Frequently Asked Questions

An LLC is a hybrid legal entity, combining the pass-through taxation of the sole proprietorships and general partnerships with the liability protection of corporate structures. The business organization is authorized according to state statute. Establishing an LLC provides business owners with a layer of separation between themselves and the service or product they sell or provide; should the company be sued the owners’ assets are usually protected.

This 1998 ruling saw the IRS shift from its initial position, that it would tax LLCs as corporations, to the stance that “a ‘member-manager’ of an LLC will be treated as a general partner.” If no one company owner is designated a ‘member-manager’, then all the members would be treated as ‘member-managers’ by default. So long as LLCs have no more than one of these other “corporate” characteristics—continuity of life, free transferability, and centralized management—they would enjoy the same pass-through taxation status as general partnerships.

By 1997, the IRS gave up trying to make these complicated determinations and turned over the reins to individual companies, allowing them to check a box if they wanted to be tax as corporations or partnerships. LLC registrations took off after this decision; LLCs are now a staple organizational structure of American and international companies.

There are no citizenship or residency restrictions on who can become a member of an LLC, nor does a member have to incorporate in the same state where they registered the LLC. States only require that individuals be of the age of majority, 18 in most cases, to register an LLC.

That means, not only that foreign nationals can become members, but also that corporations and other LLCs can become members of an LLC. In some cases, another corporate entity may be the sole member of an LLC. In that event, they would be treated as a partnership or multi-member LLC for tax purposes.

LLCs can be either member-managed or manager-managed. A member-managed LLC distinguishes between owners, or managers and members, who may play a more passive role in the day-today operation of the company. Manager-managed LLCs are structured and act like traditional corporations.

LLCs have a flexible organizational structure to go along with their flexible tax designation. These in include:

Limited Liability Protection

An LLC protects most of the members’ assets, restricting liability to the personal interest each person has invested in the company. The signatory on a business loan, for instance, would still be liable to make the payments on that loan. However, members are not liable to pay any monies awarded because of a lawsuit filed against the LLC.

Pass-Through Taxation

A single-member LLC has the same tax structure as a sole proprietorship, in which business losses and gains are paid through the member’s income tax. This has real advantages for a small-business startup, since members can use early business losses to offset taxes owed on other income.

Few Ownership Restrictions

There are no citizenship or residency restrictions on who can become a member of an LLC, nor does a member have to incorporate in the same state where they registered the LLC. States only require that individuals be of the age of majority, 18 in most cases, to register an LLC.
That means, not only that foreign nationals can become members, but also that corporations and other LLCs can become members of an LLC. In some cases, another corporate entity may be the sole member of an LLC. In that event, they would be treated as a partnership or multi-member LLC for tax purposes.

Minimal Compliance Requirements

LLCs have few state-mandated requirements other than an annual filing requirement with minima accompanying paperwork. All other compliance regulations are subject to the rules determined by the LLC’s operating agreement. LLC can have whatever meetings they wish and can document those meetings however they wish; they are not formally required to hold annual meetings with the board of directors and shareholders.

Flexible Allocation of Profits to Individual Members

The LLC can choose to distribute profits to its individual members based on their ownership percentage. For instance, in a two-member LLC, each member would receive 50 percent of the profits. However, unlike corporations, which must distribute profits that reflect the exact percentage of each shareholder, LLC members can also predetermine a special percentage allocation; if one of the two members contributes more to the company for instance, he/she might receive 70 percent of the profits.

Versatile Tax Designation

LLCs can choose how they are treated as a taxable entity. Although, the default established by the IRS, is that LLCs be taxed as partnerships, an LLC can elect to be taxed as a C or S corporation whenever its members decide to make the change.

The key difference between LLCs and other business structures is flexibility. As a hybrid, it has taken good features, from both traditional corporate structures and sole proprietorships, and it places few restrictions on how the company is managed, which gives a business freedom to evolve.

Pass-Through Taxation

Single-member LLCs differ from C corporations—but are like sole proprietorships and S corporations—in that taxes are not paid at the business level. Instead, income and loss are reported on the member’s tax return; any taxes due are paid at the individual level.

Limited Liability Protection

LLCs differ from sole proprietorships and general partnerships, in that the treat the company as a separate legal entity, which can be sued directly—this gives LLC members limited liability protection.

Flexible Management

C corporations have a formal top-down structure, where the board of directors oversees major business decisions, and the officers oversee the day-to-day business operations. S corporations have regulations that restrict the class and number of shareholders.

