Choosing the Right Legal Form for Your Business
You might have heard that everyone needs to set up an LLC before starting their business. There is some truth to this, but it is the equivalent of attempting to perform brain surgery with a broadsword. I’ll tell you a story to illustrate: When I first started practicing, a hopeful entrepreneur showed up who wanted to start a business but had a complete aversion to spending any money on legal services. Because I was a new lawyer, I quoted him a deeply discounted rate for setting up a legal entity. I would have only made about $50 after covering the filing fees and printing costs, even though I would have spent hours drafting documents and advising him. Even still, he tried to negotiate with me. Ultimately, he decided to go another direction and use an online service to set up a cookie-cutter LLC. I thought that would be the last I would hear from him, but I was wrong.
Several years later, and after I had much more experience under my belt, I got a call from this would-be client. He was being sued because of a slip and fall at his place of business. However, his reticence to pay for lawyers had not gone away. When I quoted him the $5,000 for my retainer to handle the litigation, he stormed out of my office, and at that point, I never did hear from him again.
Curiosity does get the best of us at times, and several months later I got the itch to review the publicly-available pleadings in his case. I discovered that he had received a five-figure judgment against him personally. I discovered that even though he had properly set up his LLC, he had never properly invoked the LLC’s protection. It was the legal equivalent of opening a bank account and never putting any money in it.
Sadly, this situation isn’t unique. Many lawyers can quote war stories of businesses that failed to use their legal entities, mismanaged their legal entities, or did not understand the implications of the legal entity they picked. This article is to help you understand the issues at a surface level. These issues are taught across multiple classes in law school, spanning hundreds of cases and dozens of law in each state, so this is not something that is easily or quickly grasped.
1. Default Rules
Default rules apply when you don’t do anything to incorporate your business. Every single state in the US recognizes a Sole Proprietor as the default legal entity for a business. 97% of American businesses are Sole Proprietors. Sole Proprietorships do not require you to incorporate your business in any way, but that is the only positive in a long list of negatives. The biggest weakness of Sole Proprietorships is that a business owner is unlimitedly liable for any damages caused by the business. Sell a product that hurts someone? You’re on the hook for that. Someone slips in your store? Your personal bank account is going to cover those expenses.
A close relative of the Sole Proprietorship is the General Partnership. General Partnerships are formed whenever two or more people decide to go into business together. In many ways, General Partnerships are the Sole Proprietorships for multiple people. In many states, including Alabama, a General Partnership can be formed as easily as giving a handshake. However, you are not only unlimitedly liable for your own actions, you’re also unlimitedly liable for the actions of your PARTNER. This caveat makes a General Partnership not only one of the easiest legal entities to form, but also the most dangerous of all the legal entities.
It is important to understand that Sole Proprietorships and General Partnerships are incredibly easy to set up. Cases often involve parties unintentionally forming these legal entities through short conversations and even misunderstandings. These inevitably result in significant consequences down the road. It is also important to remind you that, even if you intend to later set up some limited liability entity, until you actually do that, you will be operating as either a Sole Proprietorship or a General Partnership.
2. Limited Liability Entities
Every state has passed a statute that allows for Limited Liability Entities. Limited Liability Entities are a broad class of legal entities designed to set up, manage, protect and separate your business from your personal assets. A common misconception of Limited Liability Entities is that they are a complete protection against anything that might arise in your business, and that is not true. LLEs do provide for routine protection from 3rd parties, but only so long as they are properly maintained. LLEs also do not provide complete protection from people that are in your business, such as investors, co-owners, and employees. People often forget that some of the biggest liabilities actually come from within the company, and not from its customers or vendors. In that regard, each LLE offers different internal protections best suited to the desires of the owners, all while offering comparable protection against third-parties.
2.1. Limited Liability Partnership (LLP)
A Limited Liability Partnership is partnership on steroids. A Limited Liability Partnership has taken the additional step of registering with a state, protecting the individual partners from the actions of the other partners, providing limited liability. LLPs are used most often in professional settings where individuals want the flexibility to manage their business on their own terms.
2.2. Corporation (Inc., Corp.)
Corporations, on the other hand, are the result of hundreds of years of business “best practices” reduced to law. Corporations are owned by Shareholders, advised by Directors, and managed by Officers. This three-tier system provides a number of internal checks and balances that prevent minority owners from being run over. This is the only legal entity allowed to sell shares of stock on an open exchange and is still one of the most popular vehicles for seeking outside investment. However, the compliance necessary to maintain the business can be burdensome on small businesses.
