In Part One of this article, we looked at two major forms of business organization that require the owners to put all of their assets on the line. Now we’re going to look at two forms that allow investors to risk only what they invest – to the extent people dealing with the businesses don’t ask for additional protection.
The more familiar form is the corporation. A corporation is a separate operation set up for a purpose, usually running a business. The investors receive stock to represent their ownership. A board of directors (which can be as small as one, in a single-shareholder corporation) makes policy decisions, and officers (which, again, can be one person) carry out the operations.
Corporate law is generally well-settled and predictable. An investor in a corporation generally has a good idea what he or she is getting into.
Corporate shareholders’ liability is limited to the amount they invest, but this protection usually is important for tort claims only. Usually, lenders, landlords, and other people the corporation does business with will ask the investors to guarantee loans, leases, major purchases, and so forth. Because tort claims usually can be insured against, the limited liability protection often isn’t as important as most people think.
Corporations are usually taxed separately from their shareholders. The shareholders are taxed on dividends when issued and on capital gains if they sell their stock. It is possible to set up a corporation for “S” class treatment, which results in the corporation being taxed like a partnership, but this requires careful planning and IRS approval. It’s not a good idea to try it without talking to a lawyer or a tax professional, or both, first.
In theory, corporate management is fairly formal. The directors meet on a regular basis to make decisions. The shareholders meet annually to elect the directors and make major decisions. A corporation that doesn’t keep good records of actually meeting and following the rules might have a court penalize it by allowing debts to pass through to the shareholders. In smaller corporations, however, there are ways to get around the procedural rules. First, in many states, the shareholders are allowed to sign agreements on how they will vote their shares or manage the corporation. Second, many states allow the directors or shareholders to sign off on decisions without actually holding the meeting. As a result, a lot of decisions can be made on the fly, so long as records are kept.
A corporation is also the easiest business form for an investor to get out of. Unless there is an agreement or a law (usually applicable only to publicly traded companies) barring sales, a shareholder who can find someone to buy his or her stock can sell it. Most states also have laws designed to protect the value of a minority owner’s stock in a small company, designed to prevent the majority owner from lowballing. For example, in Oregon and Washington, if a minority owner decides he or she wants out after the majority decides on a major action (such as a merger, major stock or asset sale, or amendment to the basic articles of the corporation), he or she often can demand the corporation buy back his or her shares, and the corporation’s offer must be a fair value, as shown by a copy of the corporation’s financial documents. The minority owner is allowed to make a counteroffer, and if they can’t agree, either side can ask a court to decide.
Over the last generation, a new business form has emerged. This is the limited liability company, or “LLC.” The first LLC law was Wyoming’s, in 1977, and by the end of the 1990’s, every state had followed suit.
The LLC is designed to combine the flexibility of partnership-style management with, as the name suggests, corporate-style limited liability. The IRS has decided to allow LLC’s to choose between partnership or corporate-style taxation, basically by checking a box on the form when a tax ID number is requested. As a result, LLC’s have become very popular.
Like a corporation, an LLC has a separate identity from the investors (called “members.”) Members may choose to operate the LLC themselves or appoint a manager. The details of how the LLC runs are worked out in an agreement, similar to a partnership agreement, and, like a partnership, there is almost infinite flexibility.
It may be more difficult to get out of an LLC than a corporation. Some states allow interests to be sold. If a buyer can’t be found, however, a dissatisfied member may be forced to withdraw. In many states, this will either break up the LLC or be treated as a breach of the agreement, which basically shuts the withdrawing member out of buyout decisions. Oregon does not have a law protecting minority members similar to its protection of minority shareholders in a corporation; Washington does.
Courts tend to look to corporate law to resolve questions that LLC statutes do not cover, so there is some predictability, but LLC’s haven’t been around long enough for a complete body of law to develop. As a result, some questions are likely to remain unresolved if the legislature hasn’t thought about the issue in advance.
Limited Liability Can Be Lost
One issue that anyone who chooses a corporation or LLC has to keep in mind is that the law doesn’t like abuse of limited liability. If you don’t actually act like the business form you say you’re using, or if you don’t put in enough capital to protect yourself, the courts may decide that you aren’t entitled to the protection. In most states, this is one of the few parts of corporate law that is hard to predict. The courts in Oregon, fortunately, make it a bit easier: a shareholder or member who actually dominates the corporation or LLC has to abuse his or her rights and cause harm to the person complaining, which basically leaves the extent of control and insufficient capital (or siphoning off profits) as the primary questions.
Whatever business form you decide to use, it is probably a good idea to talk to a lawyer for any organizational issues and a tax professional for any tax issues.