Last month I described some of the advantages of incorporation. There are other ways to create a legal “person” through which to do business. These include limited liability companies (LLCs) and the various forms of partnership.
Limited liability companies first appeared about twenty years ago. Fundamentally, they represent the effort by states to create a new form of business entity that is more flexible and requires fewer formalities than does a corporation. Generally speaking, for example, a corporation has to have an annual meeting of the shareholders each year, but often this meeting is on paper and honestly there is no Maine court case saying the lack of an annual meeting voided the corporation. But in any case an LLC can, through its “operating agreement”, avoid annual meetings and otherwise provide for a minimum of corporate formalities.
The big difference between an LLC and a corporation is in its shareholders. Most owners of a closely held corporation (a corporation with just a few shareholders, maybe just one) elect “pass through” treatment of profits and losses, for tax purposes. That means the corporation does not pay income taxes. The profits pass through to the shareholders in proportion to their ownership share. So do the losses. That means if there are two shareholders each owning 50%, and the business has a $100,000 profit one year, $50,000 passes through to each shareholder, who must pay taxes on it.
The same is true of losses: If the company loses $100,000 one year, a $50,000 loss is available to each shareholder, to offset against other income. When people speak of a “Sub S” corporation, they mean a corporation that has elected this pass through treatment under Subchapter S of the IRS code. (The alternative – think General Motors – is a Subchapter C corporation, which pays its own taxes.)
Subchapter S requires that each shareholder be a natural person and a U.S. citizen. It also limits the number of shareholders to 100. The second limitation may not make much difference but the first can, if you have an investor who wants to invest not in his or her name but through a corporation, LLC or partnership. In contrast an LLC has neither limitation: it can have many members (members are equivalent to shareholders, basically). The members can be corporations, partnerships or other LLCs, and the LLC can still retain pass through status of profits and losses.
So my advice to clients is that if they hope and anticipate that the business will grow, and they think one day they will want to take on a shareholder who can invest substantial capital in the business, form an LLC. But if it’s a little business, a mom and pop with just one or two shareholders, a Maine corporation is cheaper to set up and very simple to operate.
Partnerships have fallen out of favor, except for law firms and some real estate ventures, where special considerations may apply. But it is not at all unusual for a partnership to form by mistake, so to speak, and it’s something to watch out for. Unlike LLCs and corporations, a partnership may come into existence with no formalities at all. Suppose, for example, you and a friend join forces. One of you has a boat, the other has some capital, and you decide to outfit the boat for some niche fishery and to split the profits. Maybe there’s no written agreement beyond a few emails, maybe not even that. You fit out and go fishing and the boat owner loses interest and decides to do something else. There could be a real problem, if the investor feels you haven’t treated him fair and square. When two or more folks join forces to do business, they have formed a partnership whether they meant to do so or not. Partners have to treat each other with absolute fairness and full disclosure; they have a “fiduciary duty” to each other, similar to the duty that a lawyer owes to a client or a trustee to a beneficiary. It’s serious stuff. (By the way, the same fiduciary duty exists between shareholders of a closely held corporation and between members of an LLC.) Lawsuits are filed every day stating that just such an “accidental partnership” formed, and that one partner didn’t behave as a fiduciary to the other.
Here’s another pitfall of a partnership: Each partner is liable for all the liabilities of the partnership. There are exceptions, but, using my example, if Partner A contracted for $100,000 in bait and then wanted out, Partner B would owe all the $100,000 even if Partner B didn’t know about the contract. He could look to Partner A for contribution, but if Partner A was broke, tough luck for Partner B. Really, it’s not usually a great way to do business.
Here’s some bottom line. Get yourself to a lawyer if you are thinking of incorporating or creating an LLC. If you and someone else are going to do business together and don’t want to see a lawyer, recognize that you have to treat each other with absolute fairness. A writing, even if it’s just in longhand, will at least reduce the possibility of misunderstanding.
Nicholas Walsh is an attorney practicing in Portland, Maine. He may be reached at (207)772-2191, or at email@example.com.