There is a very popular website for entrepreneurs which I will not name, but which offers to provide legal roadmaps to budding creators of businesses.  The home screen has a cool button which walks the user through a series of questions about the start-up venture.  The questions that are asked relate to the location of business, the number of initial persons involved, capital raising goals, and exit strategy.   The end result is that the website will confidently advise the user as to the best legal structure for the new business, i.e., S-corp, partnership, LLC, etc.  Interestingly enough, one slow Friday afternoon when bored, I spent a half hour inputting different factors into the program in an effort to get it to recommend any structure other than an LLC.  No chance.

For some reason, LLCs have been trendy in recent years.  We are not providing this information to make you second-guess your decision to form an LLC. In many circumstances, the LLC is an excellent business structure which provides ease of management and enhanced opportunities to raise capital.   Rather, we can de-mystify some of the intangible and unknown reasons why many start-ups end up as an LLC, and to point out some important risk factors that need to be considered when forming a new entity.

We work with numerous start up founders on a weekly basis.  My first question to a single member of a new LLC is “why did you set yourself up as an LLC,” and the answer is usually “I don’t know.”  After further questions, I usually discover that “someone else” said it would be the best choice for a new entity.  The “someone else” is not an attorney or tax professional, but usually another start-up founder of yet another single-member LLC.  Maybe he also thought it sounded cool, or was told by “someone else” that it’s “what everyone is doing nowadays.”

To define our terms properly, “LLC” means “Limited Liability Company.”  It is not a corporation.  An LLC is a creature of statute and not of common law.  The concept is fairly new to the United States. The notion of a LLC originated in Germany in 1892. Once this type of limited liability company was established in Germany it spread essentially worldwide with the interesting exception of the United States.  In fact, in 1977, Wyoming became the first state to enact a limited liability company statute.   Florida was the second state to enact an LLC statute in 1982.

Under current Florida law, a single member LLC provides little asset protection benefits to the member if he is in financial trouble.  Although Florida’s LLC statute was modified in 2011 to restrict collection efforts that can be made against multi-member LLCs, the statute still allows creditors to use numerous remedies against a single-member LLC.  In addition to charging liens, a creditor can pursue foreclosure and other collection strategies against an LLC that only has one member.  Thus, if asset protection is a primary goal and there is only one start-up founder, an S-Corporation is probably the better choice.

If there is more than one founder, an LLC might be a good choice.  New LLCs designed for asset protection should include at least two members, and existing LLCs should add at least one member to restrict creditor’s rights to charging liens and other collection efforts.  A spouse or family member can serve as the second member to satisfy this purpose, although some states and the IRS might not consider a spouse as a separate member for tax purposes.  Additionally, this can spread the liability to other family members. Although there is not statutory or common law minimum interest required for the second member to be validated, I would suggest that he have at least a five percent membership interest. 

In 2013 the Florida legislature passed a Revised Limited Liability Act to become effective in January, 2014.  The Act revised the definition of an LLC member in Section 605.0401 in a way that makes it easier to add one or more members to an LLC. The new law defines an LLC member as a person who may or may not hold any economic interest in an LLC and who may not be obligated to contribute money or other capital to the LLC.  When choosing another partner, keep in mind that your partner is NOT required to also manage the LLC. You can force them to remain silent by setting up your LLC to be manager-managed and then choose yourself as the sole manager. That way, you can limit the exposure your second partner has to the day-to-day business operations and keep all of the decision-making power to yourself.

The second negative feature of a single-member LLC is that the IRS ignores the entity structure completely.  The effect of this is that a single-member LLC is considered a “disregarded entity” and the single member is taxed as a sole proprietorship.  This is why a good tax professional will almost always advise the founder of a start-up business to create the new venture as a S-Corporation.

So what should the prudent start-up founder do?  The best advice is to consult with an experienced business law attorney, as well as a tax professional, before you go on your state’s entity registration website and create an entity that you may need to change later.  It may not be as “cool” of an approach as is going on a slick free website, but as we all know it’s easier to do something right the first time than to fix it afterward.

We highly recommend viewing this free video, in which we explain the advantages and disadvantages of both corporations and LLCs. If you have further questions, please contact us here and you can expect a reply within one business day.