Strategic business planning should involve thoughtful consideration of what form of business entity to use – whether a C corporation, S corporation, limited liability company, partnership, non-profit, or some other type of business entity.
This post is about one of the most popular entities for closely-held businesses – the limited liability company or “LLC”.
In 1977, Wyoming passed legislation allowing for an entirely new type of company called a “limited liability company” to very little notice or fanfare. Today however, over two-thirds of all new companies formed are LLCs!
An LLC is a hybrid business entity having certain characteristics of corporations and certain characteristics of partnerships (or sole proprietorships, if there is only one owner). An owner of an LLC is called a “member” and LLCs can have just one member or hundreds of members.
Like a corporation, LLCs offer limited liability to the company’s owners and have certain rules and requirements for management and maintenance set forth under state law. Like a partnership, how an LLC is governed and how its owners get paid for their participation and/or investment depends on the bargained-for contract between the owners, i.e., the Operating Agreement.
Have a Good Operating Agreement!
Because LLCs are “creatures of contract,” there is a great deal of flexibility in how you can organize and run an LLC, but failing to set forth this information in a well-written Operating Agreement (your contract with the LLC and all your fellow members) is a recipe for disaster. While a single member LLC’s operating agreement can be fairly simple and straightforward, multiple-member LLCs usually have more complex operating agreements to handle many things, including management responsibilities, the allocation of profits and losses, capital accounts, vesting provisions, dispute resolution, etc.
Even if you go into business with your very best friend and each of you is in perfect agreement at the onset, human nature is such that there will inevitably be a disagreement at some point down the road, especially if your business becomes very valuable. If you do not have a comprehensive Operating Agreement to reference, you (or your lawyers) will be forced to cobble together scraps of evidence that reflected your prior decisions or understandings about the LLC. A neutral third party, such as a judge or arbitrator, might not interpret this piecemeal information the way you hoped, and the process can be very expensive.
LLCs and the IRS
In the eyes of the IRS, an LLC is not a separate taxable entity like a corporation is. This means there is no separate “limited liability company” tax return form or code section for LLCs. Instead, the IRS refers to LLCs as “pass-through entities,” which simply means that the tax liabilities of the company “pass through” to the LLC’s members’ personal income tax.
If you are the only member of your LLC, the IRS will automatically classify your company as a sole proprietorship (and you will report the activity of your LLC on a Schedule C submitted with your Form 1040 income tax return). If you have several members in your LLC, the IRS will treat it as a partnership (and you will file the Form 1065, U.S. Return of Partnership Income) and each member should receive a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., every year.
Some LLCs choose to be taxed as corporations. To do this, you must file Form 8832, Entity Classification Election.
Why would an LLC make this choice? The most common reason is if your business wants to keep a substantial amount of its profits as “retained earnings”. Retained earnings for a corporation are generally taxed at a lower rate than they would be when “passed through” to a personal Form 1040 tax return.
Once you elect corporate taxation for your LLC, however, you can’t switch back to pass-through taxation for five years, and if you do switch back, there could be negative tax consequences. In other words, you should treat the decision to elect corporate taxation for your LLC very seriously, and with guidance from legal and tax experts and a solid understanding of how cash is going to be needed to operate your business.
Corporation or LLC?
The reason LLCs have surpassed corporations as far as choice of entity for closely-held businesses is because they are more flexible and generally easier to manage and maintain than a corporation.
If you are wondering if an LLC is right for you, however, be advised that anyone starting a new business should consult with his or her legal and tax advisors before making the big “choice of entity” decision. There are many subjective considerations and factors which will weigh in favor or against any particular choice.
For example, if you are planning to seek venture capital or go public, forming a C corporation rather than an LLC is the better choice. Venture capital firms don’t care for the unpredictable and unique management of LLCs, and prefer the familiar structure and management of a conventional corporation.
Morever, VCs generally cannot invest in an LLC. If you set yourself up as an LLC, and then seek VC funding, you will have to spend a lot of money changing from an LLC to a C corporation, if your particular state’s law even allows this. Further, the LLC ownership structure simply isn’t a good fit for a publicly-traded company.
If you’re considering starting a business or revisiting a current one, contact us today.
- Bylaws / Operating Agreement
A company’s Bylaws (in the case of a corporation) or Operating Agreement (in the case of an LLC) provide the legal backbone for how it operates. If your company does not have bylaws in place, state statutes will control how the company is run. However, these default rules might not be the best fit for your company, so it is much better to strategically think through how you would like your company to be run.
For example, if there is a major disagreement among the owners that “deadlocks” the company from being able to do anything, generally one of the only remedies under state statutes is that an owner can file a lawsuit asking the court to wind up and dissolve the company. This is usually a lose-lose for everyone, especially if the company was doing well prior to the deadlock. The owners could avoid this scenario by having certain dispute resolution provisions in the bylaws, or by having a limited, advisory-only member of the company who effectively acts as a tie-breaker, the process for which would be set forth in the bylaws.
After establishing a well-thought out corporate structure and executing governance documents, every company should make sure that they have good insurance coverage. This may not come cheap, but it’s an important investment for any business to make.
