I’m regularly asked by clients whether or not they need a corporation or an LLC. Both options carry benefits and risks. Generally, corporations are better for businesses that are going to scale into larger operations. LLCs are better when the business is going to be a closely held business or held within a family. That scalability in a corporation has more to do with the ability to offer stock and not have to ensure that all the membership interests are assigned. Normally the big issue I see in an LLC that somebody wants to scale is that all of the membership interests are not assigned. LLCs have to have 100% of their membership interest assigned. This does not mean that you are unable to obtain investors however, once you do find investors the membership interests will have to be recalculated. Unlike in a corporation which has 60,000 or more shares of stock where the original owners can take 10,000 and then sell the additional 50,000 to other investors.
What’s the difference between a corporation and LLC?
Both corporations and LLCs are creatures of statutes. Respectively the Limited Liability Company Act and the Business Corporations Act of the Michigan Compiled Laws. There was no corporation or limited liability company at common law and before the advent of both LLCs and corporations groupings together of individuals for business or other purposes was referred to as a partnership. Partnerships had a negative aspect to them in that each of the partners held full liability for any of the debts or acts of the partnership, there was no limitation of liability. As most people would guess from the name of an LLC, limited liability company, any liability incurred by an LLC is limited. Similar liability limitations apply to corporations.
In general, liability for any debts or acts of a company, both LLCs and corporations, is limited to the individuals owning the company as long as they do not violate some basic aspects of the respective laws. These issues will be addressed in later blog posts and podcasts however the simple ones are do not intermingle funds, do not sign documents in your own name as opposed to in the company’s name, and do not commit gross negligence and expect the company to protect you.
Corporations
Corporations are creatures of the Michigan Business Corporation Act. MCL 450.1101 et seq. The MBCA controls every aspect of how corporations are run. However, multiple changes can be made to the default legal requirements of the MBCA. These changes allow for the calm, cool, and collected transfer of ownership upon the death or disability of one of the shareholders or the transfer of ownership if one of the shareholders abandons his duties, rights, and responsibilities to the company.
Shareholders do not have a fiduciary duty in the sense that members do to one another in an LLC. However, in a closely held corporation, shareholders often are the directors of the company. The directors do have a fiduciary duty to the shareholders to not inadvertently or purposefully decrease the value of the company and therefore decrease the value of the shares held by the shareholders. Further, the bylaws of the Corporation can be written to require capital contributions if the company needs to ready cash. If a shareholder fails to participate in the capital contribution call additional shares can be issued to those shareholders participating in the call thereby diluting the ownership interest of the shareholder who did not participate in the capital call. This can create tension between shareholders especially if one of the shareholders is the “money guy” and the other shareholder is providing physical labor or other services in lieu of cash and capital contributions. If this is the case, it is essential that the bylaws are written to reflect that difference in duties and responsibilities to protect the partner who is not providing capital intensive distributions to the corporation.
Oftentimes people will be concerned about using a corporation versus an LLC due to tax considerations. While this blog does not attempt to offer tax advice, and we always recommend you consult your accountant prior to making tax decisions, a corporation and an LLC can both be taxed with pass-through taxation like a partnership as far as the IRS is concerned. Therefore, tax considerations should have little to do with your initial formation decision between a corporation and LLC.
Limited liability companies
Just like corporations, limited liability companies are creatures of statute. MCL 450.4101 et seq. Again just like corporations LLCs have default requirements pursuant to the LLC act. However, modifications to those defaults can be made in a LLC’s is operating agreement. These modifications can include how membership interests are transferred, upon the disability or death of one of the members, or in the event of a unanswered capital call by another of the members.
LLCs do not issue stock. Instead ownership interest in LLCs is demonstrated and provided through membership interests. The essential thing to remember in a LLC is that 100% of the membership interest must be assigned to the members. This is different from the stock structures you can see in a corporation. For example, a corporation may have 60,000 authorized shares of stock according to the state of Michigan. However, the company may only issue 10,000 shares of stock and issue 5,000 to each of the shareholders. The remaining 50,000 shares of authorized stock do not dilute the ownership interest of the two shareholders instead, those remaining 50,000 shares are available to issue to new shareholders, issue to a current shareholder if the capital contribution scheme changes, or they may simply sit unissued on the company’s books. Contrast that with an LLC, if there are two members of an LLC each member unless otherwise agreed would each own 50% of the company. You cannot have one member owning 25% the other member owning 50% and have the remaining 25% floating around unassigned. If it ever came to a court decision, that remaining 25% would be split up amongst the members pro rata.
Depending on the operating agreement of the LLC, not properly defining the ownership interests of the various members could have unintended results. Oftentimes operating agreements allow for votes that are made by majorities or super majorities. In general, it would be unlikely that a majority ownership interest would change based on this because it’s a pro rata difference. However, a super majority, depending on how it is defined, could be affected.
Investors
When clients come to me, the biggest concern I normally have is whether or not a company is intending to have investors. If the company intends to have investors, I normally recommend a corporation. This allows for the issuance of stock in return for investment capital. It also allows for different classes of stock to be issued which will limit the investor’s ability to run the day-to-day operations of the company. This is not the case if you issue membership interests from a LLC to an investor.
Membership interests carry with them the ability to affect all decisions of a LLC, not just “big decisions.” This can put a LLC seeking investment in obtaining investor members in the unenviable position of having individuals who want a hand in running a company that they may know nothing about. This is the biggest reason why I recommend corporations to individuals who are going to be seeking investors for their company.
If you are stuck with an LLC form, there are other options to increase investor interest without providing them membership interests. However, those issues will be addressed in a later blog posts.
So the general take away from this blog entry should be that you use a corporation when you’re looking for investors and use an LLC when the company is not going to need investors and you want to keep the ownership “close to home.”
As always, Hewson and Van Hellemont, and Timothy M. Kaufmann stand ready to assist you in all your corporate and real estate needs. Should you have any questions feel free to call our firm at 248-968-5200 or email tkaufmann@vanhewpc.com.
Mp# version of the podcast here.