An LLC, on the other hand, can manage its business structure however the members want, and the main rules are noted in an internal document, the operating agreement. Some LLCs are member-managed, which makes them work more like general partnerships, others are manager-managed. Also, unlike S corporations, which are restricted to 100 shareholders, LLC have no such restriction.

C corporations get their name from the section of IRS code, subchapter C, that regulates them. The traditional or “C” corporation remains one of the United States most popular business structures. It offers unlimited growth potential through the sale of stock, and there is no limit on how many shareholders a C corporation can have. For a company looking to expand and eventually attract global partners and investors, it is hard to beat the C corporation.

Regardless of whether a C corporation is small or large, it will have the same top-down structure, though in small-companies, one person may need to play several of these roles at once:

Board of Directors

These individuals manage the corporation and are responsible for the major decision-making, including the important task of setting the company’s strategic direction. They also issue stock and elect the officers.

Officers

Every corporation must have a president, treasurer, and secretary. They make the day-to-day decisions about how to run the company.

Shareholders

They own the company’s stock. They are also responsible for electing the directors, amending bylaws, the company’s articles of incorporation, and approving actions like mergers and sell offs. Only the shareholders can vote to dissolve the corporation.

Employees

They receive a salary in exchange for working at the company. Employees may or may not also be shareholders.

Owners have limited liability

A C corporation is a separate legal entity, and the liabilities of the company are separate from shareholders’ personal assets. Liability is “limited” because shareholders may have used personal assets as collateral on a business loan. The assets may be liable, depending on the extent the individual has invested in the company; in most cases, personal assets cannot be touched.

The C corporation has “perpetual existence”, independent of its owners.

Unlike general partnerships and sole proprietorships, where the business ends with the life of the proprietors, C corps live on in perpetuity—unless the shareholders vote to dissolve the company.

Corporate Ownership is fluid

To own a corporation, you must have a controlling interest in the company stock; put differently, the shareholders with the most stock own the company. Most individual investors in a publicly-traded company own just a tiny fraction of the company; however, those central to the business own larger percentages and generally seek to maintain controlling interest. It is possible however, for individuals to buy the controlling interest in a company’s stock, against the will of the directors, resulting in a hostile takeover.

It is easy to attract investors

C corps have more opportunity to raise capital than any other business structure. Although a fledging corporation could be a risk to some banks, corporations have a powerful fundraising tool at their disposal. They can raise unlimited amounts of money through the sale of common stock. Companies that wish to raise money in this way, may hold an Initial Public Offering (IPO), to offer shares of their stock on the public exchange. They can issue preferred stock which pays out dividends to the investor, before common stock does. This makes C corps an attractive prospect for venture capitalists.

Incorporated businesses garner more respect

Most of the businesses that we know, and trust, are C corporations. To the consumer, incorporating your business, means that you anticipate growth for your company, and are committed to seeing that growth come to fruition. This can give you more credibility both with customers and potential investors.

There are tax-deductible business expenses

The term “fringe benefits” is synonymous with corporate culture, and there is a reason for that. Expenses, like a company car, or an annual retreat, are tax-deductible.

Shareholders experience double-taxation on stock dividends.

Because they are legally a separate entity, C corps have two layers of taxation. First, the business itself is taxed on its profits. If the company chooses to issue some of those profits in the form of dividends, they are taxed again at the individual shareholder level. Some companies seek to avoid the worse effects of the double-tax burden. They may choose to pay shareholders, who are also company employees, a large salary (as opposed to compensation through dividends), or they may reinvest the profits back in to the business, which also serves to mitigate the tax burden.

There are a lot of rules and formalities

C corporations are subject to an extra layer of transparency that other business structures, such as LLCs and general partnerships, do not have. They are required by law to hold an annual general meeting (AGM) for both the shareholders, the board of directors; at which, important decisions are announced and discussed. The minutes of this meeting must be made public.

A C corp must elect a board of directors whose responsibility it is to draft bylaws, or written protocols for how the company will function. The C corp is also required to have a corporate structure, with shareholders, board of directors, officers, and employees. In small companies, there may not be enough individuals to fill each of these roles, so one person may wear many hats.

There is no deduction for corporate losses

With a C corp, shareholders lose the ability to deduct corporate losses the way they can in an S corporation, allowing them to lessen the overall tax burden. That is because the C corp is taxed as a separate entity.

The S corp is a change of the tax code that congress enacted into law in 1958, primarily, to give a competitive leg up to small businesses.The subchapter or small-business corporation, commonly referred to as S corp, is a very popular hybrid business structure that provides both limited liability protection and pass-through taxation.

