Principal Characteristics of Limited Liability Companies

Quick links on this page:

Separate Legal Entity and Limited Liability
Pass-through Tax Status
Comparison of LLC's with Corporations

Owners and Ownership Interests
Management
Taxation and Allocation of Profits and Losses
Fringe Benefits

Some Final Thoughts

Disclosure of Our Bias

The origin of LLC's in the United States is very recent and has been accompanied by an unexpected (and we believe, often unjustified) amount of hype and misunderstanding. Many authors have touted the LLC structure as the clear choice for the small business owner because of its simplicity of formation and advantageous characteristics of limited liability protection for owners and "pass-through" tax treatment of profits (explained below).

While these characteristics of LLC's are factually correct, we believe that the advantages they afford an LLC have been greatly overstated by others, while the disadvantages of the LLC (compared to other entities such as a corporation) have been greatly understated. This is particularly true in a state like California where LLC's, unlike any other type of entity, are subject to a yearly "gross receipts fee" (in addition to payment of an annual minimum franchise tax of $800), that could reach into the thousands of dollars.

For a variety of reasons that we will discuss in each section of our information about LLC's, we generally find that choosing a corporation, particularly an "S" corporation with the same "pass-through" tax characteristic as LLC's, is often the preferred choice. We will attempt to clearly identify our opinion and separate it from the factual information to which it relates.

A Note About LLC Statutes and Legal Cases

Because of the recent introduction of LLC's into this country, the legal cases decided under various state statutes are fairly scarce. This means that there is very little guidance provided by the courts in interpreting the scope and limitations of many of the LLC statutory provisions. Business owners and their attorneys will be faced with far more uncertainty than corporations when evaluating such issues as the factors that may cause the loss of the members' limited liability protection.

Since the limited liability protection for corporations and LLC's is the same, it is likely that the courts will look to case precedents involving corporations in deciding comparable issues for LLC's. For illustrative purposes only, we will provide examples or references to selected statutes and case decisions in California. Keep in mind that the statutes and/or court decisions in other states may vary.

Separate Legal Entity and Limited Liability

An LLC is a separate legal entity from its owners, who are called "members." This characteristic allows the members to enjoy limited liability protection that does not exist for a sole proprietor or partners in a partnership where their personal assets are at risk. There is no difference between the limited liability protection received by shareholders (owners) in a corporation and that received by members in an LLC. This occasional misconception occurs because the words "limited liability" appear only in the name "LLC."

California law makes this clear. Corporations Code §17101(b) states that

"A member of a limited liability company shall be personally liable under a judgment of a court or for any debt, obligation or liability of the limited liability company, whether that liability arises in contract, tort or otherwise, under the same or similar circumstances and to the same extent as a shareholder of a corporation may be personally liable for any debt, obligation, or liability of the corporation…"

The major difference that this statute provides between LLC's and corporations is that it specifically states that the failure of an LLC "to observe formalities pertaining to the calling or conduct of meetings" shall not be considered as a factor in holding members personally liable for the debts and obligations of the LLC, "if the articles of organization or operating agreement do not expressly provide for the holding of meetings of members or managers."

Unlike LLC's, statutes pertaining to corporations do not permit the disregard of the formalities for calling and holding meetings. It is important to note, however, that the statutes of most states permit corporations to take action without holding meetings if the shareholders or directors simply sign a written consent to the specific action set forth in the corporate minutes.

Does this mean LLC members have more protection for their personal assets than shareholders in a corporation?

For a detailed discussion of factors considered by the courts in evaluating the limited liability of shareholders in a corporation, click here.

Record keeping is also important for tax reasons.

The relaxation of certain formalities for LLC's relates solely to preserving limited liability protection. State statutes, such as California's, have no bearing on the IRS in conducting an audit of the LLC for tax purposes.

Like corporations, LLC's are a separate legal entity and are required to maintain records reflecting the separateness of the entity and the members. While it is commonplace for corporations to have a minute book and endeavor to maintain records of important transactions, especially financial transactions involving shareholder-employees and the corporation, this is often disregarded in LLC's in the mistaken belief that there is no requirement or necessity to maintain such records.

The distinction between corporations and LLC's becomes even more blurred if an LLC elects to be taxed as a corporation rather than as a partnership. This would be advantageous if the members intend to retain profits of the business to expand it, or have profits in excess of what the members need or desire to have distributed as personal income. In such cases, electing to be taxed as a corporation allows the LLC to retain a portion of the profits and have them taxed at lower rates that they would pay personally. If they were taxed as a partnership, each member would pay tax on his percentage of profits whether or not the profits were actually distributed.

When the potential of a tax audit is taken into consideration, the importance of maintaining records in an LLC increases in significance.

Pass-Through Income Taxation

In addition to limited liability protection, the "pass-through" tax status is often considered one of the major benefits for choosing an LLC. "Pass-through" taxation simply means that the profits of the business automatically "pass-through" the entity to the individual owners of the business who pay the income tax on their personal tax returns. The entity pays no income tax.

This pass-through status is the same for a sole proprietor and for partnerships. The advantage is that it ensures that income of the business is only taxed once. In a C corporation (a regular business corporation that has not elected S corporation pass-through tax status), there is a potential for double taxation. This can occur if the corporation pays dividends to its shareholders, since dividends are not tax deductible by the corporation. It can also occur if profits remain in the corporation at year-end requiring corporate taxes to be paid, and in the following year the after-tax profits are paid to shareholder-employees as salary, thereby causing them to be taxed a second time on the shareholders' personal tax returns.

