By Joel Nied, Esq.
Clients regularly call asking me to form a limited liability company. Sometimes, they call to tell me they have already formed the LLC and ask me to use it to organize their companies. My first question to them is, “Why?”
When did the LLC become the default choice for entities? Often, it’s just not the right choice.
LLCs are easy to create. In many states, you can fill out a form on a state’s website and, for $100 (plus a nominal charge for using a credit card), create an LLC within minutes. LLCs have no “corporate formalities” like corporations, such as annual board meetings and shareholder meetings. You don’t even need bylaws or membership certificates.
If the LLC is the wrong choice, things will become difficult for the company later. By the time you realize it, however, it may be difficult to fix the problems without great expense and frustration. A good example is equity compensation. If you plan to hand out option grants or restricted membership interests to employees, then using a LLC is probably a huge mistake. Why? Because instead of those employees simply being employees, they are now considered “partners” by the IRS. That means their salaries are no longer salaries. Now those payments are called “guaranteed payments”. Instead of including a W-2 with their 1040, they now need to file K-1’s. Tell an employee he needs to pay self-employment tax and watch the excitement (and blood) drain from his face.
In other words, an employee’s elation of owning a small piece of the company will soon turn to confusion and then disappointment as she realizes that life just got more complicated in exchange for a small piece of equity in an illiquid company.
Granted, converting an LLC to a corporation at that point will be a tax-free event. But the cost is not in the taxes – it comes from scrapping just about every document related to the formation of the company, drafting documents that transfer the LLC assets into a corporation, and then drafting all the necessary corporation documents (incorporation documents, resolutions, bylaws, etc.). If there are any investors at that point, you will need to effectively negotiate a new shareholders agreement. Then you will have to collect all the membership certificates and any option grants, and replace them with stock certificates and new option grants. Asking every member to dig up their membership certificate and put it in the mail to you and sign a slew of new documents will do wonders for your investor relations.
Sometimes the response I get to the advice above is that LLCs are easy to form, and that the founders will convert to a corporation before any investors come in. That line of thinking just is not right. Although there is a perception that it is cheaper to simply form a LLC than a corporation, that is not true. An attorney experienced with startups can form either an LLC or corporation for the same fee.
So, before you instinctively reach for the LLC forms, consider whether it’s the best move for the short and long term.