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The end of a chapter in South Dakota: how the LLC has supplanted the corporation as the primary form of entity for entrepreneurs.

Article Excerpt
For many individuals, the mere thought of putting their shingle out thus severing the ties associated with the security of a steady paycheck sends shivers down their spine. The risks associated with becoming an entrepreneur are well documented. In 2003, the statistics painted a grim picture, showing that only forty-four percent of small businesses are in existence after the first four years of operation. (1) As if the risk of losing your initial investment isn't severe enough, the risk is magnified by the possibility of being exposed to personal liability, risking not only your personal investment, but your private bank accounts and family home in the pursuit of starting a viable business.

Historically, a business owner was limited as to the available safeguards to protect against the risk of forfeiting personal property to satisfy the debts of a business. This protection was found in a corporate form of entity, which served to shield the business owner against exposure to personal liability. However, that protection came at the expense of double taxation, meaning the businesses were taxed as income was earned, and then taxed a second time as profits were distributed to the shareholders. While at first blush, double taxation may seem like a small price to pay for limiting the entrepreneur's potential liability, a deeper analysis reveals a contrasting position. With the failure rate so high among new businesses, the additional taxation can prove fatal as the business struggles during the early years to maintain an adequate return on investment. With that said, it must be mentioned that the S corporation was established to alleviate this dilemma, and will be discussed later in this article.

If an entrepreneur decided they did not want to pursue a corporate entity, they were then restricted as to the available forms of entity. Prior to 1993, the remaining choices were limited to either the partnership or a sole proprietorship. While these entities receive favorable taxation, they are generally subjected to unlimited liability to satisfy the businesses debt and legal obligations. There was one exception: a business could elect to become a limited partnership, avoiding personal liability for the limited partners, but still exposing the general partner to unlimited liability.

In 1993, South Dakota enacted a new hybrid form of entity known as a Limited Liability Corporation, commonly known as an LLC. The LLC is a hybrid entity, which takes the keystone corporate characteristic of limited liability and merges it with the preferential tax treatment of the partnership resulting in flow-through taxation. As a result, South Dakota became the nineteenth state to adopt LLC legislation, which all the remaining states have since adopted.

The purpose of this article is to ascertain how the creation of the LLC in South Dakota has changed the business environment as it relates to the number and type of entities filed.

Prior to analyzing how the enactment of the LLC has changed the business landscape, it is important to first gain a fundamental understanding of the characteristics of the traditional forms of entity as well as that of the LLC. Table 1 on page 7 summarizes the general characteristics of these business entities. This requisite understanding will assist the reader in comprehending the current trend as it relates to the type of entities being filed. The three traditional forms of entity include corporations, partnerships, and sole proprietorships.

Corporation

A corporation is a creature of statute whereby it serves as a legal entity possessing many of the same rights and privileges enjoyed by a U.S. citizen. It has the ability to own property, sue or be sued, and is entitled to due process under the Fourteenth Amendment. The investors of the corporation are called shareholders. (2) The shareholders are often passive investors who purchase shares of stock in the business. However, an investor does not need to be passive, as South Dakota permits single-shareholder corporations, where the shareholder also serves in various capacities within the organization. In general, there are two basic types of corporations, C corporations taxed under subchapter C of the IRS code and S corporations taxed pursuant to subchapter S of the IRS code, which are further discussed below.

The first type of corporation that will be addressed is the C corporation. The keystone characteristic of a corporation is the concept of limited liability, which serves to shield the shareholders, board of directors and officers from exposure to personal liability, thus limiting the amount of risk associated with the venture to their initial investment. (3) This principle has been instrumental in helping businesses secure appropriate financing through the issuance of corporate shares of stock. The safeguards allow passive investors to purchase shares of a corporation without the risk of being exposed to personal liability. If not for this concept, corporations would be subjected to making unrealistic profits in order to provide an appropriate level of return to adequately compensate the investors for their increased level of risk. While limited...

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