Confessions of an Entrepreneur: The Right Legal Form of Organization for Your Business is a Big Deal!

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I have started and/or been an owner of somewhere around a dozen businesses.

I also try to help as many of my current and former students as I can with their own businesses. While I am not an attorney and cannot provide legal advice, I have learned over the years that having the right legal form of organization — something that is often given way too little thought — is a big deal.

I’m not going to get into proprietorships or partnerships, beyond saying there is almost no good reason to ever have a partnership as you can end up inheriting the personal debts of your business partners — the last thing anyone should want to be involved with.

You need really good legal and tax advice from experienced and specialized attorneys and accountants on this subject — ones who understand what your future plans are for providing equity capital to your business as well as what your future exit strategy will be.

The big problem is this: Way too many people set up LLCs with little to no thought of the future ramifications of that decision.

There are several reasons for this.

LLCs are simple. They don’t require a separate tax return. They are pass-through tax entities, which means that they pay no income taxes as an entity and instead, tax obligations flow through to individual owners in accordance with their respective shares of ownership. And if you have non-U.S. citizen owners and want a pass-through entity, an LLC is your only real choice because S-corps won’t allow that.

That said, using an LLC as your legal form instead of a corporation could be a huge mistake that will lead to all kinds of future problems.

For starters, LLCs are not designed for “going concern” organizations. Some states even have limited lifespans for them, something corporations do not have. That can be a problem you don’t need down the road.

One of the best uses of this type of legal form (LLCs) is for a real estate development project. Let’s say two friends want to buy and develop a piece of property to build an office building and then sell it. The process could take several years to plan for, buy, permit, build and sell the project when completed. No ownership changes are likely to occur during that time. The members are not planning to have an ongoing business using this entity going forward.

My biggest concern with LLCs is when the founders plan on having additional owners over time, and/or when they need to remove a member for one reason or another. A huge issue inherent with LLCs is that any change in ownership requires all members of the LLC to sign off on changes in the LLC operating agreement.

If the controlling members want to move someone out for any number of reasons (non-performance, ethical lapses, competing with the LLC through another business, etc.), the member being thrown out is unlikely to willingly sign off on changing the LLC operating agreement. That problem is compounded by the fact that valuation and payback provisions for departing members are rarely even spelled out in the LLC operating agreement.

So you end up in a legal dispute.

All you have to do is a quick Google search and you will find evidence of many of these disputes. We have even had some of them covered by our local business media recently right here in Northwest Arkansas.

I’m convinced that most attorneys really aren’t thinking about what their clients’ needs are when they suggest this legal form. And then they don’t help them draft a proper and well-engineered LLC operating agreement when their clients do go this route. It’s almost like a dentist handing out candy. They are creating their future work! That said, I don’t think this bad advice is intentional. I think it is more likely borne by the attorney’s own lack of specialization.

When questioned on this, the typical response of firm founders is they want to have a pass-through tax entity, hence the LLC. An S-Corp can provide you with that benefit as well as other tax benefits — and it has stock versus ownership interest — stock that can be bought and sold.

Do your homework and research, plan for your future capital needs, and have a long-range business plan with a clearly-defined exit strategy — and then proceed with caution when establishing a legal form for your business.

Stock sales in a corporation are governed by the corporation’s bylaws and shareholder agreement. No changes are required in the shareholder agreement. If changes are needed in that shareholder agreement for any reason, typically that can be done by a simple majority or supermajority of shareholders. One minor shareholder cannot hang everything up and hold the rest of the shareholders hostage for threat of litigation.

The important thing here to keep in mind is this. You need really good legal and tax advice from experienced and specialized attorneys and accountants on this subject — ones who understand what your future plans are for providing equity capital to your business as well as what your future exit strategy will be. Not all advisers are qualified to provide this input, but many will be willing to do so anyway.

The moral of the story is this — do your homework and research, plan for your future capital needs, and have a long-range business plan with a clearly-defined exit strategy — and then proceed with caution when establishing a legal form for your business.

Using an LLC may be expedient but could be a huge mistake!