Limited Liability and Corporate Formation
General Legal Considerations
LLCs are unincorporated legal entities created under state law. Even though LLCs are unincorporated vehicles, the fundamental intent of LLC statutes is to allow the formation of entities that are legally more similar to corporations than to partnerships. Nevertheless, LLCs usually can be treated as partnerships for federal income tax purposes. The critical point to remember is that, legally, LLCs are not corporations, nor are they partnerships.
LLC owners are referred to as “members” rather than shareholders or partners. This is indicative of the fact that LLCs are completely distinct legal creatures that are permitted and governed by the LLC statute in the state of formation.
Because LLC laws are new, there are inevitable legal uncertainties associated with making the choice to operate as an LLC rather than as a partnership or as a C or S corporation. For example, when an LLC operates in several states with LLC statutes (which can vary considerably), it is not always clear which has precedence: the LLC statute in the state of formation or the laws in the state where operations are conducted. Most LLC statutes provide that the LLC laws in the state of formation apply, but this may be limited to the types of businesses permitted to operate as LLCs in the state where the operations are conducted. Even when an LLC operates only in the state of formation, the novelty of LLC statutes means there are inevitably some legal uncertainties that do not exist with more established types of entities. The LLC statutes provide legal frameworks, but these can never anticipate all the questions and issues that arise from real-life events and transactions.
In summary, LLCs have a very short legal track record. There is essentially no LLC case law. As a result, the rights and obligations of LLC members, creditors, and other third parties contracting with LLCs are just not as well understood as would be the case if operations were conducted as a limited or general partnership or corporations.
Limited Liability of LLC Members
An LLC is a separate legal entity (apart from its members and managers) that owns its assets and is liable for its debts. Therefore, the personal assets of LLC members and managers generally are beyond the reach of LLC creditors. The limited liability of all LLC members and managers is the fundamental nontax advantage of LLC status.
The liability-limiting advantages of LLCs are critically important, but they should not be overlooked. While the personal assets of LLC members and managers are protected from “general” LLC debts and obligations (often referred to as “contract liabilities”), these persons generally remain exposed to LLC liabilities resulting from their own negligent acts and professional errors and omissions. (negligent acts are defined as wrongful acts leading to civil actions, other than those involving breach of contract.)
LLC members and managers may also be personally liable for negligence in supervising other members, managers, or employees.
In short, LLCs generally do not offer liability protection to members and managers beyond what corporations are able to offer to their shareholders who are officers, directors, and employees.
The issue of members’ and managers’ exposure to liabilities related to totious acts, omissions, and negligence is a matter of state law. If you have any questions about this issue, we recommend you consult with an attorney.
Guarantees of LLC Debts
Like corporate shareholders, LLC members may be required on occasion to personally guarantee certain of the entity’s debts as a condition of obtaining financing or for other reasons.
Members are personally obligated with respect to LLC debts that are specifically guaranteed.
Tax Treatment of Multi-Member LLCs as Partnerships for Tax Purpose
The key tax advantage of a multi-member LLC is that they can be treated as a partnership for federal income tax purposes.
Tax Treatment of a Single-Member LLCs as Sole Proprietorships for Tax Purpose
The existence of a single-member LLC is ignored for federal tax purposes. Accordingly, business activity would be treated as a sole proprietorship in the eyes of the IRS.
Only LLCs are able to offer both the legal advantage of limited liability for all owners and the tax advantage of partnership taxation, which combines pass-through treatment with maximum flexibility. This unique combination of legal and tax benefits is the driving force behind the increasing popularity of LLCs.
We would appreciate the opportunity to consult with you as you make the important decision of choosing the most advantageous type of entity to operate your new venture.
CORPORATIONS (C and S)
Limited Liability of Shareholders
The principal advantage of C and S corporation status is that the corporation is treated as a legal entity separate and distinct from its shareholders. Therefore, the corporation owns its own assets and is liable for its own debts. As a result, the personal assets of shareholders (including shareholder-employees) generally are beyond the reach of corporate creditors.
The liability-limiting protections offered by C and S corporations are substantial, but they should not be overstated. While the personal assets of shareholders are protected from “general” corporate debts and obligations (often referred to as “contract liabilities”), shareholders generally remain exposed
to corporate liabilities resulting from their own negligent acts and professional errors and omissions. (negligent acts are defined as wrongful acts leading to civil actions, other than those involving breach of contract.)
The issue of shareholders’ exposure to liabilities related to tortious acts and professional errors and omissions is a matter of state law. If you have specific questions about this issue, we recommend you consult with your attorney.
Guarantees of Corporate Debts
Shareholders may be required on occasion to personally guarantee certain of the corporation’s debts as a condition of obtaining financing or for other reasons. Shareholders are personally obligated with respect to corporate debts that are specifically guaranteed, but shareholders are still protected against liability for other corporate debts.