Beyond a general commercial liability policy, insurance can cover anything from cyber liability to director/officer liability to life insurance for key founders. Also, if you are selling any kind of product to the public, consulting with an attorney who specializes in products liability is advised, as they will be able to assist you in mapping out this additional exposure to risk and preparing any contracts or disclaimers to include with the sale of your product.
- Shareholders’ Agreement
This agreement, which also may be called a “Founders’ Agreement” or “Buy-Sell Agreement”, can help you govern the relationship between the owners of your company. You and your business partners may be on the best of terms now, but running a company might put a strain on your relationship sooner than you think. Interpersonal conflict between founders is one of the most common and predictable reasons for why companies fail. Thus, a shareholders’ agreement goes a long way to protect your investment in the new business.
This type of agreement should contain vital information such as who can be a shareholder or serve on the board of directors, what happens in the case of a shareholder’s death or impairment, or what happens when a shareholder files for bankruptcy, resigns, retires or is fired. It should also outline how much shares of stock are worth and who will be required to purchase the shares of the owner who is leaving.
- Non-Disclosure Agreement (NDA)
NDAs protect the confidential information of your business. They are used when one or both parties in a relationship wish to disclose confidential information, but want to ensure that the person or organization who receives it does not disclose it to anyone without consent. For example, if you are looking for a manufacturer to produce your company’s new widget on a mass scale, you should probably have each potential manufacturer you interview sign an NDA so that they can’t turn around and start making your widget anyways.
Keep in mind, NDAs are worthless unless they are actually signed by the party against whom you wish to enforce it. No matter what verbal promises were made before or after information was disclosed, it is advised you get your NDA in writing and signed by both parties before any confidential information is shared. This way, both parties clearly know their duties and privileges as they are receiving business information from the other.
- Intellectual Property Agreement
This document is mandatory if you wish to acquire, sell or license intellectual property (e.g. copyrights, trademarks, patents).
If you are giving or receiving all the rights to a certain piece of intellectual property, that is called an “assignment”. If you are giving or receiving only a few rights related to the intellectual property (for example, the right to print and distribute someone’s copyrighted book), that is a “license.”
Whether you are just starting out or a well-established business, intellectual property or “IP” is often a significant piece of your business’s value. An IP agreement protects this value.
A good IP agreement should be comprehensive, covering the financial compensation, date of the assignment/license, the rights and obligations of the Assignor and Assignee and timelines for payment, representations and warranties, indemnities, and more.
Currently, data privacy laws are a patchwork of various state laws and federal regulations. Some industries, such as education and finance, are also subject to special rules. Some states, such as California, have enacted laws for any business that targets customers in that state. If you have concerns about whether you are following the law in this complex area, consulting with an attorney is strongly advised.
- Terms & Conditions
This item is essential if you conduct any business online. Your website’s terms and conditions regulate the online transactions where you sell your products or services to clients.
Well drafted website “Terms and Conditions of Use” will deal with issues such as returns and refunds, consumer guarantees, deliveries, disclaimers and competitors. They will also have the effect of limiting liability for any information and material that may be on your site in relation to third party information or content that is included on your site.
Additionally, it should lay down the rules for people visiting the website as well as explaining that any intellectual property on the website is protected. Your website’s terms and conditions should be easy to read and accessible before a transaction takes place.
- Founders’ Assignment of Intellectual Property
Each and every person who works in any manner for the company, including the founders, should execute an agreement assigning their creations to the company. A founder’s IP contributions could be anything from patents, software, logos and marketing materials, customer data, and more.
Especially during the startup phase of a company, almost all of the value of the venture will be tied up in the IP, so if the company cannot prove it actually has legal title to these assets, the company is essentially worthless.
- Employee Contracts or Offer Letters
Having a easy to understand contract or offer and acceptance letter with employees is essential for setting forth expectations and ensuring the employee is tied into the team. Topics that could be covered in an employee contract or offer letter include who the employee reports to, who will own the employee’s work product, basic expectations, required commitments, share vesting and all other “rules” the employee must abide by. This prevents misunderstandings and thus can go a long way to protect the company from HR-related disputes.
- Liability Release Forms
Startup companies tend to have a variety of fun work events that may involve risk. For example, maybe your company has an annual dodgeball tournament against an important vendor or maybe you want to organize a company “hiking day” for bonding and team-building. If so, you should have all employees sign a liability release form so that your company doesn’t become liable for an unexpected accident.
As socially conscious entrepreneurship becomes more visible and viable, you may keep hearing the terms “B Corp” and “Benefit Corporation” or “Public Benefit Corporation.” What do these terms mean and how are they relevant to a Colorado small business owner?
Many use the terms “B Corp” and “Benefit Corporation” interchangeably, but they are in fact very different things!
A B Corp is a for-profit entity that has obtained a voluntarily certification from a certain nonprofit organization headquartered in Wayne, Pennsylvania, called B Lab.
As of the date of this posting, there are 1,925 certified B Corps in 50 different countries spanning 130 different industries. Some nationally-recognized Colorado B Corps include New Belgium Brewing Co. and Bhakti Chai.
