If the U.S. SM LLC is disregarded and the LLC or owner is engaged in a U.S. trade or business (USTOB) and has any U.S.-sourced effectively connected income, if yes, it will be subject to U.S. taxes.
Here is the issue: USTOB is NOT explicitly defined in the tax code. There have been some cases in the past on USTOB, but there is a grey area. It is highly recommended to analyze first to determine if you are likely USTOB. Don’t assume just because you don’t have any dependent agents in the U.S. you are NOT USTOB, and there is no such tax law. That is why it is an analysis.
Forming a U.S. LLC (Limited Liability Company) offers a range of advantages, particularly for entrepreneurs, small business owners, and international entities looking to establish a presence in the U.S. market. Here are some of the key benefits:
Limited Liability Protection
LLCs provide a shield between your personal assets and business liabilities. This means that in most cases, your personal assets like your home, car, and personal bank accounts are protected from business creditors.
An LLC is a “pass-through” entity for tax purposes, meaning profits and losses are passed through to the individual members and reported on their personal tax returns. This avoids the “double taxation” that corporations are subject to. Additionally, LLCs can choose to be taxed as corporations if that’s more advantageous.
Flexibility in Ownership and Management
LLCs can have as many or as few members as desired, and there’s no requirement for U.S. citizenship or residence. This makes them ideal for international business owners looking to establish a U.S. entity.
Having LLC at the end of your business name can enhance your credibility. Vendors, suppliers, and lenders may look more favorably upon your business when it’s an LLC or other formal business structure.
LLCs often have an easier time allocating profits among members in a way that differs from the ownership percentages, as long as the members agree.
Easy Transfer of Ownership
The operating agreement can provide for an easier transfer of ownership rights compared to other business structures.
Estate Planning Benefits
LLCs are often used as estate planning tools, helping to manage, distribute, or pass on assets or businesses to heirs.
Access to U.S. Markets and Capital
For international businesses, forming a U.S. LLC can simplify the process of entering U.S. markets. It may also make it easier to open a U.S. bank account, raise capital from U.S. investors, or engage in transactions with U.S.-based businesses.
The most important advantage of incorporation is that it gives its stockholders limited liability. Since the corporation is a separate legal entity, its stockholders are protected from the debts and liabilities of the corporation. This is because, in the eyes of the law, a corporation is a separate entity distinct from its shareholders. In contrast, sole proprietors have no limitation of liability, therefore their personal assets can be used to pay debts of the business. Some other advantages are:
- A corporation can easily established deductible employee benefits such as insurance and retirement plans, profit-sharing and stock options;
- Owners can retain anonymity;
- Capital can be raised through sale of stock. Additionally, the limited liability granted through incorporation appeals to investors who are fearful of personal liability;
- Ownership of a corporation is easily sold or transferred through sale or transfer of stock.
- Tax Advantages
- A corporation has unlimited life. If an owner dies or sells his interest, the corporation will continue to exist and do business.
- A corporation has centralized management, which may remain in place after sale of business.
- A corporation enjoys enhanced credibility to its customers and in the marketplace.
The primary disadvantage to incorporation is the possibility of double taxation. The profits of a corporation are taxed twice – first as income to the corporation, then as income to the shareholder. However, all reasonable business expenses such as salaries and other operating expenses are deductions against corporate income, which can minimize double taxation. Double taxation can be eliminated by instead choosing an S Corporation. S Corporations only pay taxes once at the tax rate of the shareholder(s). S Corporations can deduct the same expenses as a C corporation.
Other disadvantages are the complexity and expense of forming a corporation, and the legal formalities involved with a corporation, all of which can be minimized with Nevada Corporate Planners’ comprehensive assistance.
The act of incorporation creates a separate legal entity whose Board of Directors, officers and shareholders are protected by limited liability. In order to keep this protection intact, the corporation must operate as a separate entity. This means the corporation must do three things properly: follow corporate formalities, have proper capitalization, and under no circumstances may it commingle corporate funds with personal accounts.
If the corporation is sued, it has not done these things properly, and there is not enough money in the corporation to pay off the lawsuit, then the suing party may attempt to go through the corporation and try to seize personal assets. This is called “piercing the corporate veil.”
