April 13, 2015
When it comes to limiting business liability, you have choices.
The paradox of choice is this: we need to have choices, because one size does not fit all, but the more choices we have, the more anxious we tend to become. Anecdotally, I have seen this borne out time and again with start-ups choosing a business structure. “Which structure is right for us,” they wonder, but then, after drowning for several hours (or even mere minutes) in an ocean of options, they reach for a good ol’ LLC (Limited Liability Company). Why? For no better reason than this: because that’s the most popular choice.
“Autonomy and Freedom of choice are critical to our well being, and choice is critical to freedom and autonomy. Nonetheless, though modern Americans have more choice than any group of people ever has before, and thus, presumably, more freedom and autonomy, we don’t seem to be benefiting from it psychologically.”—Barry Schwartz
Well, maybe that’s not entirely fair. After all, many people involved in start-ups do have significant liability issues about which they are legitimately concerned. Limiting liability is a major reason people choose LLCs. Still, even when choosing a business structure with an eye towards limiting business liability, why choose an LLC over an LLP? Don’t let the choice exhaust or frustrate you. Pause and consider your options, because the choice of business structure is an important one.
The LLC vs. LLP choice is not always an easy one to make. Fortunately for you, I have a few questions for you to ask yourself, which are designed to help you think through the LLC vs. LLP choice. Here is the major issue, though, which you should keep in your mind throughout this self-interrogation: Does this structure best fit the actual organization / deal / circumstances?
Remember, too, LLCs are hybrid organizations–kind-of a cross between a partnership and a corporation. They have elements of each, but that doesn’t mean LLCs are superior to both partnerships and corporations. Often sold as a “best of both worlds” compromise between partnerships and corporations, many people assume this is the default “best” option for them. What is really best for a business, though, is to choose an organizational structure that most accurately reflects the intentions of the parties operating and investing in the business.
LLC vs. LLP: Five Questions to Help You Choose
Ask yourself the following questions, and see where the answers lead you.
Are there any “silent partners”?
“Silent partners” are not typically involved in the day-to-day management and operation of a business, but they do have rights, as part-owners in the business. These rights often include the right to audit the business’s financial records and to do other things to ensure their investment is being well-managed and reasonably protected. Silent partners have a legitimate reason to be concerned about the possibility that their partners might violate their fiduciary duty to the business and / or the other owners thereof. Silent partners also have a legitimate reason to be concerned the business might fail, and they could lose some or all of the money they have invested.
Silent partners should, therefore, take into consideration which business structure will best protect them from their other partners, or from third parties trying to collect from their other partners, in the event something were to go wrong with the business. LLCs typically do a better job of providing this protection than LLPs.
Is the number of owners in the business likely increase, decrease, or remain constant? If so, how much and how fast?
Assuming your business is starting small (five or fewer owners, to begin with), if your budding enterprise is expected to grow rapidly, an LLC might be a better choice than an LLP, because of the similarities between an LLC and a corporation. Essentially, compartmentalization of management is somewhat easier for LLCs than for LLPs. In partnerships, everyone expects to have a voice, whereas in an LLC different classes of memberships can exist–some with voting rights, some without. While, technically, this is also possible with partnerships, the LLC structure lends itself more naturally to the centralization of management, while still providing much-sought-after liability protection for the members.
How will the business handle compensation of its owners, operators, and employees? What tax implications will related choices have?
Under the right circumstances, LLCs can be taxed like partnerships for federal income tax purposes. What if you don’t want that, though? What if you don’t want your LLC to be a “disregarded entity?” What if you want to trap funds in your business to lower your personal income tax obligation? Well, then an LLC would be a better choice, because you can’t do that with a Partnership. In fact, you’re going to want to run the LLC vs. LLP question by your accountant(s) and tax attorney(s), because you’ll definitely want to know the implications of choosing one form of business over the other. Ignore the tax implications of this choice at your peril.
Do you need a centralized management structure?
As mentioned, above, if you need to centralize management, LLCs are the way to go. Sometimes, partnerships compartmentalize management by forming “steering committees” and the like, which advise all the partners. Partners then vote based on the recommendations of the committees. Of course, there are a lot of ways to compartmentalize management, no matter which structure you choose; but LLCs make it easier, because in an LLC (especially a manager-managed LLC), the default is centralization of management. So, less custom contract drafting (with respect to your Partnership Agreement or Operating Agreement) is required to make the system work.
How much potential liability is there–really–and how much protection from it do you really need?
If the business you’re doing is small, and if the liability is also small, it might not be worth the cost and hassle of forming an LLC to protect yourself and the other people operating the business from their liability to each other and to third parties. Maybe the business has one or more insurance policies which would cover the cost of any potential liabilities which could arise. Maybe the business uses preventive legal services and contracts which further limit its liability, directing potential litigants to Alternative Dispute Resolution (e.g. mediation, arbitration, etc.) and insurance policies for the settlement of any claims which might arise. In such circumstances, partners might determine that the marginal additional cost of forming an LLC is greater than the marginal additional benefit of the liability protection doing so would provide, and, therefore, they may further conclude an LLP is the right choice for them.
Whatever the case may be you want to ask yourself these questions, and think through the answers. Then, you should also go through them with your accountant(s) and your lawyer(s), and get their perspective. Remember, there is no panacea, no one-size-fits-all solution that will work, no matter the circumstances. The shield you choose needs to be the right tool for the job–both strong enough and light enough, both the right shape and the right size to give you the mobility and the protection you need to stay safe as you battle for a toehold in today’s rough and tumble business world.
-  Schwartz, B. (2004). Chapter 5. In The Paradox of Choice: Why More Is Less. New York, NY: Ecco.
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