Limited Liability Examined: Part 1 – Common Questions Related to Limited Liability in the Context of a New Business

Do I need an LLC or corporation for my new business or is it safe to operate as a sole proprietor? Is purchasing insurance enough protection? If I form a limited liability company or corporation, is it still possible that I can be held liable for something? How can I make my entity “bulletproof?” Will my LLC provide asset protection to me? What can I do to limit my contract liability? If I decide to form a limited liability company or corporation, are there costs or downsides?

These are common questions we get from clients. In this series of posts, we’ll tackle these questions and maybe a few others and try to provide some practical guidance and suggestions. [Read more...]

When does a deal involve securities regulation? Part 5: Corporate Stock

This post is the fifth in a series exploring when securities laws impact business transactions.

In my previous posts, I provided a general overview of the definition of a “security” under federal securities laws, and covered when various categories of instruments constitute a security, including partnership and limited liability company interests and promissory notes. In this post, we’ll explore when corporate stock falls within the definition of a security under federal law. [Read more...]

Does a negative “Say on Pay” vote trigger a breach of fiduciary duty claim?

The Dodd-Frank Act, passed in 2010, includes the so-called “Say on Pay” provision for publicly traded companies. This provision requires that, at least once every three years, the shareholders of a publicly traded company must vote on its executive compensation arrangements. In addition, the shareholders also vote at least once every six years on the frequency of the “say on pay” vote.  Shareholders are able to elect whether the vote will happen once every one, two, or three years.  In most companies, the shareholders have chosen to have the “say on pay” vote conducted annually.  Publicly traded companies are also required  to disclose, in any proxy solicitation asking for the approval of a merger, acquisition, or other sale of the company, any compensation from “golden parachutes” that would be triggered.  Shareholders also have a chance to “approve” (or not approve) such golden parachute payments. [Read more...]

U.S. House Votes to Adopt Six Measures Loosening Securities Regulation for Smaller Companies; Provisions Include Crowdfunding and “IPO On Ramp”

The U.S. House of Representatives voted earlier today (March 8, 2012) to pass the Jumpstart Our Business Startups (JOBS) Act.  The bill is actually a compilation of six separate measures that have been proposed in Congress (and in some instances already passed in the House) which loosen securities restrictions on smaller companies.  Here are brief summaries of each measure: [Read more...]

How the Federal Government Taxes LLCs

One of the benefits to using a limited liability company is the flexibility of being able to choose how the entity is taxed. After a new LLC is formed, its owners must decide the method by which they would like their business taxed. By default, an LLC is treated as a pass-through entity, which means that it does not pay federal taxes directly, but its income or loss is allocated to the owners, who then pay taxes on that income. If the LLC has only one member, it files no tax return and all transactions of the LLC are treated as transactions of the owner for tax purposes. If the LLC has more than one member, the LLC files a partnership tax return, which reports the LLC’s income and how that income is to be allocated to each owner. Partnership style taxation is governed by Subchapter K of the Internal Revenue Code. However, the owner(s) of an LLC, whether the LLC has a single member or multiple members, may choose to have their LLC taxed as a corporation. In this case, the LLC can be taxed as a so-called “C Corporation,” which is governed under Subchapter C of the Internal Revenue Code, or an “S Corporation,” which is governed by Subchapter S. This ability of LLC owners to elect the company’s means of taxation is called the “check the box” regulations. Below are summaries of the four methods of taxation of an LLC:

  • Disregarded Entity – This is the default rule for any LLC that has only one member. A single member LLC is treated as though it does not exist for tax purposes and thus the owner is treated as if he were running a sole proprietorship. All transactions — income and expenses — are included on the owner’s tax return. Therefore, no separate tax return need be filed for the LLC.
  • Subchapter K (aka partnership taxation) – This is the most flexible form of taxation for a multi-member LLC. All income and losses of the LLC are allocated to the owners, who pay taxes on that income regardless of the amount of cash they received from the company. A distribution of cash to owners is itself a tax-free event. The owners of the LLC can be compensated for service to the company (called “guaranteed payments”) in which case the payments are treated as an expense to the partnership and income to the owner. Subchapter K is quite flexible, and allows the owners to allocate the income between themselves in a variety of ways, sometimes in quite complex formulas (subject to certain limited restrictions in the Internal Revenue Code). One downside to using a partnership taxation structure is that the income of the partners is generally subject to the self-employment tax.
  • Subchapter C – If an LLC elects to be taxed under Subchapter C, it is treated for tax purposes, as if it were a corporation. The company must file a corporate tax return (regardless of whether there is one member or multiple members) and the LLC itself pays taxes. Any income that is paid to owners in the form of dividends is also taxable income to the owner (so-called “double taxation”), though the dividends are taxed to the owner at the capital gains rate. Because of this, many C Corporation owners pay themselves a salary or bonus. Such income is deductible to the corporation, though the compensation must be “reasonable.” If the IRS were to deem the salaries paid to an owner as higher than what would be reasonable if the owner were just an ordinary employee, it could reclassify part of the salary as a constructive dividend, subjecting the company to additional taxes and potential penalties.
  • Subchapter S – If an LLC elects to be taxed under Subchapter S, it is treated for tax purposes, as if it were a corporation that had elected to be treated as an S Corporation. In this form, the company will still file a corporate tax return but does not itself pay taxes. Instead, each owner is allocated a portion of profits or losses based on the percentage interest that they each own. As in a partnership, the owners must then pay the taxes themselves, regardless of whether any cash has been distributed to them. Any cash payments to owners (called distributions or dividends) are tax-free. Active owners are considered employees of the company and can also be paid for their services to the company in the form of a salary or other payments, in which case, the payment will be deductible to the company and will be taxable wage income to the owner. The benefit of taxing an LLC as an S Corporation is that income that is not paid out as a salary is not subject to self-employment taxes. However, the IRS can scrutinize the salaries paid to owners and if it deems that the owners have been underpaid, it may reclassify some of the LLC’s income as wages, subjecting the LLC and the owners to additional payroll taxes and potential penalties. Another disadvantage to using Subchapter S is that the designation is very “fragile.” There are a number of requirements the company must adhere to (such as having only one class of stock and no more than 100 owners). If the company fails to adhere to these requirements, it will automatically be converted to a C-Corp and face double taxation. The single class of stock requirement is especially easy to violate inadvertently. If the LLC gives any owners preferred distributions or distributes distributions in any way except through a straight pro rata method, it could be deemed as having more than one class of stock. In addition, many of the default provisions in LLC statutes violate the single class of stock requirement, which means that the operating agreement of an LLC taxed under Subchapter S must be carefully written to override the default provisions.

As you can see, there are many factors to consider in choosing how to have an LLC taxed. Your final choice should be based on your own specific situation. Therefore, before making any decisions on your form of business, you should speak with your attorney or accountant.

© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.