Delaware’s General Corporation Law dates back more than a century. Most people understand that a corporation is viewed as an entity separate from its owners, called 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 have used the corporation to commit 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.
Delaware recognizes three types of corporations: general, not for profit and close corporations. Subchapter S is a federal income tax provision (IRC sec. 1361, 1366) which provide that the shareholders recognize the company’s income and expense on their personal tax returns once a timely election form has been filed with the IRS (Form 2553).
A subchapter S corporation does not pay taxes itself on its income. Instead, it files an “informational” return on IRS Form 1120S to report the income and expense which the shareholders will report on their personal tax return, Form 1040. There are numerous limitations on subchapter S corporations and their shareholders. When we form 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 filed with the IRS.
Limited liability companies are a relatively new creation. First legalized in Delaware in 1992, 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 or sometimes an operating agreement. The company agreement may be either written or oral, however, Delaware law requires that the company must have a company agreement. If the company agreement is silent on any matter, the Delaware Limited Liability Company Act provides the default provisions. We do not think that it is wise to have an oral company agreement, even for a single-member LLC.
The Delaware Limited Liability Company Act is considered to be the most modern and most flexible in the nation.
The IRS has ruled that a company that qualifies as an LLC under the laws of its state of formation will not be treated as a partnership and its income is not taxed at the entity level. Instead, its income and expense will be taxed to its owners, who are called members in proportion to their ownership in the LLC or as provided in the company agreement. If an LLC has only one member, the IRS still recognizes it as an LLC, however the entity is disregarded and is treated as a sole proprietorship for tax purposes. A single member LLC has the same limited liability as a single shareholder corporation.
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, but the manager need not be a member. Managers may be similar to officers and directors, and may have a title such as president. If the company is managed by one or more of its members (but less than all), that person is sometimes called the “managing member.”
The Delaware Limited Liability Company 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. In fact, 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.
Unlike a subchapter S corporation, an LLC is not subject to rigid tax laws regulating who may be a shareholder, the nature of the business, the number of shareholders or any requirement that tax election forms must 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) distributed to shareholders. 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 only the names and addresses of its officers and directors on an annual basis. The names of shareholders are not filed with the State of Delaware.
Please remember that this article is not intended as a substitute for good legal or accounting advice.
The LLC tax report is not even required to be signed by the LLC.