handle the corporate structure was to allocate profits and losses on a one-third basis to each Millennium Salsa shareholder. The bookkeeper said she used an S corporation for every such situation and that most of her clients were satisfied.
Thelma then sought the advice of a local attorney who specialized in business formation and structure. It was during her initial consultation that Thelma became aware of the limited liability company. She learned that special allocations according to partnership formulas could be made to accommodate Pepe’s conditions. She learned that a flexible LLC management structure could be implemented so that neither Pepe nor Hans would be involved as decision makers.
The attorney charted for her the difference between the rigidity of an S corporation and the flexibility of an LLC when it came to distributions:
In Millennium Salsa, Inc. the flow-through distributions have to be made according to each shareholder’s percentage ownership. Because Pepe owns one third there is no way to allocate him 100 percent of either profits or losses. He is stuck with what flows through to him strictly according to his ownership interest. However, Thelma liked what could be accomplished with an LLC:
In the LLC scenario, Pepe’s goals are achieved. He is able to take the first losses and receive the first $300,000 in profits. It should be noted that special allocations such as this must be based on legitimate economic circumstances as opposed to simply shifting tax obligations from one taxpayer to another. For more information, see Garrett Sutton’s How to Use Limited Liability Companies and Limited Partnerships. The attorney informed Thelma she needed to work with a tax professional so that Millennium Salsa’s objectives were properly documented and carried out.
The attorney also noted that money flowing through the LLC to Thelma, as an employee, was subject to self-employment taxes of 15.3 percent to the statutory salary maximum of now above $100,000 and 2.9 percent over that salary amount for the Medicare portion. Because Pepe and Hans were not employees but rather investors, their flow-through of monies, as of this writing, was not subject to self-employment tax. It was noted that an S corporation, where self-employment taxes were only paid on monies deemed to be salaries, and profits above that were not taxed as self-employment income, might be an option for Thelma’s distributions. But again, the attorney noted the flexible distributions Pepe wanted could not be achieved in an S corporation. One entity did not fit all situations.
Thelma also learned that the management structure of an LLC was different, and much more flexible, than that of a corporation. A corporation had directors elected by shareholders, officers elected by directors, and employees hired by officers. By contrast, an LLC could be managed by all its members, which are akin to shareholders in a corporation, or be managed by just some of its members or by a nonmember. The first was called a member-managed LLC, the second a manager-managed LLC. Because Pepe wanted no management responsibility and neither Thelma nor Pepe wanted Hans anywhere near management authority, it was decided that Thelma would be the sole manager of a manager-managed LLC. As manager she had complete authority for the company’s affairs. In corporate terms, she was the board of directors, the president, secretary, treasurer, and all vice presidents of Millennium Salsa. And all her business card had to say was “Manager, Millennium Salsa, LLC.”
Pepe liked the plan that Thelma brought back from the attorney’s office. He funded the project and they were in business.
The LLC was designed to overcome the problems corporations faced in attempting to avoid double taxation. In the process, as we have seen, some unique and useful features were created as additional benefits to the entity. The main features are as follows:
LIMITED LIABILITY PROTECTION
In an LLC, like a corporation, the owners do not face personal liability for business debts or for legal claims made against the company. In this day and age when litigation can unexpectedly wipe out a lifetime of savings, limited liability protection is of paramount importance.
The LLC, as well as the LP, offers even greater protections through the changing order procedure. This will be further discussed in Chapter 4.
It is important to note that in an LLC, as with a corporation, you may become personally liable for certain debts of the company if you sign a personal guarantee. As an example, most landlords will require the owners or officers of a new business to personally guarantee that the lease payments will be made. If the business goes under, the landlord has the right to seek monthly payments against the individual guarantors until the premises are leased to a new tenant. Likewise, loans backed by the Small Business Administration will require a personal guarantee. The SBA’s representative will state that they will only loan to those persons committed enough to put their own assets at risk. In truth, as with any bank, they want as much security as they can get. Such personal guarantees are standard business requirements that will not change.
The important point to remember is that you are not going to sign a personal guarantee for each and every vendor agreement and customer transaction you enter. And in these matters, you will be protected through the proper use of an LLC. To obtain such protection it is important to sign any agreement as an officer of the LLC. By signing an agreement “Joe Doe” without adding “Manager, XYZ, LLC” you can become personally liable. The world must be put on notice that you are operating as an independent entity. To that end, it is important to include LLC—or Inc. if you use a corporation, or LP for a limited partnership—on all your stationery, checks, invoices, promotional literature, and especially written agreements.
UNLIMITED OWNERSHIP
One of the reasons people have a problem utilizing the S corporation is the limits on owners. An S corporation can only have one hundred or fewer shareholders. As well, some foreign citizens and certain entities are prohibited from becoming shareholders of an S corporation.
The LLC offers the flexibility of allowing for one member to an unlimited number of members, each of whom may be a foreign citizen, spendthrift trust, or corporate entity. And unlike an S corporation, you won’t have to worry about losing your flow-through taxation in the event one shareholder sells their shares to a prohibited shareholder.
FLEXIBLE MANAGEMENT
LLCs offer two very flexible and workable means of management. First, they can be managed by all of their members, which is known as member-managed. Or they can be managed by just one or some of their members or by an outside nonmember, which is called manager-managed.
It is very easy to designate whether the LLC is to be member- or manager-managed. In some states, the articles of organization filed with the state must set out how the LLC is to be managed. In other jurisdictions, management is detailed in the operating agreement. If the members of an LLC want to change from manager-managed to member-managed, or vice versa, it can be accomplished by a vote of the members.
In most cases, the LLC will be managed by the members. In a small, growing company, each owner will want to have an active say in how the business is operated. Member management is a direct and simple way to accomplish this.
It should be noted that in a corporation there are several layers of management supervision. The officers—president, secretary, treasurer, and vice presidents—handle the day-to-day affairs. They are appointed by the board of directors, which oversees the larger, strategic issues of the corporation. The directors are elected by the shareholders. By contrast, in a member-managed
