THE ADVANTAGES OF LIMITED LIABILITY COMPANIES
There have been two articles recently in Wisconsin Technology News, one authored by
Attorney Matt Storms entitled ―About that LLC. . .‖, WTN News, June 23, 2010 and the
other authored by Attorneys Gregory J. Lynch and Melissa M. Turczyn, entitled ―Top
legal mistakes entrepreneurs make: Choice of entity,‖ WTN News, June 28, 2010, stating
that using LLCs for start-up tech companies is a mistake. They cite several reasons for
their conclusions. This vigorous debate is welcome. These articles provide the
opportunity to make the case for LLCs as the entity of choice for start-up companies,
including tech companies, once again.
Every advisor would give perfect advice if he or she knew what was going to happen for
a particular business over the years. However, advisors do not have that luxury. One
must choose, as the business begins, a form of business. I believe that amongthe three key
factors in choosing an entity is not only superior taxes and limited liability but also
flexibility. Flexibility is an important criterion – as important in many respects as the
others simply because one cannot predict where the business is going to end up.
Attorney Storms cites several situations in which LLCs did not work. There are as many,
if not more, ―war‖ stories of C and S corporations being poorly advised for young
companies. Rather than go over a laundry list of those examples, I merely will note that
in my law practice, spanning more than three decades, I have seen many companies
poorly served by being a C or S corporation.
The main criticisms of LLCs appears to be that 1) they are not attractive to investors, and
2) they will result in a less-than-optimal result when the owners ―exit‖ the business.
Predicting that companies are always going to exit with either an IPO or substantial buy-
out is foolish. Let’s look at recent Wisconsin statistics. The Department of Financial
Institutions (―DFI‖) statistics for the last few years show that about 30,000 entities are
formed as LLCs, corporations or non-profits. In addition, there are sole proprietorships
and general partnerships which are not listed with the DFI. Of those, how many go
public or be acquired in a substantial buyout? Very, very few. Probably well below 1%.
All of us would like to represent companies which go public or get bought out for a
substantial sum. Who wouldn’t? However, realistically most of us represent companies
that either fail (which is the highest percentage) or have modest success but do not hit a
home run. The question is: What advice should they receive as they proceed? The
advice is far different if you could predict they would go public or be bought out in a
substantial merger. We ought to focus on the 99%, not the 1% long-shots.
In the article by Attorneys Lynch and Turczyn a chart is presented on page 1 which has,
in my opinion, several mistakes. In contrast with their assertions, an LLC is attractive to
investors. To suggest that a C corporation has moderate complexity but an LLC has
moderate-to-high is incorrect. Any entity can either be really, really simple or really,
really complicated. It just depends. Any entity can be inexpensive or costly. It just
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depends. Again, this is not an accurate portrayal. LLCs are attractive to outside
investment. Investors can use the tax losses and tax credits, if applicable. At my firm we
have represented numerous tech companies over the last 25 years. We have been using
LLCs extensively since they became available in 1994, and our clients have found that an
LLC is an advantage.
To further make the point, let’s review two articles authored by professors and tax
lawyers. Don W. Llewelyn and Ann O’Connell Umbrecht’s ―No Choice of Entity After
Check-The-Box,‖ Tax Lawyer, Vol. 52, No. 1. (―Llewelyn‖); and Daniel S. Goldberg’s
―Choice of Entity for a Venture Capital Start-Up: The Myth of Incorporation,‖ Tax
Lawyer, Vol. 55, No. 4. (―Goldberg‖) These articles highlight in detail why an LLC is
the entity that one should choose to begin a company.
In Llewelyn the authors make the following comment:
We have concluded that what used to be a difficult choice
should now be recognized as an obvious one. That is, if
pass-through treatment is desired and available, the choice
of entity involves selecting the best available pass-through
entity from a hierarchy of entities, the clear leader of which
is the state law LLC treated as a pass-through entity for
federal tax purposes.
Tax Lawyer, Vol. 52, No. 1, p. 2
They go into substantial detail on the double tax effects of a C corporation and the higher
tax effects of an S corporation, all relative to a pass-through entity such as an LLC. They
state:
For a C corporation to produce better tax results than an S
corporation or partnership, it would be necessary to retain
earnings and gain on inside appreciation in corporate
solution long enough that on a present value basis, the
minimum fourteen percent additional tax cost on
distribution to shareholders (twenty percent if section
1202 does not apply) is less than the extra five and one-
half percent payable immediately if the shareholders
alone are taxed . . . .
Tax Lawyer, Vol. 52, No. 1, p. 8
They go on to say:
With the introduction of the LLC, the business
advantages of the C corporation have been eliminated and
the tax savings from excluding fringe benefits would be
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too small in many cases to justify the significant
comparative disadvantages of this choice.
