What is an LLC?

A limited liability company (LLC) is a relatively new business entity, at least in the United States. Its basic features are that its owners have limited liability for the entity's debts and obligations, similar to the status of shareholders in a corporation, and its income and losses are normally passed through to the owners as if it were a partnership. It is probably most like a limited partnership, without the requirement that there be at least one general partner liable for the debts and obligations of the partnership.
An LLC is a statutory creation. That is, unlike general partnerships which developed under common law, an LLC, like a corporation, is created by filing a document (usually called Articles of Organization) with an officer designated by state law.
Business entities that bear strong similarities to limited liability companies existed in some European countries, but the first modern LLC statute in the was adopted by the Wyoming legislature in 1977. At first, the novel entity was slow to gain acceptance. The second state to enact a limited liability company act was Florida in 1982, five years after Wyoming's act. However, in the 1990's the popularity of the LLC snowballed and by 1997, every state and the District of Columbia had passed statutes allowing the formation of limited liability companies.

LLC vs S Corporation

In researching the various business structures, one inevitably comes across the S corporation. S corps and limited liability companies (LLCs) are similar in that they are both "pass-through" entities for tax purposes; the income of these companies are passed through to their owners and reported on the owners’ personal income tax returns, thereby eliminating the double taxation incurred by owners of a standard corporation, or C corporation. (With a C corporation, the net business income is subject to corporate income tax, and the monies remaining after the corporate income tax are taxed a second time when they are distributed as dividends to its owners who must then pay personal income tax.)
So what is the difference between an S corporation and an LLC? And which structure is right for you?
The answer depends on your own unique situation. If operational ease and flexibility are important to you, an LLC is a good choice. If you are looking to save on employment tax and your situation warrants it, an S corporation could work for you.

Business Ownership & Operation

There are restrictions on who can be owners (called "shareholders") of an S corporation. An S corporation can have no more than 75 shareholders. None of the shareholders can be nonresident aliens. And shareholders cannot be other corporations or LLCs.
An S corporation is operated in the same way as a traditional C corp. An S corp. must follow the same formalities and record keeping procedures. The directors or officers of an S corp. manage the company. And an S corp. has no flexibility in how profits are split up amongst its owners. The profits must be distributed according to the ratio of stock ownership, even if the owners may otherwise feel it is more equitable to distribute the profits differently.
LLCs offer greater flexibility in ownership and ease of operation. There are no restrictions on the ownership of an LLC. An LLC is simpler to operate because it is not subject to the formalities by which S corps must abide. An LLC can be member-managed, meaning that the owners run the company; or it can be manager-managed, with responsibility delegated to managers who may or may not be owners in the LLC.
And the owners of an LLC can distribute profits in the manner they see fit.
Let’s say, for example, you and a partner own an LLC. Your partner contributed $40,000 for capital. You only contributed $10,000 but you perform 90% of the work. The two of you decide that, in the interest of fairness, you will each share the profits 50/50. As an LLC you could do that; with an S corporation, however, you could only take 20% of the profits while your partner would take the other 80%.