Apart from some restrictions, S corps function in much the same way as C corps, i.e., they establish articles of incorporation, hold annual meetings, and publish minutes, to name a few.

By limiting the number of shareholders and stipulating that the business must be domestic, S corps are different from traditional C corporations and LLCs, both of which can expand internationally and place no limit on the number of members.In addition to its structural limitations, S corps have the following features:

Pass-Through Taxation

In an S corp, profits form the business are divided among the shareholders, or investors, in the company. The shareholders then report the profits as income on their individual 1040 form, and the business is not taxed as a separate entity. In this way, S corps function like general partnerships, sole proprietorships, and LLCs. They are different from C corps, which are taxed first as an entity, and then later when shareholders receive distributions from the company in the form of stock.

Limited Liability Protection

Unlike sole proprietorships and general partnerships, S corps have limited liability protection. Should and individual, or an entity, file suit against your company, they would not be able to come after your personal assets (see exceptions).

Freely Transferable Stock

Although S corps only allow one class of stock, that stock can be sold or exchanged freely, meaning shareholders of an S corp can sell off a controlling interest in the company without obtaining the consent of other members. This is very different from how an LLC operates. An LLCs operating agreement defines clear roles for all of the members, including how much interest they have in the company and how they can divest of assets.

Asset Protection

Like LLCs and C corps, S corps have limited liability protection. Theoretically, that means that if the company gets sued, the claim cannot target your personal assets. Limited liability is a valuable feature, but many experts point out that it is not a silver bullet. For instance, if an S corp was originally an unincorporated partnership or sole proprietorship, an owner can still be liable for any claims or debts the company held before it incorporated. Likewise, an owner is liable for any personal assets put up as collateral on a business loan. If the loan defaults, an S corp owner could lose the assets tied to the loan.

Tax Advantages

S corps are exempt from most federal income tax, except for some capital gains tax and taxation on personal income. Instead of being taxed as an entity, the way a C corp is, the S corp passes all the income losses and gains through its individual shareholders. This structure effectively eliminates double-taxation, which happens when a company pays its taxes, then the distributions to shareholders get taxed a second time.

Another important tax advantage comes from what might also be characterized as a strategic way of determining income. As a shareholder, you can be an owner of a business and pay yourself a salary, on which you would owe the necessary FICA taxes. You can also pay yourself in dividends, which are taxed at a much lower rate than your salary would be.
The IRS is well-aware of the scope for [potential] abuse—i.e., some owners might want to pay themselves entirely on dividends to avoid paying their own FICA taxes—and requires S corp owners-employees to be paid a “reasonable salary”.

Regardless, S corp owner-employees have a distinct advantage over the owners of incorporated businesses. A sole proprietor must pay Social Security and Medicare taxes on all the businesses’ net earnings. Owner-employees of an S corp only pay taxes based on their compensation.

Easy Transfer of Ownership

Unlike in an LLC, which determines ownership requirements and responsibilities through a founding document, ownership of an S corp by who has a controlling share in the stock. The company cannot be liquidated id someone leaves, nor are there significant tax consequences or a need to comply with complex accounting rules. Likewise, the company has unlimited life; it does not cease to exist when the owner gets sick or dies.

While the S corp offers distinct tax advantages and ease of transferability, it is not the right choice for everyone. Here are some of the chief disadvantages of becoming an S corp:

Restrictions on shareholders

The code establishes several restrictions on shareholders. There can only be 100, they all must be either American citizens or legal residents, and they cannot be an entity (e.g. LLC, C corp, etc). That means that you do not have the option of raising venture capital or rapidly expanding the business by bringing in another company. Your main source of raising money will be funneling profits back into the business.

Restrictions on the class of stock offered

S corps can only issue common stock, which makes their company a less attractive option for investors who would rather have the benefit of receiving preferred stock.

Restrictions on company growth

S corps are a good choice for American companies that plan to offer American services and products indefinitely. For anyone who wants to work internationally or bring foreign members into the company, S corps are not a good option.

Red tape, and lots of it

Although S corps are allegedly triggered less for audits than unincorporated companies, you still need to do a lot of work to jump through the legal and tax loopholes that come with meeting the requirements of both, the corporate structure, and the IRS code regulations. There are state requirements on how to report minutes and shareholder records. The IRS is screening to make sure S corp owners do not abuse their tax reporting.

Anything less than due diligence, and you can lose your S corp status—possibly incurring a huge tax bill in the process.

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