Tax Lawyer, Vol. 52, No. 1, p. 13
In comparing an S corp to a partnership for tax purposes the authors state:
From the federal tax standpoint, the choice is like that
between a tuxedo and a sweatsuit: they both cover
basically the same territory, but subchapter S is harder to
get into, harder to get out of and less comfortable in the
meantime.
Tax Lawyer, Vol. 52, No. 1, p. 17
The article goes on to cite many reasons for picking a LLC taxed as a partnership over an
S corp, including a potential tax-free liquidation for an LLC versus an S corp.
In conclusion, the authors state:
As a matter of state business law, the LLC juggernaut
seems unstoppable: all states have created some form of
LLC and some degree of uniformity can be expected
eventually to result. On the tax side, the Treasury has
capitulated to the trend by allowing access to the LLC
without extracting a price in C corporation treatment.
The only faction yet to climb on the bandwagon seems
to be the bar. Whether out of reflexive caution or
unfamiliarity, lawyers do not appear to be encouraging
the use of LLCs to the degree they should. In that, they
do their clients a disservice. The LLC is a gift horse.
We would hope its future use will be so widespread as
to cause the advice in this Article someday to go
without saying. (Emphasis added).
Tax Lawyer, Vol. 52, No. 1, p. 33
Mr. Goldberg states:
In the high-tech start-up industry, however, entrepreneurs
are often advised to begin business as a corporation,
albeit sometimes an S corporation if the entity can
qualify. This advice is based largely on several perceived
operating advantages which are either more easily
achieved by or require the corporate form.
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Most important of these perceived advantages, perhaps, is
the need for the corporate form to achieve the most
sought after exit strategies of a public offering or a tax-
free acquisition by a public company, sometimes referred
to as the ―home run‖ exit strategies. Another perceived
advantage of the corporate form is its facility to allow for
stock options to employees, giving them additional work
incentives . . . .Another commonly perceived corporate
advantage lies in satisfying the desire of investors to
invest in corporation rather than other types of entities.
These investors may be early state investors, sometimes
referred to as ―angel investors‖ or simply ―angels,‖ or
later state investors, sometimes referred to as ―venture
capitalists.‖ Venture capitalists sometimes form
investment funds with several participating investors,
called ―venture capital funds.‖
Tax Lawyer, Vol. 55, No. 4, p. 923
The author goes on to say:
This article asserts that advisors who advise
immediate incorporation rely largely on myths that
the corporation, rather than the LLC, is the more
desirable entity for a start-up seeking venture capital
funding. (Emphasis added)
Tax Lawyer, Vol. 55, No. 4, p. 924
Goldberg goes on to rebut all of those perceived advantages of a corporation and shows
again that the main criticism of a C corp remains the same. There are many tax
advantages of a partnership for tax purposes over a C corp. The article highlights many
of them, including loss deductions for the initial investors, allocating tax losses and tax
credits, and others.
Goldberg writes a very complicated article. But suffice it to say that the author points out
that the perceived advantages of a C corp are just that—perceived—and are in fact not
true. He goes on to talk about venture capital and states:
As the economic world changes, the players must adapt.
If LLCs offer significant tax advantages over
corporations to the owners of those entities, then the
market will favor businesses that adopt the LLC structure
over those that adopt the corporate structure.
Tax Lawyer, Vol. 55, No. 4, p. 950
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Goldberg states in conclusion:
The principal lesson to be taken from this article is that
the choice of entity in a start-up situation should be made
with care, taking into account the advantages of each
available structure. It is likely that upon full
consideration of the issues discussed in this article and
the probable short-term and long-term outcomes for the
business, the LLC will prove to be the best choice in most
start-up situations, particularly where a hybrid structure is
not feasible or is too expensive to institute.
Continuing on, he states:
Even if the LLC structure is chosen at inception and it
proves to be inferior to the corporate structure in a
particular situation, the parties can change the structure to
a corporate one, or a hybrid, with relative ease and cost
efficiency. It is this flexibility of the LLC that is one of
its most significant advantages. In contrast, it is
generally very costly to go from a corporation to an
LLC. (emphasis added)
Id.
In short, people who study these matters on a day-to-day basis and teach the subject
extensively have concluded that the LLC is generally the best choice.
Most of the criticisms in Attorney Storm’s article can be dealt with by an experienced
attorney, including the issues of dealing with investors, dissolution issues, and stock
options.
At the end of the day, LLCs are still the most flexible entity. Until, and unless, the
double tax scheme of C corporations is changed and the liquidation benefit of an LLC is
eliminated, one is going to be hard pressed to pick a C corp when a minute percentage of
companies hit a ―home run‖ by either going public or being acquired in a merger.
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