The Limited Liability Company and Raising Capital

May 24, 2001

A limited liability company (LLC) is a form of business entity, available in all 50 states and the District of Columbia, that combines the “pass-through” tax characteristics of a partnership with the insulation from personal liability found in traditional business corporations. Nonetheless, the majority of new businesses, including those that are seeking capital, form as business corporations, rather than limited liability companies. Some of the factors contributing to the election of corporation status include the ability of corporations to go public and the ability of corporations to offer stock options to attract and retain key employees, both features not readily available to limited liability companies. If a company’s short-term goals include a public offering, the LLC form of business entity may not be ideal because the LLC would most likely be converted to a corporation prior to commencing an offering. However, recent events in the markets and the “right sizing” of the dot-com economy may have caused entrepreneurs to think more realistically about growth and, generally, may have extended the time-line for a new venture to consider conducting a public offering. The selection of the limited liability company format by a new entity, even one seeking to raise capital funds, should be explored.

A New York limited liability company is formed by filing articles of organization, a short biographical sketch of the new company, with the New York State Department of State. Within one hundred twenty days after the filing, a notice of the LLC’s organization must be published in two designated, local newspapers. The members of the company should then adopt an operating agreement called an operating agreement which details the rights, powers, preferences, limitations or responsibilities of its members, managers, employees or agents and provides the framework for the conduct of its affairs.

LLCs are attractive because they can qualify, for tax purposes, as a partnership, whereby the income, gains and losses of the LLC are taxed only at the member level. In comparison, a “C” corporation is taxed twice, first on the income earned by the Corporation and then upon dividends paid to the shareholders. Corporations can qualify for the favorable tax treatment available to LLCs.

However, to obtain the “pass-through” tax treatment status available to LLCs, a corporation must make an “S election” under the Internal Revenue Code. To obtain and retain “S” corporation status, the corporation is subject to certain burdensome restrictions. For instance, generally, an “S” corporation may have only one class of shareholders, may not have persons other than natural persons as shareholders, may have no more than 75 shareholders and may not have non-U.S. shareholders. The inability to issue a preferred class of stock or to have shareholders other than natural persons often rules out the “S” corporation as an appropriate entity for a company seeking capital.

Another very attractive feature of the LLC form of entity is flexibility in management structures. A limited liability company must have at least one member and can be member-managed or managed by a “manager”, who may be, but does not have to be, a member of the LLC. The operating agreement may create multiple classes of members with differing rights, privileges and responsibilities. This feature, which is unavailable in the “S” corporation, may be very important when seeking to raise capital. The LLC structure also generally insulates members and managers from personal liability even if they actively participate in management of the company – a result that cannot be achieved through the creation of a limited or general partnership, for instance.

The limited liability company may not be the right entity for every business. The form of entity for any new business should be carefully analyzed by the proposed company’s lawyers and accountants in consultation with the client.

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