2.3. Limited Liability Company (LLC)
Limited Liability Companies are the combination of partnerships and corporations into a hybrid entity. LLCs have the flexibility to add and remove Members, contract to expectations, and elect to implement some or all corporate formalities. LLCs, unlike partnerships, can be formed with as little as a single individual, and unlike corporations, can be directly managed by the LLC’s Members. The LLC’s hallmark is its flexibility, which is both a strength and a weakness, allowing it to perform a number of actions well within the law, including permitting minority oppression. LLC laws also vary greatly from state to state, making consistency a problem in interstate matters.
3. Special Purpose Limited Liability Entities
While LLPs, Corporations, and LLCs are the most common Limited Liability Entities, there are a number of special-purpose entities that might be better suited to your situation.
3.1. Professional Corporations (PC)
Professional Corporations are corporations that are allowed to perform certain “professional” duties, such as practicing law or medicine. While these entities have special requirements, the structure provides professionals the ability to have limited protection through a professional entity. However, no legal entity, including a PC, provides for protection against professional malpractice or other personal torts.
3.2. Non-Profit Corporation or Limited Liability Company
Non-Profits do not have owners, which means that they cannot pay out a profit. This also allows them to avoid a number of federal and state taxes if they otherwise qualify. One of the biggest misconceptions is that Non-Profits are cheap to set up and manage because of their non-profit nature. However, non-profits routinely spend a significant amount of money on legal and accounting expenses because of the difficulty in managing them.
A relatively new concept borne out of the “social entrepreneurship” trend, Benefit Corporations or “B-Corps” are for-profit companies with a twist. Traditional law mandates that a company’s owners and managers work to maximize profit and increase shareholder value. A B-Corp, while still seeking a profit, does not set profit or shareholder value as the most important factor. Therefore, an owner or a manger may be well within his or her rights to donate a significant portion of the company’s profits to a charitable purpose instead of distributing it to the company’s shareholders.
3.4. Series Limited Liability Company
Many states have added a unique version of an LLC to their repertoire. A Series Limited Liability Company is a self-contained holding company and subsidiary. The Series LLC can choose to segment individual subsidiaries into “Series,” which each act as their own Limited Liability Entities without having to register and maintain separate legal entities with the state. I once had a client that had 42 separate LLCS, requiring thousands of dollars every year in compliance fees across a number of states. A Series LLC would have significantly decrease the amount of legal filings and accounting that client needed to perform annually.
4. An LLC Might Not Be Right for You
Deciding which legal entity to operate as is deceptively simple. Setting up an LLC and assuming you’ve done everything you need might actually be the worst decision you can make. Even if you decide that an LLC is right for you, it can be as nuanced as buying a house. For instance, you might need to buy a house as opposed to renting one, but that question does not consider how much of a house you can afford, what size, layout, side of town, and other amenities characterize the house in question. Your answers to each of those questions depend on a number of factors.
Many people hear tidbits of information from friends and relatives and assume that LLCs are the best legal form. But there are problems with LLCs, such as:
- Owners are allowed to actively compete against the LLC without any recourse
- Minority owners effectively have no power in an LLC
- Courts can go after an LLC’s assets in an owner’s personal bankruptcy
- All owners are assumed to have the power to sign on behalf of the company
- Courts are much quicker to ignore LLC protections because of owner’s mismanagement than other entities
These are only a few of the dozens of reasons that an LLC might not be right for your business. An LLC’s biggest benefit, flexibility, also makes it a sinister threat. It also never ceases to amaze me how many people set up an LLC and never execute an Operating Agreement. Under many state laws, including Alabama, the Operating Agreement covers 99% of the LLC’s operation. If you fail to execute an Operating Agreement, or if you have a cookie-cutter Operating Agreement you found online, chances are that there are no provisions covering some major issues you might face down the road, such as breaking ties, distributing profits, or deciding how to close the business down.
5. Bottom Line
Setting up a business is a complicated and nuanced process. There are a number of factors to consider, and knowing which questions to ask is often as important as knowing the answers. I cannot recommend enough seeking the help of a knowledgeable business lawyer when you set up your business. It is simply not worth the headache of learning too late that you’ve made a major mistake.