This is our final topic on the subject of things you need to consider in selecting an appropriate business entity. After our initial discussion of general issues involved in making this decision, we then examined in summary the legal and tax attributes of sole proprietorship and partnerships.
We have elected to discuss corporations and LLC’s in the same article because they share the characteristic of providing limitations on the liability of all owners in most cases. There are some situations, most commonly involving the failure by the owners to treat the corporation or LLC as separate entities apart from their personal property, in which the “corporate veil” or protection from unlimited liability may be lost. Moreover, some professions such as doctors or lawyers are restricted by public policy from limiting their liability for negligence in this manner. However, the law does allow them to practice through “professional corporations” or associations which possess essentially the same legal and tax attributes except for limiting negligence liability.
Corporations and limited liability companies (LLC’s) complete the roster of entity types commonly used for operating businesses in the United States.
The Process of Corporation or LLC
The process of creating a corporation or LLC is a little more complex if for no other reason than they are created by the issuance of a certificate or charter from the state. Articles of Incorporation for a corporation or Articles of Organization for an LLC are filed with the appropriate state regulator, and when they are approved, a certificate or charter is issued. The Articles set out basic terms for the entity such as the purpose and duration, business location, identity of initial organizers and owners, and manner of voting, among other factors.
It is important to remember that the issuance of the certificate or charter by the state creates a legally-recognized entity– separate and distinct from its owners. These entities are also recognized by taxing authorities as separate entities operating under unique tax identification numbers and requiring filings separate from the owners. This also means that income, assets, and liabilities of these companies must be separately accounted for and must be segregated from those of the owners.
These types of companies are governed under the rules set out in the articles and under the detailed provisions of Bylaws (for corporations) or Operating Agreements (for LLC’s). Typically, a corporation is governed by a Board of Directors at a policy level and by elected officers on the level of day-to-day operations. On the other hand, an LLC may be managed by the members as a whole, by any one member or even by a non-member manager or managers. It is important that records be kept memorializing the decision-making processes in managing these companies, such as resolutions or minutes of meetings of directors, shareholders, officers, or members. This further establishes that the LLC or corporation is an independent entity being managed in accordance with duly adopted rules and not merely as an “alter ego” of the owner or owners. This is important in avoiding personal liability of the owners.
Owner Limitations and Types
The number of owners of both a corporation and an LLC may be one or more persons or other business entities. However, there are some limitations on the number of owners and types with respect to receiving certain tax treatment.
A few types of businesses generally cannot be LLC’s such as banks and insurance companies.
The ownership of a corporation is represented by shares of stock which may divided into various types of stock with different voting, profit-sharing, or other characteristics. LLC ownership is typically represented by ownership units or percentages, much like a partnership. Ownership of these entities is typically easily transferable and is as simple as selling the shares or membership units, often represented by a share or unit certificate. Nonetheless, many such companies enact separate agreements restricting the right to freely sell, transfer, or encumber ownership shares. Transfer may also be regulated under federal or state securities laws.
If allowed by the articles or by-laws, new shares or units may be also issued by corporations or LLC’s allowing for additional owners over time. Because of the limitations on personal liability and the ability to create shares or units of ownership, it may be relatively easier to attract additional equity capital to corporations and LLC’s than to partnerships or sole proprietorships. Attracting capital may depend to a great degree on the tax treatment of the entity, for which there are various options available with both corporations and LLC’s.
From a federal income tax standpoint, corporations may elect to be taxed under Sub-chapter C, Sub-chapter S, or the Internal Revenue Code, subject to some restrictions on the number and characteristics of owners. If treatment under Sub-chapter S is not affirmatively elected by a filing with the IRS, corporations are automatically taxed under Sub-chapter C. This tax treatment may result in the notorious “double taxation” situation for which such corporations are well-known. Under Sub-chapter C, the corporation pays tax on income at corporate rates and the shareholders then pay tax on any dividends received at individual levels. Any operating losses are not passed through to the owners but remain with the corporation and may be offset against taxable corporate income in later years.
If an election to be taxed as a Sub-chapter S corporation is filed, the corporation then essentially becomes a pass-through entity, taxed much like a partnership. As do partnerships, Sub-chapter S corporations issue Schedule K-1 tax forms each year to owners showing their respective shares of corporate profit or loss. The corporation itself must file an informational return but pays no income tax itself. Income and loss is “passed through” to the owners.
Depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation (Subchapter C or S), as a partnership, or as a “disregarded entity.” An LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and affirmatively elects to be treated as a corporation. An LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes (a sole proprietorship), unless it files Form 8832 and affirmatively elects to be treated as a corporation.
In addition to deciding what type of entity to use in conducting your business, there are many decisions “buried” in this process as to what tax treatment is best for the business and its owners. There are many consequences inherent in the decision as to whether to be taxed as a partnership, C corporation or S corporation, the details of which are beyond the scope of this discussion.
UPDATE: In 2017, Congress passed the Tax Cuts and Jobs Act of 2017, which significantly altered how companies are taxed. This has created some incentive to consider C-Corporations over LLC’s. We have a new blog article that discusses this, entitled Return of the C-Corporation.
One last time, this brief discussion of the attributes of the corporation and limited liability company, like our previous articles about sole proprietorships and partnerships and General Consideration When Choosing a Business Structure, are intended to merely alert future or potential business owners of the importance and complexities of these decisions and to identify some of the issues involved. These articles are in no way intended to give you nearly enough information to “go it alone” in this process. Always seek the advice of a tax and legal professional before forming a business and thoroughly discuss with him or her your vision, goals and projections for your venture.
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