You may have heard that LLC’s are the best entity structure for small businesses. Perhaps you’ve received advice to form an LLC for your new business. You may see other small business owners who have formed an LLC. It seems like everyone is talking about LLC’s, so what is not to love about them?
For starters, they’re not as simple as people tend to think. LLC’s appeal to small businesses because it seems like they are the simplest and easiest way to set up a new business. But this is where LLC’s can be deceptive. They may LOOK simple, but they are actually quite complex.
You see, people started thinking that corporations were so complicated – with all their shareholders and directors and officers, etc. Not all businesses wanted to fit into that mold – the established structure that all corporations have. They wanted the freedom to create their business with a different structure. They wanted customization. So LLC’s were invented that allow a customized structure.
When an LLC is formed, it’s an empty box. It has no structure. The owners have to create that structure for themselves. This is great for those sophisticated businesses who need the freedom to mix and match different elements and create their own way of doing things. They are knowledgeable enough to be able to do that.
But when an LLC is formed, it’s an empty box. What happens if a small business owner wants a “simple” set up so they choose an LLC but they don’t know they have to create the structure themselves? Or what if they don’t know how to create the structure? Then it’s not so “simple” to have an LLC if all you have is an empty box and no structure. Every entity must have a structure. This is the trap that small businesses fall into. They must take additional steps to set up the structure of the LLC, but unfortunately, many don’t.
So what kind of structure is needed or wanted? LLC’s can be structured in all flavors and sizes. They can be set up as manager-managed or member-managed. The term “manager” for an LLC is the highest level of authority in a manager-managed company. If there are multiple managers, each manager can have different voting rights – or they can have equal voting rights – or their authority and decision-making can be limited in certain circumstances. Managers do not have to be owners, but they can be. LLC owners are called “members” and in a member-managed company, all owners have the right to be involved in the management of the LLC. This may be good for some and bad for others.
When it comes to money, there are all kinds of options. Owners can choose how they are going to split the profits and how they are going to split any losses – and they don’t have to be the same. Distributions of profit may be paid differently depending on how the LLC is taxed. And speaking of taxes, an LLC is not recognized by the IRS (I think they’re too new) so an LLC gets to choose to be taxed as a sole proprietor, partnership, C corporation, or S corporation. Basically, the IRS forces an LLC to choose an old and established form for taxation purposes.
When it comes time (at some point) to shut the LLC down, there has to be structure around when that could happen and how it would work. Where does the money go? Where do the assets go? Who has the authority to shut it down? All good things to consider because once the ball gets rolling…
All of this structure is set out in one big contract called an “Operating Agreement”. What makes things even more complicated is that here in Florida, an Operating Agreement doesn’t have to be written or signed. So it’s kinda like the wild, wild west – open for conflicts. Flashback to that small business that is set up as an LLC but the owners didn’t realize they had to create the structure, so they have no formal Operating Agreement. Those owners are operating the LLC on thin air because there’s no proof of any agreement between them. Enter disagreements and misunderstandings … and problems. This isn’t keeping it simple at all.
In reality, for small businesses what turns out to be the most “simple” type of entity is the corporation because it is born with structure. When it’s created, the structure is there automatically by law. It’s more like a “plug and play” type of setup. You fill in the boxes on the grid and the setup is done.
Important Side Note #1: On top of all that we’ve already discussed, LLC’s present even more complexity when there’s just a single owner of the business. For various reasons, the law has developed in a way that makes single-owner LLC’s vulnerable in some situations. If a single owner really wants an LLC then he or she may need to take extra steps to get the full protection, and in some cases that full protection will not even be possible.
Interesting Side Note #2: Most states authorized LLC’s in the 1990s (Wyoming created the first LLC back in 1977 but it took a while for other states to accept it). That means LLC’s aren’t very old compared to corporations, which started in the 1790s. With LLC’s being just over thirty years old, there’s still quite a lot of development going on in the law with them. Plus, there’s not much consistency with LLC laws from state to state. They’re still toddlers on the legal front.
In conclusion, this article is not saying that LLC’s aren’t good entities for business. They certainly can be good – but only for certain businesses. For sophisticated businesses that need flexibility, they don’t mind making the complex decisions needed to set up the structure for the LLC. For small businesses that want to keep things simple, however, LLC’s can be quite the opposite.
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