No. An attorney is not a legal requirement of forming a corporation. However, certain knowledge is necessary in order to properly file the required documentation in the designated state of incorporation. You can use Nationwide Incorporating Services’ guaranteed services to form your corporation, and save a substantial amount of money. However, if you need legal or financial advice pertaining to your corporation, consult your attorney or financial advisor.
Generally, in most states a corporation is only required to have one director, although you can have more. Certain states base the required number of directors on the number of stockholders. If the corporation has three or more stockholders, then the corporation must have at least three directors. If the corporation has less than three stockholders, then the number of directors may be equal to or more than the number of stockholders. The states that have this rule are: CA, CO, CT, HI, LA, ME, MD, MA, MO, NY, OH, VT and UT.
Yes. Shareholders are the owners of the corporation. If no stock shares are issued, then there are no legal owners of the corporation. Shares must be issued to those individuals who will be owners of the corporation. This is the case even if only one individual will own the corporation.
In some circumstances, a corporation can sell shares of stock to investors in order to provide the corporation with its own capital. The sale of securities is heavily regulated by both the state and federal governments, and we recommend that you contact an attorney in your state of incorporation before issuing stock.
There is no minimum number of shares that must be authorized in the Articles of Incorporation, but the corporation may not sell more shares than it is authorized to issue. The number of authorized shares can be increased or decreased by filing an amendment to the Articles of Incorporation with the Secretary of State.
Most states require that a corporation have a Registered Agent who maintains a registered office within the state of formation. This registered office’s address may be different from the corporation’s business address. This individual or service company must be responsible for receiving important legal and tax documents. The Registered Agent must have a valid street address within the state of incorporation, and be available during normal business hours to receive documents.
The services performed by a Registered Agent include, but are not limited to:
- Receiving and forwarding legal documents.
- Receiving and forwarding tax and report forms.
- Accepting and forwarding service of process.
An S Corporation is merely a corporation that has elected a special tax status. This tax treatment permits the corporation’s income to be treated like the income of a partnership or sole proprietorship in that the income is “passed through” to the shareholders. Thus, shareholders report the income or loss generated by the S Corporation on their individual tax returns, avoiding double taxation.
In order to be considered an S Corporation, the stockholders of a properly filed corporation must elect such status within 75 days of formation for the current tax year, or at any time during the preceding tax year. This election is made by filing Form 2553 with the IRS.
The ownership of an S Corporation is subject to certain restrictions. S Corporations can have no more than 100 shareholders, cannot have any non-US resident shareholders and cannot be owned by C Corporations, other S Corporations, many trusts, LLCs or partnerships. In addition, S Corporations are not allowed to own 80% or more of another corporation’s shares.
- Must be a domestic corporation;
- Must have only one class of stock;
- Must not have more than 100 stockholders;
- Stockholders must be individuals, estates or certain trusts.
A C Corporation is merely a corporation that pays tax directly to the IRS.
A C corporation can be contrasted with an S Corporation, which generally doesn’t pay tax. Instead its shareholders (owners) pay tax on their share of the S Corporation’s income.
A Federal Tax Identification Number (also known as an Employer Identification Number, or “EIN”) is used to identify a business entity for taxation purposes. What a social security number is to an individual, the Federal Tax I.D. Number is to the corporation. Generally, any corporation doing business within the U.S. is required to have an EIN. In fact, the EIN is necessary when filing tax returns and for establishing bank accounts.
A corporation can receive an EIN by completing and submitting IRS Form SS-4. However, you can have NCP save you time and paperwork by completing and submitting the necessary EIN form on your behalf.
A corporation is not required to incorporate in the state in which it operates; therefore you can incorporate in any of the 50 states. There are many considerations involved in deciding where to incorporate, including the cost of incorporation, tax laws, and general laws governing the actions and liabilities of corporations. You can choose to incorporate in the state that is most advantageous to you.
Certain issues are involved when determining the proper state in which to incorporate your business. First, you must consider the costs of incorporating in your home state vs. the costs involved in qualifying as a foreign corporation in another state. Second, you must determine the advantages and disadvantages of each state’s corporate laws and tax structure. And of course, there are many others determined by your particular situation.
