becoming a member in an LLC make sure you obtain competent counsel to discuss, your business goals, liability concerns, and operational matters.
Authored by: Attorney Guy Jeffress
*This information is designed to provide general information, is not intended to constitute legal advice and should not be utilized as a substitute for professional services in specific situations. If legal advice or other expert assistance is required, the services of a professional should be sought.