This article explores the key legal and practical elements involved in the establishment and operation of a multi-member entity, including: type of entity; taxation; reporting; corporate and member liability; distributions; compensation, operating v. non-operating members; member disagreements; transfer restrictions; corporate valuation; confidentiality; and non-competition.
Multi-Member Entity Formation Basics
In today’s economic and work environment, there are an increasing number of individuals who have decided to leave more traditional employment positions and establish their own business entities. This appears to be a result of many factors, including: the post-COVID recognition that work can be performed in a variety of settings; the need and desire for a better work/life balance; and the realization that owning one’s own business can be very lucrative and ideal for certain individuals and business models. This article specifically addresses the more complex issues involved when there is more than one owner establishing and operating the entity.
Key Entity Establishment Considerations
Type of Entity
The primary types of multi-member entities are as follows:
For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders.
S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.
Limited Liability Company
A Limited Liability Company (LLC) is an entity created by state statute. Depending on elections made by the LLC and the number of members, the IRS will treat an LLC either as a corporation, partnership, or as part of the owner’s tax return (a disregarded entity). A domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and elects to be treated as a corporation. For income tax purposes, an LLC with only one member is treated as an entity disregarded as separate from its owner, unless it files Form 8832 and elects to be treated as a corporation. However, for purposes of employment tax and certain excise taxes, an LLC with only one member is still considered a separate entity.
Entity type is a state law issue, whereas tax status is a federal law issue.
Entity classification is a state law specific issue, whereas taxation is a federal law issue. The taxation of C corporations and S corporations is set forth under the Internal Revenue Code (“IRC”). Likewise, LLC taxation is governed by the IRC; however, the federal tax status of LLCs is somewhat flexible based on the number of LLC members and structure of the same. For this reason, LLCs are an advantageous choice for many single- and multi-member business entities.
Reporting for the multi-member entity is required on both a state and federal law level. State law requires annual or biennial reports. Federal law requires tax reporting as applicable to the specific type of entity.
Key Entity Operational Considerations
Corporate and Member Liability
It is important to keep in mind the corporate structure, verses the interests, goals, and potential liability of the individual members. The overall goals of the business venture can help determine how to align these interests and develop the related corporate agreements.
For a corporation, the entity’s Bylaws and Stock Restriction Agreement will largely govern the legal and operational matters that affect the shareholders. For an LLC, the Operating Agreement governs the legal and operational matters that affect the members.
As with other key components, distributions to the entity owners largely depend on the federal tax status of the multi-member entity. The details regarding distributions will be set forth in the operational documents of the entity.
Owners of the entity can be compensated through shareholder or member distributions, or through employee compensation, depending on what makes the most sense from a corporate and tax standpoint.
In many cases for closely held-entities, it makes the most sense from a corporate and tax standpoint to have only one ownership class for the entity. S corporations are only permitted to have one class of stock.
However, certain C corporations may want to establish more than one class of stock for various investment, regulatory and operational reasons. If an entity wants to establish more than one class of stock and/or voting classes, corporate legal counsel should be consulted to make sure it is properly structured and in compliance with applicable federal and state law.
With regard to owner disagreements, the Stock Restriction Agreement or Operating Agreement, as applicable, needs to be carefully drafted by the entity’s legal counsel. Such agreement can appropriately address what is required of a member’s or owner’s shares when there is a corporate dispute. This includes buy-back and valuation provisions.
Depending on the entity structure, transfer restrictions should be set forth in either a Stock Restriction Agreement (for a corporation) or an Operating Agreement (for an LLC). The provisions of the Stock Restriction Agreement or Operating Agreement can be as simple or complex as desired by the entity’s owners. The complexity depends on the overall corporate goals of the entity and related administrative plans.
There are multiple ways that an entity can and should be valued. The valuation largely depends on the type of entity and the reason for the valuation. Both the corporate accountant and attorney should be involved in corporate valuation discussions because the formula needs to be assessed from both a financial and legal standpoint.
Confidentiality agreements and the need for confidentiality is extremely important for many types of entities. While some entities may require all employees to sign confidentiality agreements, other entities may outline their general confidentiality requirements in the Employee Handbook and then require that certain employees who have greater access to more highly confidential information sign stricter confidentiality agreements.
For closely-held, multi-member entities, confidentiality may be a key component of the business and trust amongst the owners. In such cases, confidentiality provisions can be included in the Stock Restriction Agreement or Operating Agreement; or as a best practice, each owner can be required to sign his or her own Confidentiality Agreement. This ensures that the entity’s confidentiality requirements are made clear and outlines the recourse available to the entity and other owners in the event any owner fails to comply with such confidentiality requirements.
Non-Competition and Non-Solicitation
As with the need for confidentiality restrictions, the need for non-competition and/or non-solicitation requirements is essential for multi-member entities in many industries and practices.
Multi-member entity formation is becoming increasingly common and desirable in today’s economic environment. In addition to the above-stated key considerations, it is important for any business owner to work with a team of legal and financial advisors who understand the company’s key players, as well as its short-term and long-term goals.
Author: Emily Langdon