In response to job losses resulting from the coronavirus pandemic, many New Hampshire business people are starting new businesses of their own. For many of them, this is something they’ve thought about and wanted to do for a long time even before the pandemic.
And despite the great insecurity often attending the formation of many closely-held businesses, many New Hampshire business founders experience real joy at the prospect that they themselves can now control their professional destiny.
But if they do start a new business, they, their lawyers and their accountants must address two basic tasks:
— The first of these tasks is called “non-tax choice of entity.” Non-tax choice of entity is the task of choosing, on purely legal grounds, among the three main types of businesses available to New Hampshire business founders— namely, sole proprietorships, corporations and LLCs.
— The second task is “tax choice of entity.” Tax choice of entity is the task of choosing the federal tax regimen that will be best for a business founder. The relevant regimens are sole proprietorship taxation and taxation under Internal Revenue Code Subchapters C, Subchapter, K (partnership taxation) and Subchapter S.
In this column I’ll address the first of these tasks; in my next column, I’ll address the second.
New Hampshire state-law sole proprietorships are unincorporated business organizations that are owned by one individual. You don’t have to file anything or pay lawyers or accountants to start and conduct a business as a sole proprietorship, and sole proprietorships have the simplest possible management structure: sole proprietors run their businesses however they wish.
However, sole proprietorships don’t provide you with a liability shield — i.e., a statutory shield that will protect your personal assets from claims against your business. Thus, if there is a significant risk that anyone will ever make a claim against your sole proprietorship and if you own any significant personal assets, you probably shouldn’t use a sole proprietorship to conduct your business.
Furthermore, if your business will have even one employee besides yourself, it is imperative that you avoid the sole proprietorship business organization form. This is because you, as the owner of your business, will be personally liable for any mistakes or misconduct by your employee.
New Hampshire has an excellent business corporation act. It is based on an American Bar Association model statute called the Model Business Corporation Act (the BCA), and leading New Hampshire corporate lawyers have tailored this model statute specifically for our state.
The BCA provides its shareholders with a strong liability shield. However, its basic management structure is the classic corporate shareholder-director-officer structure.
Unfortunately, for many closely held businesses, and especially for those with only one or a few shareholders, this structure is unduly complex, and it can be highly impractical for small businesses and their owners.
It is true that BCA Section 7.32 effectively allows shareholders of multi-shareholder New Hampshire corporations to completely override the shareholder-director-officer structure and to adopt, instead, a simple and user-friendly general partnership management structure, while still fully retaining their corporate liability shield.
However, implementing BCA section 7.32 to change the management structure of a corporation to that of a partnership can be a complex and difficult task that requires many hours of tailored legal work. By contrast, the default business structure of single-member LLCs is that of sole proprietorships, and the default management structure of multi-member LLCs is that of general partnerships — the simplest possible multi-owner management structure.
In addition, although BCA section 7.32 provides corporate shareholders with significant flexibility in structuring their businesses, the Revised New Hampshire Limited Liability Company Act (the official name for the current version of New Hampshire’s LLC statute) provides far greater flexibility than section 7.32. It does this above all under LLC Act section 2.
Section 2 provides as follows:
— The basic policy of the New Hampshire LLC act is to provide maximum freedom of contract to LLC members to tailor their LLCs in their operating agreements to meet their needs and interests. This freedom of contract provides tremendous scope for creativity to business founders and their professional advisers in planning and drafting New Hampshire LLC operating agreements.
— Regardless of how one-sided and even unfair these operating agreements may seem, the New Hampshire courts must enforce them in the absence of fraud or oppression. Furthermore, section 107 of the New Hampshire LLC act provides that in their operating agreements, LLC member may “expand, reduce or eliminate” any fiduciary duties or other duties to which the members or their managers might otherwise be subject.
Business people who have founded multi-member LLCs and who are majority owners of these LLCs often find it useful to employ section 107 to insulate themselves from fiduciary claims by other members. The BCA contains no provision similar to section 107.
In addition, virtually all of the other provisions of the New Hampshire LLC Act relevant to New Hampshire single-member and multi-member LLCs are “default” provisions — that is, provisions expressly allowing LLC members in their operating agreements to alter these provisions or to entirely eliminate them from their LLC deals.
Finally, the New Hampshire LLC Act contains “charging order protections” and “pick-your-partner” provisions. The Act’s charging order protections limit creditors of LLC debtor members from seizing the membership rights of these debtors or the assets of their LLCs. And the Act’s default pick-your-partner provisions ensure members of multi-member LLCs that no non-member can become a member without the consent of all existing members. These provisions thus protect the all-important partnership compatibility of multi-member LLCs. The BCA contains no such provisions.
Thus far in 2020, New Hampshire business people have formed a total of about 8,500 LLCs and only about 450 corporations. It is safe to say most of these 450 corporations are mistakes. They should have been formed as LLCs.
And yet, for all their legal advantages, the most important reason for forming new New Hampshire businesses as LLCs rather than as corporations and for converting existing New Hampshire corporations to LLCs are not legal advantages; they are federal tax advantages. I’ll discuss these advantages next week.
John Cunningham is a Concord tax and businesses lawyer and estate planner. He has published Drafting Limited Liability Company Operating Agreements and Maximizing Pass-Through Deductions under Internal Revenue Code Section 199A. Both are the leading books in their fields. If you have business or tax questions you’d like addressed in this column, call John at (603) 856-7172 or e-mail him at lawjmc@comcast.net.