Obtaining a B Corp certification requires passing the B Lab Impact Assessment, which analyzes a company’s operations and provides a score based on meeting higher standards of transparency, accountability, performance and impact on the community. Passing the assessment test requires a score of at least 80 out of 200 points. There are many workshops and boot camps available in the Front Range area for business owners looking to hit the Impact Assessment’s various benchmarks. After passing the assessment, B Corps must pay a membership fee based on annual revenues.
Obtaining B Corp certification allows a business to join a community dedicated to creating a more just and conscious economy yet still driven by profit motives. B Corps organize various gatherings around the world, including an annual retreat, and such events provide opportunities to network and support other like-minded business owners.
A Benefit Corporation is a type of business entity (i.e., a special kind of corporation) that is authorized by state law. As of the date of this posting, 31 states – including, as of April 4, 2014, Colorado – have recently enacted legislation to allow for these entities. This legislation allows socially conscious entrepreneurs another entity option when starting a business.
The Benefit Corporation movement, largely spearheaded by B Lab, was to fix what many saw to be a major limitation in standard corporate law.
As you may know, the business and affairs of any for-profit corporation must be managed by a board of directors. Traditionally, the individuals on the board of directors have a legal duty to manage the affairs of the corporation in the company’s best interest. If they do not follow this duty, they could be liable to the corporation’s shareholders for breach of their duties.
So…what does “in the company’s best interest” actually mean? Some perceived it to mean only the maximization of shareholder value. This would severely limit the goals and the general ethos of the socially-conscious business/B Corp assessment movement. If a board of directors was trying to decide between two options, with Option 1 promising high profits but harm to the environment and Option 2 resulting in lower profits but no harm to the environment, the maximization of shareholder value theory would require the board of directors to pick Option 1.
Benefit Corporation legislation has thus been enacted to address this limitation in traditional corporate law.
Beyond corporate doctrine, however, forming a business as a Benefit Corporation may be important for reasons of marketability, relaying a message to current and potential employees and customers, and signaling participation in the socially-conscious business movement.
Colorado Public Benefit Corporations
The Public Benefit Corporation Act of Colorado (“PBCA”) contains the relevant provisions for those electing to operate their corporations as a Public Benefit Corporation (a “PBC”). A Colorado PBC is a for-profit corporation that is “intended to produce a public benefit or public benefits and to operate in a responsible and sustainable manner.”
What would be considered a “public benefit”? The PBCA defines public benefit as “one or more positive effects or reduction of negative effects on one or more categories of persons, entities, communities, or interests other than shareholders in their capacities as shareholders, including effects of an artistic, charitable, cultural, economic, educational, environmental, literary, medical, religious, scientific, or technological nature.”
A key thing to realize is that PBCs are still subject to the rules and requirements contained in the regular corporate statutes, including the Colorado Business Corporations Act and the Colorado Corporations and Associations Act. The PBCA merely imposes “additional or different requirements, in which case such additional or different requirements apply.” The primary differences are:
- A PBC’s Articles of Incorporation must list one or more public benefit which the company must strive to achieve.
- A PBC’s name must contain the words “public benefit corporation” or the abbreviation “PBC” or “P.B.C.”
- A PBC’s board of directors must manage the company to balance (1) the pecuniary interest of the shareholders; (2) the best interest of those affected by the company’s conduct, and (3) the public benefit(s) listed in the Articles of Incorporation.
- A PBC must prepare an annual benefit report with (1) a description of how the company promoted the benefits listed in the Articles of Incorporation and any obstacles the company faced in promoting those public benefits and (2) an assessment of the overall social and environmental performance of the company against a third-party standard. This annual report must be provided to each shareholder of the PBC and posted on its website.
- Any share certificates of the PBC must consciously state the company is a public benefit corporation.
A PBC is formed the same was a traditional Colorado corporation would be formed – by filing Articles of Incorporation with the Colorado Secretary of State. Thereafter, all other documentation used to organize a PBC is extremely similar as what is used to organize a traditional Colorado corporation.
The PBCA specifically protects directors of a PBC from lawsuits by third parties who are interested in the public benefits listed in the Articles of Incorporation and by people who may be affected by the PBC’s conduct.
This section is meant to be a general summary of the PBCA and if you are thinking of creating such an entity or converting your current corporation to a PBC, consulting with an attorney is strongly advised.
 Section 7-101-501 et cet., C.R.S. Added by Laws 2013, Ch. 230, § 1, eff. April 1, 2014.
 Section 7-101-503(1), C.R.S.
 Section 7-101-503(2), C.R.S.
 Section 7-101-502, C.R.S.
 Section 7-101-503(1)(a)-(b), C.R.S.
 Section 7-101-503(4), C.R.S.
 Section 7-101-506(1), C.R.S.
 Section 7-101-507(1)(a)-(b), C.R.S.
 Section 7-101-507(4), C.R.S.
 Section 7-101-505, C.R.S.
 Section 7-101-506(2), C.R.S.