Startup Steps #2: What Business Owners Need to Know About Limited Liability Companies and Corporations
Use of liability limiting entities such as corporations and/or limited liability companies are extremely common for today’s business owner. This article briefly summarizes the legal structure of these entities and provides some examples of how they can be useful in your business.
Limited Liability Companies
Limited liability companies, or “LLCs” for short, have become the predominant form of liability limiting entity for a variety of situations, including real estate investment. The LLC is a relatively new business structure authorized by state statute. The LLC is chiefly inspired by the GmbH, a type of business organization in Germany, and by limitadas, a type of business organization available in many Latin American countries. The primary advantage an LLC provides over another common pass-through entity known as the Subchapter S corporation is its flexibility, given that LLCs have no restrictions on who can be a member, as well as the fact that members of an LLC can have different rights depending upon their class of ownership.
In the United States, the first limited liability company act appeared in Wyoming in 1977 as special interest legislation for an oil company. In 1980, the Internal Revenue Service issued a private letter ruling to an LLC formed under Wyoming LLC Act indicating that the IRS would treat the LLC as a partnership for federal tax purposes. However, later that year, the IRS proposed regulations that would deny partnership classification to any business entity in which no member bore personal responsibility for the entity’s liabilities. In 1982, Florida adopted an LLC act modeled on Wyoming’s LLC Act. Due to uncertainty over the tax treatment of LLCs, no other states introduced LLC legislation until after 1988. In 1988, the IRS issued a revenue ruling stating that it would treat a Wyoming-style LLC as a partnership for tax purposes. By 1996, nearly every state had enacted an LLC statute.
In 1997, the IRS introduced the “Check-the-Box” Regulations, a series of regulations that for the first time allowed single-member LLCs. These single-member LLCs were “disregarded” for Federal income tax purposes, meaning that not only was there no separate entity tax to be paid, but there was also no need to file a separate return for the LLC (as is the case with the Subchapter S corporation where one files an 1120S for the entity and issues K-1s to each shareholder who pay tax on their pro rata share of the corporation’s profits). Following the introduction of the “Check-the-Box” rules, every state amended its LLC statute to allow for single member LLCs.
Benefits of the LLC Form
And the rest, as they say, was history. With the rule change allowing for ownership by a single member, the LLC – be it the single member or multi-member variety – has become perhaps the most useful planning tool for a number of situations, for the following reasons:
1. Because the single-member LLC is disregarded for Federal income tax purposes, there is no separate return required to be filed for the entity; the LLC owner thus benefits from the liability shield over his/her personal assets without increased administrative costs (in the form of an additional tax return).
2. Business owners can compartmentalize liability for of their businesses within a separate single member LLC, and in turn each single member LLC is owned by a holding company LLC with all income from the operations flowing up to the individual owners.
3. In the multi-member context, the LLC’s flexible structure works well for the unique and sometimes complex structure which business deals sometimes have. For example, it is possible to have multiple classes of LLC membership interests with different rights – voting vs. non-voting, preferred distributions, etc. In short, whatever deal the owners strike amongst each other, a well-drafted set of LLC documents can give legal effect to the terms.
A basic set of LLC documents includes the following:
• Articles of Organization (filed with the Secretary of State);
• Bylaws (also sometimes referred to as the “Operating Agreement);
• Written Resolutions of the Board of Governors (a basic set of resolutions ratifying the formation of the LLC);
• Contribution Agreements (one for each member);
• IRS Form SS-4, Application for Employer Identification Number; and
• Member Control Agreement with Buy-Sell Provisions (if a multi-member LLC).
Corporations are classified as one of two types by the Internal Revenue Code: C corporations (so named because they are described in Subchapter C of the Internal Revenue Code) which have two levels of taxation; i.e., the corporation itself pays tax and any dividends paid to shareholders are taxed at the shareholder level. This “double taxation” aspect makes the C corporation extremely unattractive in today’s business environment.
S corporations (again named after the pertinent Subchapter of the Internal Revenue Code), by contrast, are taxed only at the shareholder level. Any profits of the S corporation “pass through” to the shareholders pro rata and typically the corporation’s governing documents provide that the corporation shall distribute sufficient profits to the shareholders to cover their respective tax liability from corporate earnings. Note, however, that while no corporate level tax is paid, the S corporation does have to file an information tax return with the IRS, and each shareholder is given a Schedule K-1 which evidences each shareholder’s pro rata portion of income attributable to the S corporation.
To qualify for S corporation status, the corporation must meet the following requirements:
• Be a domestic corporation
• Have only allowable shareholders (including individuals, certain trust, and estates and may not include partnerships, corporations or non-resident alien shareholders
• Have no more than 100 shareholders
• Have one class of stock
• Not be an ineligible corporation i.e. certain financial institutions, insurance companies, and domestic international sales corporations.
In order to become an S corporation, the corporation must submit Form 2553 Election by a Small Business Corporation (PDF) signed by all the shareholders.
In the business context, the primary advantage an S corporation has over an LLC is that self-employment tax may be less with an S corporation than it would be with an LLC. Stay tuned to Startup Steps #3 for more on that issue.
A basic set of corporation documents includes the following:
• Articles of Incorporation (filed with the Secretary of State);
• Written Resolutions of the Board of Directors (a basic set of resolutions ratifying the formation of the corporation);
• Subscription Agreements (one for each shareholder);
• IRS Form SS-4, Application for Employer Identification Number;
• IRS Form 2553 (if an S corporation); and
• Shareholder Control Agreement with Buy-Sell Provisions (if a multi-shareholder corporation).
Use of LLCs or corporations can be a valuable planning and asset protection tool for business owners. Most attorneys can form these entities at reasonable fixed fees in a short period of time. It is strongly recommended that business owners consult with a qualified attorney in order to properly form the desired entity so as to avoid later headaches.