For years, I have advised my clients to carefully consider their entity selection, especially regarding Limited Liability Companies (LLCs.) However, by the time I meet them for the first time, most have already committed to an LLC. In my opinion, LLCs are oversold to entrepreneurs, and the ability to manage them is underrated.
I believe a Sole Proprietor entity type is appropriate for many businesses with one owner. However, I’m also convinced that most founders are lemmings who follow someone’s recommendation that, to be a legitimate business, they must create an LLC without considering the consequences associated with LLCs as an entity choice. Entrepreneurs are told that LLCs are a popular choice for small businesses due to their limited liability protection, flexibility, and simplicity, all of which are overemphasized.
Tort liability is a member’s exposure to civil lawsuits as a result of harm to an individual or their property. However, if a manager of an LLC makes a conscious decision that results in harm to another party, that manager can often be held personally liable for their decision.
In a member-managed LLC, each member has equal rights and authority to participate in the day-to-day operations and decision-making processes of the LLC. Therefore, members collectively manage the LLC, and decisions are typically made by a vote or consensus among the members. In a member-managed LLC, all members are entitled to participate actively in the management of the business unless otherwise specified in the operating agreement. Consequently, all the members of a member-managed LLC can potentially be held liable for harm inflicted on another party as a result of their decisions.
Additionally, many LLCs fail to comply with the appropriate formalities out of ignorance, and therefore, what is known as “piercing the corporate veil†is likely exposing members to personal liability. Moreover, let’s assume that a member does not control their investment, for example as a silent partner. In that case, the LLC has just offered that person a security and is now subject to rules established by the Securities and Exchange Commission (SEC).
Then, there is contract liability, such as when an LLC gets a loan. Unless the LLC has a substantial amount of unencumbered assets that it can pledge as collateral when applying for debt financing, the lender will require a personal guarantee from members. This means that if the LLC defaults on its debt, the creditor can go after the members to recover the debt.
So, from my perspective, the liability protection offered by an LLC can often be circumvented, creating the optics of liability protection rather than extending actual liability protection to some or all of its members.
Flexibility and Simplicity
Flexibility is a double-edged sword. LLCs offer a blank slate in terms of how owners can manage nearly every aspect of the entity. While the flexibility of management and profit allocation may sound appealing on the surface, few founders understand the consequences and magnitude of defining all governance issues in an operating agreement unless they are assisted by a competent lawyer. Failure to initially address every governance issue and modify them as conditions change leaves LLCs vulnerable to a misalignment between the assumptions and expectations of the members.
Unlike corporations, which have a default governance structure, LLCs do not, requiring owners to address the question of LLC governance in a separate operating agreement. Unfortunately, many LLCs do not have an operating agreement and the ones that do often place them on a shelf after they are initially drafted and never update or follow them.
With an S-Corp, the entity issues stock certificates with the number of shares allocated to each owner. The number of shares a person owns dictates the amount of control they have over the company’s direction, as each owner votes their shares. Moreover, the number of shares also dictates how distributions are made. Of course, the S-Corp’s Bylaws may contain specific rules governing handling decisions and distributions. However, in the absence of any special rules, S-Corps default to a uniform set of federally defined statutory rules and regulations that govern corporations.
However, LLCs only have a legal framework defined by each Secretary of State, and the operating agreement must define everything else. And that is why setting up an LLC is more difficult, in my opinion, than simply following the rules defined for the corporation.
Computing Ownership Percentage
Since the Corporate Transparency Act went into effect on January 1, 2024, many LLCs are just now discovering what they don’t know about LLCs. One of the requirements of FinCEN’s beneficial ownership is to report members with an ownership percentage greater than 25 percent. Since LLCs do not issue shares, how does the LLC determine a member’s ownership percentage? Normally, this is addressed in the LLC’s operating agreement, but how is it determined?
Well, the answer is lots of potential ways. While having the flexibility to determine ownership percentages in ways other than the number of shares controlled by a person makes LLCs more flexible, understanding the pros and cons of each way to determine ownership percentage in an LLC is far from simple. Let me explore just a few common ways LLCs can determine a member’s ownership percentage:
1. Initial Capital Contribution: This is the most common method where the ownership percentage is determined by the amount of capital the member contributed to the business.
2. Capital Account: Capital accounts record the capital contribution made by each member. A capital account can also decrease if a member takes a share of the profits and increase if additional capital is contributed.
3. Resource Contribution: The types of resources, often equipment, that a member brings to the business can also affect their ownership percentage.
Note: The downside with all these above methods so far is that they do not take into account the value of a company. We all know that starting a business is risky, and early investors should be compensated for their additional risk. However, if a successful LLC brings on a new member and that member contributes the same amount of capital or resources as the initial members, their ownership percentages would be the same since there is no way to account for the increased value of the business unless the operating agreement is rewritten and agreed to by all members. Corporations account for the value of a company by increasing or decreasing its share price. In the LLC examples above, it is just the money contributed or the value of the resource titled to the business, regardless of when in the LLC’s life cycle the contribution was made.Â
4. Work Contribution: A member’s work, albeit skill level or number of hours, can also influence their ownership percentage. The rub is, “How do you develop a formula that values work contribution over an extended period of time?†The formula you come up with must also be well documented in the operating agreement and understood by all members.
5. Membership Units: Ownership of an LLC can be expressed by membership units, similar to stock shares in a corporation, provided that what constitutes a unit is clearly defined in the operating agreement.
The five methods described above for determining a member’s ownership percentage are by no means a complete list, but hopefully, you can see that when it comes to determining a member’s ownership percentage, while more flexible than an S-Corp, it is in no way as simple.
Distributions
We spent a bit of time exploring just a single thread – ownership percentage – mostly used with an exit event such as a sale or liquidation. However, unlike an S-Corp, an LLC member’s ownership percentage does not have to equate to how distributions are made. Since an LLC is a pass-through entity, the profits, and losses must be allocated to the members. In LLCs, I have seen some members get to claim all the LLC’s losses to offset income from their other sources. I have also seen some members of an LLC getting paid distributions before others. The flexibility of how an LLC can make its distributions is only limited by the creativity of the members. Any changes in distribution must be documented in the operating agreement and approved by all members, which can be problematic if all members are not in agreement.
Decision-making
While day-to-day decisions may extend to all members, the weight of their decisions is often not aligned with their ownership percentage. In fact, LLCs can have managers that are not even members of the LLC. Furthermore, LLCs can have other LLCs as members, complicating things even more.
Conclusion
The nature of LLCs is that they are very flexible, but with flexibility comes more complexity, not simplicity. So, in my opinion, LLCs are oversold to entrepreneurs, and the ability to manage them is underrated. LLCs do not provide a level of liability protection, flexibility, and simplicity that entrepreneurs are led to believe. In the end, if you want simplicity, remain a sole proprietor. Anything else will require that you get counsel from accountants, lawyers, and mentors who can clarify your options. And for God’s sake, don’t choose an LLC just because somebody told you to, or choose an entity before you know how you will fund it and who its members will be.
Is an LLC really the right option for your business?