Comparison of LLC's with Corporations

Because there are many factors that could be used for comparison, and different types of corporations to consider for comparison, our discussion will necessarily be limited in scope. We will focus on some of the major distinguishing factors in selecting either a corporation or an LLC as your business entity and will provide comparative details in a more summary fashion. Where there are important distinctions that apply between a "C" corporation and an "S" corporation for a particular factor, we will discuss these distinctions.

You should also note that the discussion in this section does not include any advantages or disadvantages that may be imposed by state statutes.

You can access more information about the different types of business entities and their characteristics by going to the Other Business Entities section of our Learning Center.

Owners and Ownership Interests

• Corporations: Owners are called "shareholders" and receive shares in the corporation.

• LLC's: Owners are called "members" and receive "membership interests."

  Common Characteristics:

• There is no minimum or maximum number of shareholders or members that a C corporation or LLC may have.

• Members and shareholders have the same limited liability protection for their personal assets.

  Important Distinctions:

• S corporations are limited to a maximum 75 shareholders who generally must be individuals who are U.S. citizens or permanent residents.

• S corporations can only have one class of stock. This often precludes the use of stock options and use of corporate stock to attract outside investors since two classes of stock would probably be needed.

• State and federal statutes extensively regulate the ownership and sale of corporate shares. This provides a unique advantage in using corporate shares to attract investors or to provide stock options to attract or retain key employees. Membership interests in an LLC do not enjoy these advantages.

Management

• Corporations: Primary management resides with the board of directors. Day-to-day management is delegated to the corporation's officers.

• LLC's: Management may be with the members or with one or more managers.

  Common Characteristics:

• In small corporations where one or two people are the officers, directors and shareholders, decisions are typically made as a group without regard to which hat is being worn. This is essentially the same as an LLC being managed by its members.

• In corporations where different people fill the positions of officers, directors and shareholders, management is very similar to a manager-managed LLC where one or more managers may not be an owner (member) of the LLC.

  Important Distinctions:

• Management in corporations and LLC's has far more similarities than it does distinguishing characteristics. The main difference is that there is more flexibility in an LLC to choose which management style it prefers, while the management structure of a corporation is largely determined by statute and not subject to major alteration by the corporation's governing instruments.

Taxation; Allocation of Profits and Losses

• C Corporations: C corporations are not "pass-through" tax entities. They pay taxes on their income at the corporation level. Corporate tax rates are lower than individual tax rates up to about $75,000 of taxable income. The payment of profits as dividends to shareholders creates "double taxation" since dividends are taxable income to shareholders but are not deductible by corporations from their taxable income.

• S Corporations: S corporations are "pass-through" tax entities like LLC's. They do not pay federal taxes at the corporate level, but may be subject to state taxes. Losses of the corporation are also passed through and can be used by shareholders to offset taxable income from other sources. Profits must be passed to the shareholders according to their ownership interests.

• LLC's: LLC's have pass-through taxation like S corporations and pay no federal income taxes at the entity level. However, LLC's can elect to be taxed like a C corporation and pay taxes as an entity. This election might be made if the LLC intends to accumulate profits rather than distribute them since members would otherwise be required to pay tax on their full distributive share of profits even if they were actually not paid to them. Like S corporations, profits and losses are passed through to the members of an LLC, though the members of an LLC have the ability to make allocations in different percentages than their membership interests.

Common Characteristics:

• As indicated above, the choice for a corporation to be a C or S corporation (a taxable or pass-through entity, respectively), has strong similarities to an LLC maintaining its inherent pass-through tax status or electing to be taxed like a C corporation.

  Important Distinctions:

• LLC's have an advantage over S corporations in being able to allocate profits and losses differently than ownership percentages.

• S corporations have a significant advantage over LLC's when it comes to the payment of self-employment (SE) taxes. LLC members who are active in the management of the business are currently required to pay self-employment taxes on the income they receive. This amounts to 15.3% for Social Security and Medicare taxes in addition to the federal and state income taxes that are payable. The profits paid to S corporation shareholders as distributions are not subject to SE taxes.

Fringe Benefits

• C Corporations: Fringe benefits, such as group life, health and disability insurance, are deductible expenses by all corporations and the value of these benefits is not included in the taxable income of shareholders in a C corporation. Corporations generally enjoy more tax advantages concerning contributions to retirement plans than LLC's.

• S Corporations: While fringe benefits may be fully deductible by an S corporation, there are limitations on the deductibility of such expenses and/or requirements for including some portion of the value of the benefit as part of the taxable income to the shareholder when benefits are received by shareholders holding certain ownership percentages in the corporation.

• LLC's: The advantages enjoyed by corporations generally are unavailable to LLC's or subject to substantial restrictions and limitations.

Some Final Thoughts

This discussion is not intended to provide you with a comprehensive checklist to make your own evaluation of whether a corporation, C or S, or an LLC is the preferred entity to run your business. Our objective is to provide you with an understanding of some of the major similarities and important distinctions in selecting a particular entity, and to encourage you to explore this issues in more depth with your personal financial and/or legal advisors to ensure that you select the entity that is best suited for your type of business and the objectives and composition of the principals involved in the business.