Employment Tax: Savings vs. Paperwork

A major factor that differentiates an S corporation from an LLC is the employment tax that is paid on earnings. The owner of an LLC is considered to be self-employed and, as such, must pay a “self-employment tax” of 15.3% which goes toward social security and Medicare. The entire net income of the business is subject to self-employment tax.*
In an S corporation, only the salary paid to the employee-owner is subject to employment tax. The remaining income that is paid as a distribution is not subject to employment tax under IRS rules. Therefore, there is the potential to realize substantial employment tax savings. Case in point:
Mary owns a print shop. In keeping with the industry standard, Mary decides that a reasonable salary for a print shop manager is $35,000 and pays herself accordingly. Mary’s total earnings for the year are $60,000: $35,000 paid in salary and the remaining $25,000 paid as a distribution from the S corp. Mary’s total employment tax is $5,355 (15.3% of $35,000).
If Mary were the owner of an LLC, she would have to pay employment tax on the entire $60,000, equaling $9,180. But as an S corporation, she realizes savings of $3,825 in employment tax.
One might assume that these savings could be further manipulated by reducing the salary to an extremely low amount and attributing the rest of one’s earnings to distributions—but this would be an incorrect assumption. In practice, the IRS is careful to notice whether a salary is reasonable by industry standards. If it determines a salary to be unreasonable, the IRS will not hesitate to reclassify distributions as salary.
Still, while the potential employment tax savings may make the S corporation an attractive structure for your business, bear in mind that you would then have to deal with all the paperwork associated with payroll tax. The payroll tax is a pay-as-you-go tax that must be paid to the IRS regularly throughout the year--on time, or you will incur interest and penalties. The paperwork alone can be an overwhelming task for someone who is not familiar with this; and if you expect to incur losses or otherwise experience a cash flow crunch during the year that would hinder you from paying the payroll tax when due, this could present a problem.
Owners of LLCs pay their self-employment tax once a year on April 15 when income taxes are normally due. Income tax filings are also relatively easy for the owners of an LLC: A single-member LLC files the same 1040 tax return and Schedule C as a sole proprietor; partners in an LLC file the same 1065 partnership tax return as do owners of traditional partnerships.

LLC Advantages

A limited liability company (LLC) has many advantages as a form of business entity:

  • Pass-through taxation - under the default tax classification, profits taxed at the member level, not at the LLC level (i.e., no double taxation).
  • Limited liability - the owners of the LLC, called "members," are protected from liability for acts and debts of the LLC.
  • With "check-the-box" taxation, an LLC can elect to be taxed as a sole proprietor, partnership, S Corp or corporation, providing much flexibility.
  • Can be set up with just one natural person involved or, in some states, one owner which may be an entity itself.
  • No requirement of an annual general meeting for shareholders (in some states, such as Tennessee and Minnesota, this statement is not correct).
  • No loss of power to a board of directors (although an operating agreement may provide for centralization of management power in a board or similar body).
  • LLCs are enduring legal business entities, with lives that extend beyond the illness or even death of their owners, thus avoiding problematic business termination or sole proprietor death.
  • Much less administrative paperwork and recordkeeping.
  • Membership interests of LLCs can be assigned, and the economic benefits of those interests can be separated and assigned, providing the assignee with the economic benefits of distributions of profits/losses (like a partnership), without transferring the title to the membership interest (i.e., See VA and Delaware LLC Acts).

LLC Disadvantages

While a limited liability company (LLC) offers many advantages over other forms of business entity, there are also some disadvantages. Some of the drawbacks to selecting an LLC over another entity are:

  • Earnings of most members of an LLC are generally subject to self-employment tax. By contrast, earnings of an S corporation, after paying a reasonable salary to the shareholders working in the business, can be passed through as distributions of profits and are not subject to self-employment taxes.
  • Since an LLC is considered a partnership for Federal income tax purposes, if 50% or more of the capital and profit interests are sold or exchanged within a 12-month period, the LLC will terminate for federal tax purposes.
  • If more than 35% of losses can be allocated to non managers, the limited liability company may lose its ability to use the cash method of accounting.
  • A limited liability company which is treated as a partnership cannot take advantage of incentive stock options, engage in tax-free reorganizations, or issue Section 1244 stock.
  • There is a lack of uniformity among limited liability company statutes. Businesses that operate in more than one state may not receive consistent treatment.
  • In order to be treated as a partnership, an LLC must have at least two members. An S corporation can have one shareholder. Although all states allow single member LLCs, the business is not permitted to elect partnership classification for federal tax purposes. The business files Schedule C as a sole proprietor unless it elects to file as a corporation.
  • Some states do not tax partnerships but do tax limited liability companies.
  • Minority discounts for estate planning purposes may be lower in a limited liability company than a corporation. Since LLCs are easier to dissolve, there is greater access to the business assets. Some experts believe that limited liability company discounts may only be 15% compared to 25% to 40% for a closely-held corporation.
  • Conversion of an existing business to limited liability company status could result in tax recognition on appreciated assets.

