for a public offering. If stock incentives and public tradability 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 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 edible mold 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.
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 became aware of the limited liability company. 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 more information, see Garrett Sutton’s How to Use Limited Liability Companies and Limited Partnerships. 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 salary maximum of now above $100,000 and 2.9 percent over that salary amount for the Medicare portion. Because Pepe and Hans were not employees but rather investors, their flow-through of monies, as of this writing, 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, might 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 of an LLC 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