Your Entity Menu : Part 7

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

(Page 7 of 11)

How could they satisfy Pepe's demands? Thelma knew she had to figure out some way to get it done or Pepe would not agree to the project. Thelma went to her part-time bookkeeper, who told her she had to use an S corporation. Thelma was told that Pepe's demands could not be met and that the only way to 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 learned of the limited liability company for the first time. 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 an excellent discussion on these rules see Chapters 11-15 of Diane Kennedy's Loopholes of the Rich. 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 maximum of $80,400 for 2001 and 2.9 percent over that for the Medicare portion. Because Pepe and Hans were not employees but rather investors, their flow through of monies 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, may 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 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.

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.

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.