Living and Dying with an LLC
We live in the Era of the Limited Liability Company (LLC). The LLC has become the dominant business vehicle of the early 21st Century, the “must use” vehicle for all real estate transactions, and an increasingly popular choice for operating a commercial business as well.
How did this come to pass? The short answer is that the LLC is the most flexible and personal business vehicle available. It is not the perfect choice for every situation, but it is the best available vehicle for a majority of situations these days, and its use is likely to continue to burgeon.
The Vehicular Metaphor
Years ago, when the LLC was a brand-new legal concept, I was asked by one of the major U.S. airlines to write an article describing this new-fangled business vehicle for the readers of their always popular in-flight magazine. While the readership was not going to be technically proficient in tax law, they were going to be smart and sophisticated business travelers for the most part, and so the piece had to be clear and cogent in the explanations, as well as sophisticated and insightful in the analysis.
To describe the role of the LLC in the pantheon of business vehicles, I chose to make comparisons to automotive vehicles.
C Corporation – The C corporation is like your father’s Cadillac. It is a big, roomy, comfortable business vehicle that can fit everyone and anyone inside and bring them along for the ride. The trouble with a C corporation is that it is a business vehicle that gets bad or low tax mileage. It is a tax guzzler, like the old heavy big Cadillacs in the days of yore. If you want to get their easily and comfortably, and don’t care about the operating costs, a C corporation is for you. If, however, you want to operate on a lean, mean efficient basis, look elsewhere on the automotive used car sales lot.
S Corporation – The S corporation is like a 1973 Honda Civic. The old and early Civic was a two-seater that was extremely uncomfortable to get into unless you weighed about 140 pounds (which, fortunately, I then did) but it got unbelievable gas mileage – to my recollection, something like 85 miles to a gallon. I used to pull into the gas station, fill up the tank and then tell the gas station attendant, “See you next year.” The point is that the Honda Civic 1973 Honda Civic got phenomenal gas mileage – it just wasn’t a vehicle that everyone could fit into. Like an S corporation, which cannot have a corporate shareholder, cannot have a nonresident alien shareholder, cannot have a partnership shareholder, and can only have a limited number of shareholders, etc. S corporations have passive taxation, and are “tax efficient,” but not everyone can fit inside the business vehicle.
General Partnership – The general partnership is the business vehicular equivalent of the 1973 Ford Pinto. The Pinto was a fabulous car to drive until you got rear-ended, at which point the gas tank exploded. OOPS! The general partnership has similar characteristics – it is extremely easy to form manage and operate, until something bad happens. And then all of the general partners have joint and several liability for the full liabilities and debts of the general partnership. The five person general partnership has been described as every partner having 20% of the upside and 100% of the downside. Only thing worse than the five person partnership is a 10 person partnership – then you have 10% of the upside and 100% of the down side. And so on.
Limited Partnership – The limited partnership is like a racing car built by Ferdinand Porsche during the 1930s. The car edification was the fastest cars the world at the time. It had 18 cylinders, and not one but two clutches. The problem with the Porsche racing car was that it was phenomenally difficult to drive. Only three people ever learned to drive the car to its maximum potential, and two of those people died while driving the car.
Likewise, the limited partnership was a phenomenally powerful business vehicle for its time, but it was extremely awkward to operate. Before the advent of the LLC, a limited partnership required that the limited partners could take no active role in the partnership business. The partnership instead was managed by a general partner, which was often an incorporated entity. The people who actually were the individuals running the partnership were the officers of the corporation, and the insuperable complexity of the business structure often lead to dangerous and life-threatening errors.
I once had a client who was the president of the corporate general partner, which in turn signed on behalf of the limited partnership. He was forever signing his name as “President of the Partnership.” Unfortunately it’s a very august and solemn sounding office, but the problem is it does not exist: he was the president of the corporate general partner, which in turn was the general partner of the partnership.
He was essentially signing documents and using a title that was the equivalent of “Queen of the United States.” It is a very impressive title – the problem is it just doesn’t exist.
He was also signing loan documents, and I was very concerned that if he signed his name, followed by “Queen of the United States” or the equivalent as his title, the bank would very likely decide that he had personal liability or had otherwise misrepresented himself in the document. Limited partnership was a very awkward vehicle for ordinary transactions.
LLC – To me the LLC was the business vehicular equivalent of the 1957 Chevrolet. When I was in high school in the 1960s, the 1957 Chevy was 10 years old and there were a zillion of them. You could get a 1957 Chevy for $50, and everybody in high school had one. You could then strip it down to the chassis and build your dream car. Friends put in Hemmy overhead engines, dual and quad carburetors, metal flake paint jobs, chrome exhaust pipes on either side of the rocker panels and hang a pair of dice from the rearview mirror – just like the cars in American Graffiti. Awesome.
The LLC has the exact same characteristics of the 1957 Chevy: it is a chassis on which you can build the business vehicle of your dreams. A corporation is more like a factory automobile – it comes exactly the same way every time. With an LLC, by contrast, you can build the vehicle in whatever manner you want. You can create company officers like president, treasurer and secretary or not.
You can have annual meetings, or not. You can have a Board of Directors, or not. Anything goes with an LLC, as long as you write it down.
I sometimes hold up a blank piece of paper and say I have in my hand an LLC. It is a blank piece of paper. You get to write your deal in whatever manner you want, sign the bottom, and that is your business operating structure. It is also, in essence, exactly what the 1957 Chevy provided to high school students throughout America: it was a chassis upon which you could build your dream car.
Just to illustrate the flexibility of LLC, I once drafted an LLC operating agreement and sent it out to a client. We did not have any specific discussion about what offices and one officer titles the LLC would have, so in a moment of puckish Irish humor, I inserted his name and gave him the title “Sun King.” I sent the document out and in a few days later called him to review the document. I told him that I had inserted a made-up title for him, which is permitted by an LLC, and that I had picked Sun King. When he mentioned that he saw it, I said, “What would you like to be called?” He said, “I am sticking with Sun King. I love that name. I am the Sun King.” A true story.
The point is that the LLC is a highly flexible, all-terrain vehicle, and if that is what the situation requires then the LLC is the perfect choice. However, its most common competitors is the S corporation – that simple prosaic Honda Civic, which is easy to set up (an S corporation is virtually turnkey operation), and easy to operate. People intuitively understand how an S corporation works, while an LLC requires accountants and some level of administrative and accounting sophistication. No one said that section no one thought that a souped-up 1957 Chevy was a going to get gas mileage – that was never the point.
In the end, the correct business vehicle depends on what purpose you want it to serve. If you want to jump in the car and drive to the store to buy some milk, or the business equivalent, an S corporation may well be a perfect vehicle, cheap, easy to operate, economical. On the other hand, if you have sophisticated needs or uses, the LLC is likely to be the optimal choice.
You can of course go public, or get VC investors, in which case you jump into the C corporation, the roomy, if tax inefficient Cadillac of business vehicles.
Do not under any circumstances get into a general partnership: the world is the full of people who drive too fast, and are likely to run into you from behind.
Author: Jay Darby is a partner in Sullivan & Worcester LLP’s Tax Department and focuses on business and transactional tax law.