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We have received e-mail asking us the difference between a general corporation and a limited liability company (LLC) as well as the difference between an LLC and a subchapter S corporation. We will try to answer your questions and provide you with some general information about corporations and LLC's. Please remember that this article is not intended as a substitute for good legal or accounting advice.
Delaware recognizes "general," "not for profit" and "close" corporations. Subchapter S is a federal income tax provision (IRC sec. 1361, 1366) which avoids taxation at the entity level (the company does not pay tax) and allocates income and loss for tax purposes to the shareholders once a timely election form has been filed with the IRS (form 2553). A subchapter S corporation does not pay taxes on its income and does not file tax returns, it does however file an "informational" return on form 1120S to report the income and loss which the shareholders will then report on their personal return, form 1040. There are numerous limitations on subchapter S corporations and their shareholders. When we form what we call a subchapter S corporation we form a "general" corporation and add language to the certificate of incorporation which is intended to protect the subchapter S status from being inadvertently lost once the election form is timely filed with the IRS.
The law of corporations date back more than a century. Most people understand that a corporation is viewed as an entity separate from its owners (shareholders) and the shareholders are not personally liable for the debts of the corporation unless they have agreed in writing to be liable (responsible) or are guilty of fraud. The term "limited liability" refers to the concept that generally the shareholder's liability for the debts or obligations of the corporation is limited to the amount of money already paid to the corporation for the stock.
Limited liability companies are a relatively new creation. LLC's were first created by Wyoming in 1977. Delaware created its Limited Liability Company Act in 1992. In the 1960's and 70's several states including Delaware adopted close corporation acts which were intended to create flexibility in the operation of limited liability entities. These companies never became popular because of the limitations and rigidity contained in the law. Delaware's Act was drafted to avoid that rigidity and to provide the required flexibility. It is important to remember that there is no requirement that either a shareholder of a corporation or the member of an LLC be an US citizen or resident. The same applies to officers, directors and managers.
The IRS has ruled that a company which under its state's law qualifies as an LLC will not be taxed at the entity level but its income and loss will be taxed to its owners who are called in the context to an LLC, members. If an LLC has only one member, the IRS still recognizes it as an LLC, however the entity is disregarded and is, for tax purposes only, treated as a sole proprietorship. A single member LLC has the same limited liability as a single shareholder corporation.
An LLC can be viewed as a partnership whose partners have limited liability. It has all of the best features of partnerships and corporations with none of their rigidity. As with a partnership, the relationship between the partners, and the partners with the company, is determined by an agreement. In an LLC that agreement is called a company agreement. The company agreement may be either written or oral. If no company agreement is adopted, the Act is the default company agreement. We do not think that it is wise to have an oral company agreement.
The company may be managed by all or just some of its members. If it is managed by less than all of its members it is considered to be a managed company. The person(s) who manage the business is then called the manager. There may be one or more managers. The manager need not be a member. We speak about either member managed companies or manager managed companies. Managers are similar to officers and directors. A manger may have a title such as president.
Delaware's Act is considered to be the most modern and most flexible in the nation. Delaware places almost no limitation on the ingenuity of attorneys and business persons in drafting operating agreements.
Unlike a subchapter S corporation an LLC is not subject to rigid tax laws dealing with who may be a shareholder, the nature of the business of the company, the number of shareholders or any tax requirement that a tax election forms to be filed with the IRS. Please remember that an S corporation must pay FICA taxes on wages paid, including wages paid to shareholders, but not on earnings and profits (dividends). Members of an LLC, except those who do not participate in the management of a company with centralized management, must pay self employment taxes on income derived from the LLC.
Delaware requires that corporations report the names and addresses of its officers and directors on an annual basis. There is no filing of any names associated with a LLC. The franchise tax report is not even signed by the LLC. Membership or management of a Delaware is truly anonymous.
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