Why favor the LLC over the Corporation?
I like to think of the LLC as a hybrid of the traditional Corporation and the traditional Partnership.
The LLC blends aspects of both in a way that is productive and appealing to modern investors and legal professionals. It combines the flexibility in management structure of a partnership with the liability protections of a corporation.
It also has significant tax flexibility as compared to corporations and partnerships. This article will discuss mainly the differences in management structure. We have a separate article on "check-the-box" taxation of LLCs that you may want to read.
First, an LLC has 2 main management options:
- Member Managed
- Manager Managed
Member managed more closely resembles the structure of a traditional partnership, with every partner actively involved in the management of the business and with no formal board of directors.
Manager managed on the other hand more closely resembles the structure of a traditional corporation, with the Members of the LLC voting for one or more Managers (who may or may not also be Members) to manage the LLC.
In this instance, the Members of the LLC are acting like traditional shareholders who vote on Directors in a corporation structure. Members who are not also Managers do not take an active role in the management of the business except for certain fundamental business transactions and for voting on the Managers. The company's agreement and certificate of formation (or operating agreement and articles of organization in Michigan) can expressly define which parts are controlled by the Manager and which parts are controlled by the Members, with some restrictions built into the law.
So, how did we get to the modern LLC from partnerships and corporations?
Investors and lawyers were basically wanting the best of both worlds in a legal entity and the states slowly started implementing LLC statutes. Wyoming was the first in the late 1970s with most other states implementing LLC statutes in the 1990s. Each state is different mind you, so a Texas LLC and an Oklahoma LLC are two completely different animals.
Why did the states start implementing these statutes?
Because there was a demand for an entity that gave the liability protection of a Corporation with the flexibility of a Partnership.
Corporations lack management flexibility in that you must have corporate by-laws, there must be a board of directors with specific voting rules, and the most common form of small-business corporate taxation doesn't allow more than one class of shareholder as well as restrictions on what kinds of owners could be shareholders (i.e. other Corporations, trusts, estates, partnerships, foreigners).
Partnerships on the other hand have massive flexibility compared to a Corporation in that they could dream up whatever management structure they wanted (within reason of course) to achieve their goals. But, general partnerships convey absolutely no liability protection, and in fact, make all partners subject to the liabilities of all their other partners. While many states, including Texas but not Michigan, do have a statutory concept of a "close" corporation, I still prefer the LLC in my practice absent a compelling reason to use the corporate form.
The LLC was born to combine these two favorable qualities, and to get rid of their downsides. The LLC typically has easier maintenance and lower formalities than a corporation while maintaining the liability protection.
Also, the LLC has a new variation called the "series" LLC in Texas that is especially ideal as an asset holding entity, particularly for real estate.
Finally, in Michigan, Texas, and certain other states such as Nevada and Delaware, LLCs offer more asset protection in that if an owner of the LLC suffers a judgment, the exclusive remedy agains that owner's interests in the LLC is a "charging order." Whereas a creditor can typically take control of a debtor owner's stock, a creditor typically isn't going to have that luxury with a Texas LLC due to our charging order statute.