LLC vs C Corporation vs S Corporation

Entities Characteristics

LLC Limited Liability Company

C Corporation

S Corporation

Ownership Rules

Unlimited number of members allowed

Unlimited number of shareholders; no limit on stock classes

Up to 100 shareholders; only one class of stock allowed

Personal Liability of the Owners

Generally no personal liability of the members

Generally no personal liability of the shareholders

Generally no personal liability of the shareholders

Tax Treatment

The entity is not taxed (unless chosen to be taxed); profits and losses are passed through to the members

Corporation taxed on its earnings at a corporate level and shareholders are taxed on any distributed dividends

With the filing of IRS Form 2553, a C Corporation becomes a S Corporation, where the profits and losses are passed through to the shareholders

Key Documents Needed for Formation

Articles of Organization / Certificate of Formation; Operating Agreement

Articles of Incorporation; Bylaws; Organizational Board Resolutions; Stock Certificates; Stock Ledger

Articles of Incorporation; Bylaws; Organizational Board Resolutions; Stock Certificates; Stock Ledger; IRS & State S Corporation election

Management of the Business

The Operating Agreement sets forth how the business is to be managed; a Member (owner) or Manager can be designated to manage the business

Board of Directors has overall management responsibility; Officers have day-to-day responsibility

Board of Directors has overall management responsibility; Officers have day-to-day responsibility

Capital Contributions

The members typically contribute money or services to the LLC and receive an interest in profits and losses

Shareholders typically purchase stock in the corporation, either common or preferred

Shareholders typically purchase stock in the corporation, but only one class of stock is allowed

What is a Series LLC?

A series LLC is the latest and by far most sophisticated form of business entity created. The concept is that a single entity may be formed in a state, but separate series or "cells" may be internally created within the LLC. The series LLC is an innovative concept that was created by the State of Delaware approximately nine years ago, but has just now been receiving more attention. The series LLC is essentially a single umbrella entity that has the ability to partition its assets and liabilities among various sub-LLCs or series. Each sub-LLC may have different assets, economic structures, members, and managers. The profits, losses, and liabilities of each series are legally separate from the other series, thereby creating a firewall between each series. In addition, it eliminates the administrative burden and expense of forming multiple LLCs. The structure is very similar to a parent corporation with subsidiaries only without the expense, formalities, and heavy taxation.
The assets of a particular series are protected from enforcement against the assets of the LLC or any other series if (1) the LLC agreement provides for the establishment of one or more series, (2) separate and distinct records are maintained for each series and its assets are accounted for separately from the other assets of the LLC or any other series (and the LLC agreement so provides), and (3) notice of such limitation of liability is set forth in the LLC's certificate of formation. See Del. Code Ann. tit. 6, Section 18-215(b). However, a member or manager may agree to be obligated personally for any or all of the debts, obligations, and liabilities of one or more series. See Del. Code Ann. tit. 6, Section 18-215(c).
Series LLC's are definitely the advanced planning tool of the future. It offers tremendous advantages in planning for such businesses as hedge funds, venture capital funds, oil and gas deals, and fractional share arrangements. Complex business arrangements can sometimes be better managed by the use of a series LLC. As stated above, the first state to enact series LLCs was Delaware. The Delaware statute protects the assets of one series from the liabilities of another series. Other states which have enacted series LLCs stop short of these internal walls, but still gives each series what amounts to a separate business entity having separate rights, powers and duties from the other series, as well as different rights or obligations to participate in profits or losses.
Like LLCs in general, the Delaware series LLCs are not without certain risks. There are numerous unresolved issues regarding the series LLC, including, without limitation, tax issues and creditor/debtor issues (i.e., the interplay between the Federal Bankruptcy Code and state series LLC law.
Some practitioners have expressed concerns that the Internal Revenue Service will not permit the series LLC to file just one tax return for all the series combined. The California Franchise Tax Board's position is that each series in a Delaware series LLC is considered a separate LLC, must file its own Form 568 Liability Company Return of Income and pay its own separate LLC annual tax and fee if it is registered or doing business in California.
States which have adopted series LLCs (other than Delaware) are Iowa, Illinois, Oklahoma and Nevada. There are a number of other states that are considering series LLC legislation. The fact that a state has not adopted a series LLC statute does not prohibit one from forming a Delaware series LLC and having it registered to do business in the state, though there may be complications in doing so from state to state.