Federal Income Tax Treatment of C Corporations
The key disadvantage of C corporations is that they are subject to double taxation. The double taxation issue appears in several different ways including dividends, tax on sale of stock, and tax on liquidation of corporate assets. The most common manifestation of double taxation is the treatment of C corporation dividend distributions to shareholders. In order for dividends to be available, the corporation must have earnings, and these are taxed at the corporate level. Dividends are also taxed as ordinary income to the recipient shareholders, but the payments are not deductible by the corporation.
Federal Income Tax Treatment of S Corporations
The key advantage of S corporations is that they are not subject to double taxation. S corporations are not taxpaying entities. Instead, the corporation’s items of income, gain, deduction, loss, and credits are passed through to the shareholders, who then take those items into account on their individual income tax returns.
The “Reasonable Compensation” Issue
Corporations often attempt to solve the double taxation problem by “zeroing out” corporate income with deductible compensation payments to shareholder-employees. As a result, the IRS frequently raises the so-called reasonable compensation issue when C corporations are audited. When challenged by the IRS, the corporation must be able to show that the purported compensation payments were not dividends in disguise. In other words, the compensation amounts must be “reasonable.” If they are not, the IRS will reclassify the excessive amounts as dividends and reduce the corporation’s compensation deductions accordingly.
Potential Mitigating Effect of “Splitting Income”
The ability of high-bracket individuals to “split income” with a C corporation and thereby take advantage of the graduated corporate rates (which can be as low as 15%) can sometimes counteract the negative effects of double taxation.
Tax Losses Cannot Be Passed Through to C corporation Shareholders
Unfortunately, tax losses incurred by a C corporation cannot be passed through to the shareholders. Instead, a C corporation’s net operating losses (NOLs) can be used only to offset corporate taxable income earned in the 2 years preceding the NOL year or in the 20 years following the NOL year.
If the taxable income earned in that period is less than the NOL, all or part of the NOL will expire without generating any tax benefit. In contrast, tax losses incurred by pass-through entities are passed through to their owners, where they generally can be used currently to offset taxable income from other sources (subject to other potential limitations of tax law, such as the passive loss rules). When significant taxable losses are expected to be incurred (as is often the case in the early years of a new venture), generally it is advisable to use a pass-through entity if at all possible. In a C corporation, capital losses are “trapped” inside the corporation, where they can be used only to offset capital gains. Unused capital losses from a year can be carried back years or carried forward a limited number of years. Any unused capital loss carryforwards in a C corporation expire.
Pass-Through of Taxable Losses to S corporation Shareholders
Often, substantial tax losses are expected in the first few years of operation of a new business. If the business is conducted as an S corporation (or other pass-through entity), the losses can be passed through to the owners, where they can be deducted currently (subject to possible limitations under the basis, at-risk, and passive loss provisions). If the business is expected to incur significant capital losses, S corporation status is preferred. The losses can be passed through to the owner, where they can offset up to $3,000 of ordinary income plus capital gains for the year. Any unused capital losses are carried forward to future years.
Election of S Status
The election of S corporation status is made by filing Form 2553 (Election by a Small Business Corporation). The form can be filed during the preceding tax year for an election to become effective for the following tax year. For an S election to be effective for the current tax year, it must be filed by the fifteenth day of the third month of that year. (In most cases, this translates into a March 15 deadline.) Newly formed corporations generally intend for the election of S status to be effective for the initial tax year. The election must be filed by the fifteenth day of the third month after the “activation date” of the corporation. This is the earliest date the corporation has shareholders, acquires assets, or begins conducting business. We would be pleased to assist you in filing Form 2553 to implement your corporation’s S election.
Special Restrictions on S Corporations
Achieving S corporation status depends on meeting a number of strict eligibility rules. Unfortunately, these rules greatly restrict stock ownership and capital structure possibilities and can therefore make operating as an S corporation much less attractive than it first appears. If the eligibility rules are not met at any time during the tax year, the S status of the corporation is immediately terminated and the corporation falls under the C corporation taxation rules. To qualify for S status, a corporation must (1) be a domestic corporation; (2) have no more than 100 shareholders; (3) have no shareholders other than individuals who are U.S. citizens or resident aliens, estates, or certain types of trusts; (4) have only one class of stock (issuing both voting and nonvoting shares is permitted, but there can be no preferred stock or common stock classes with differing economic characteristics); and (5) not be by definition an ineligible corporation.
LIMITED LIABILITY COMPANY (LLC)
Multi-member LLCs (defined as “more than one member”) are increasingly popular because they combine the best legal and tax characteristics of corporations and partnerships, while avoiding many of the disadvantages. An LLC can offer limited liability protection to all its owners (referred to as “members”) along with the advantages of being treated as a partnership for federal income tax purposes.
Single-member LLCs (defined as “one member”) are popular because they combine the best characteristics of S corporations and sole proprietorships, while avoiding many of their disadvantages. Specifically, a single-member LLC offers liability protection to you, the owner, along with the simplicity of being treated as a sole proprietorship for federal income tax purposes.
Our online web-based portal offers you an alternative to e-mail for a secure transfer of your financial records.
© 2011 Todd D. Knapp, CPA, P.C.. All Rights Reserved.