Each year, the limited liability company (LLC) becomes increasingly popular as a form of business entity. This popularity speaks to the ease of formation and the low administrative burden of LLCs– which allow business owners to combine the tax benefits traditional to partnerships with the limited liability traditional to corporations. There are no limits to how large an LLC can become (Chrysler is one, for example), but we find that growing companies can strain under the form of an LLC. If you’ve experienced some of these LLC growing pains, you might want to explore incorporating your company.
1. Growing Ownership
Shareholders of LLCs are known as “members.” Members can be actual flesh-and-blood people like you and me, or they can be other companies or trusts. In most states, LLCs are governed by “operating agreements.” These documents are a sort of hybrid: part corporate by-laws and part contract. The operating agreement governs the relationship between the members as well as the relationship between the members and the company.
Whenever someone wants to buy a share in the company, that person must become a party to the operating agreement. In most cases, the existing members must approve new members by either a majority or unanimous vote. While this system usually works well for LLCs with a small number of members, this requirement can become cumbersome for companies looking to raise money quickly or from a variety of investors. In contrast, a corporation looking to raise capital can simply sell shares to interested investors.
2. Burden on Investors
In corporations, most decisions can be made by the officers or board of directors. Shareholders are not called upon for decision-making, except for the election of directors. In contrast, LLC operating agreements (or state default rules) often require members to make decisions for the company. Not only can this become burdensome for members, but it can be distasteful investors seeking a passive role. You might also have members with no knowledge or experience in your field of endeavor, who feel obligated to involve themselves in decision-making.
3. Burden on Founders
You founded your LLC in your garage with money from a few friends and relatives. Today there are more zeroes in the company bank account but you don’t know half the members of your company. Decision-making by your membership can feel like cat-herding.
If you convert to a corporation, your officers can handle day-to-day decision-making and the board of directors can do the rest. There’s no need to notify every shareholder about mundane decisions, or to explain to your spouse’s uncle Leo what “back-end development” is, just because he invested a few bucks in your startup phase.
4. Taxes? Taxes!
By default, LLCs are treated like partnerships, that is to say that profits and losses pass-through to the owners. This means that owners pay income taxes on company profits even if the owners never receive that money as a distribution. In contrast, corporation shareholders only pay income taxes on dividends actually paid. This can prevent you from having a surprise tax liability on money you never actually see.
5. Dilution Illusion
In most cases, an LLC member’s ownership interest is expressed as a percentage that person owns. When you want to bring on new investors, not only do you usually require the permission of the existing investors, but each of those existing members sees her percentage decrease with the addition of new members. You, of course, know while each member’s slice of the pie gets thinner, the pie gets bigger. Your members might not see it that way.
When companies incorporate, they declare a number of shares that the company is authorized to issue to shareholders. Most companies start out issuing only a portion of these authorized shares; so that when they need more capital, they can issue more shares to new shareholders. The dilutive effect on shareholders is the same economically, but a whole lot easier emotionally and administratively.
6. Trucking up to Delaware
In the United States, business entities are regulated by the states. While there are many similarities, each state has its own laws, rules, and history of caselaw governing corporations and LLCs (as well as their own taxes and fees). For a variety of reasons, a substantial portion of businesses are founded in Delaware, which is known for its business-friendly laws and cooperative bureaucracy. Maybe when you founded your LLC, you did it in your home state, but now you find some of its rules constricting, or its fees burdensome. You might want to explore incorporating in Delaware or another of the business-friendly states.
Remember that every business is unique, and that this was a general discussion. Some of the problems imparted to LLCs can be changed with amendments to the operating agreement, while in some cases, incorporation might create new burdens not discussed here. Before making any decisions regarding your companies organization consult with legal and accounting professionals.