Your Entity Menu : Part 6

Own Your Own Corporation : Why the Rich Own Their Own Companies and Everyone Else Works for Them
by Garrett Sutton, Esq.

(Page 6 of 11)

In fact, it was the above-named limitations that led to the creation of the limited liability company. Because many shareholders wanted the protection of a corporation with flow-through taxation but could not live within the shareholder limitations of a Subchapter S corporation, the limited liability company was born.

The Subchapter S corporation requires the filing of Form 2553 by the 15th day or the third month of its tax year for the flow-through tax election to become effective. A limited liability company or limited partnership receives this treatment without the necessity of such a filing.

Another issue with the Subchapter S corporation is that flow-through taxation can be lost when one shareholder sells his stock to a nonpermitted owner, such as a foreign individual or trust. By so terminating the Subchapter S election, the business is then taxed as a C corporation and the company cannot reelect S status for a period of five years. The potential for this problem is eliminated by using a limited liability company.

Both C and S corporations require that stock be issued to their shareholders. While limited liability companies may issue membership interests and limited partnerships may issue partnership interests, they do not feature the same ease of transferability and liquidity (or salability) of corporate shares. Neither limited liability companies nor limited partnerships have the ability to offer an ownership incentive akin to stock options. Neither entity should be considered a viable candidate for a public offering. If stock incentives and public tradeability of shares are your objective, you must eventually become a C corporation.

Rich Dad Tips

If you think you may want to go public at some point in the future but want initial losses to flow through, consider starting with an S corporation or a limited liability company.

You can always convert to a C corporation at a later date, after you have taken advantage of flowing through losses.

Limited Liability Companies

The limited liability company is a good entity to use in certain situations. Because it provides the limited liability protection of a corporation and the flow-through taxation of a partnership, some have referred to the LLC as an incorporated partnership.

There are two more features that make the LLC unique:

• Flexible management structure
• Flexible allocation of profit and loss

These features will be illustrated in our next case.

Case No. 4-Thelma/Millennium Salsa

Thelma was looking to start a salsa business with two partners, Pepe and Hans. They had taken the beneficial step of preparing a business plan. They analyzed the market and their competition. They calculated their expenses, projected conservative revenues, and figured that Millennium Salsa could break even in two years.

The problem was that each partner had his or her own agenda that was difficult to reconcile. They had agreed that for their efforts each was to receive a one-third interest in Millennium Salsa. But beyond that it was looking doubtful that they could structure the business in such a way that it would work. Pepe was putting in $200,000 of start-up money to get the business going. He wanted no part of managing the business but wanted, first, to use any losses to offset other business/personal income; and, second, that all of the first profits be paid directly to him until he was paid back $300,000, or one and one half times what he had invested. Hans, on the other hand, was putting his salsa recipe into the company. It was a well-known and world-famous recipe renowned for its freshness and long shelf life, but beyond that Hans's contribution to the company would be limited. He had offered to work for the company, but for Thelma and Pepe, who both knew of Hans's odd work habits and culinary eccentricities, that was more of a threat than a promise.

Thelma was going to work in the business. Her contribution was to spend the next two years-or however long it took - working for a very low wage to make a go of it. She had learned from her cousin Louise that a general partnership was a bad entity to use. The last thing Thelma wanted was for Hans to be out obligating their business to another bizarre food project like the banana-shaped onion fiasco.

The management of the business, and keeping Hans out of it, was one issue. But an even bigger issue was how to satisfy Pepe's demands for all the losses to flow through to him and the first $300,000 in profits to go to him.

Thelma knew that in a Subchapter S corporation when profits and losses flowed through the entity, they flowed rigidly according to the shareholder's ownership percentage. If you owned 50 percent, then 50 percent flowed through to you. In the case of Millennium Salsa, each person would have a one-third interest in whatever entity was to be used. But they needed to initially distribute more than one third to Pepe.

Copyright © 2001 by Garrett Sutton, Esq.

About the Author

Garrett Sutton, Esq. has over twenty five years experience assisting and advising entrepreneurs, families and business in selecting the appropriate corporate structures to limit their liability, protect their assets, build their credit and advance their personal and financial goals through real estate investments and other means of wealth creation. Sutton is the owner of Sutton Law Center, Sutton Law which has offices in Reno, Nevada, Jackson Hole, Wyoming and Sacramento California.