Filings with the Secretary of State can take from 1-2 days to 4-6 weeks. Although states do not guarantee processing times, they do offer expedited filing service or states that normally take longer.
Once you have decided on the type of entity that’s best for your business, the Articles of Incorporation must be filed with the Secretary of State (or State Division), and you then must obtain an EIN for the corporation through the IRS.
After the Articles of Incorporation are filed and have been accepted by the designated state, your corporation must hold an organizational meeting. At this meeting, acts taken and resolutions adopted by the incorporation director are approved and recorded, the corporate seal is approved, officers are elected and shares of stock are distributed. The necessary record keeping material, corporate seal and stock certificates are all included in NCP’s corporate kit.
Next, you will file the appropriate list of officers/managers with the Secretary of State to put the public on notice to the officers/mangers of the new corporation or LLC. Typically, your corporation must register with your state taxation department. Nevada Corporate Planners will provides a business checklist to ensure that you’re aware of local and state requirements that you must personally fulfill.
You must also open a local bank account, obtain a D.B.A. name (if needed) for your business, obtain a local business license, and determine whether you need a sales tax number or resale number. You should register with workman’s compensation and unemployment divisions for your employees, and check with your CPA for any other tax requirements.
If you have a partner, you should speak to an attorney about a buy-sell agreement. You should also be ready to issue payroll to all employees and officers. Of course, there may be many other steps particular to your situation, such as updating all your material with the new corporate name, contacting any vendors with your new name, etc.
Once a corporation has been legally formed and is ready to complete its organization, it will require a corporate kit to maintain certain of its required records and facilitate stock distribution.
The corporate kit includes:
- Stock Certificates;
- Stock Transfer Ledger;
- Sample Minutes and By-Laws;
- Minute Book/Binder;
- Miscellaneous Forms.
A Corporate Seal is a small press into which a document is placed to be embossed. The imprint made by the seal indicates the corporation’s name, state of incorporation and date of incorporation. At one time, corporate seals were required by all states, though now they are optional in some states. However, a corporate seal’s impression conveys the mark of authority on business documents.
A Stock Certificate is a printed document used to indicate ownership of shares of the corporation.
The Stock Transfer Ledger contains a record of the number of shares that have been issued by the corporation, as well as the dates of issuance, stock certificate number and the person or entity to whom the shares were issued.
Most kits contain sample Minutes and By-Laws to be used as a guide or reference for proper record keeping. Minutes are written records of Board of Directors or stockholders meetings documenting what has transpired. It is extremely important for the corporation to maintain these records in order to prove the existence and validity of the corporate entity.
Incorporation only prevents the Secretary of State from filing a document to create another business entity with the same (or deceptively similar) name as your company’s name. It is the responsibility of the company to protect its name and the goodwill associated with it.
Corporate laws typically require that corporations follow certain formalities, such as annual meetings of shareholders and directors. Corporations are also required to keep meeting minutes and other corporate records, including keeping an original or a copy of the bylaws at the company’s office. In addition, most states require annual or bi-annual filings regarding corporate status. For example, California requires that every domestic corporation file a document called a “Statement” within 90 days after the filing of its original Articles of Incorporation, and every other year thereafter during the applicable filing period. A Statement must also be filed whenever the agent for service of process or the agent’s address is changed. Nevada Corporate Planners helps to ensure that all necessary formalities and filings are maintained properly.
And, of course, the corporation must pay taxes. The amount and calculation of your taxes will depend on your state of incorporation and on the type of business entity you form. Your corporation will be responsible for both income tax and a franchise tax, which is a separate tax levied on corporations for the privilege of doing business in the state of incorporation.
D.B.A. stands for “doing business as”. Your corporation may need a D.B.A. name if it conducts business using a name other than the name set forth in the organizational documents. To get a D.B.A. name, you must file an assumed name certificate with the county clerk in each county in which business premises are maintained and with the Secretary of State.
Delaware is well known in the business community as great place to incorporate. Over half of the Fortune 500 companies are Delaware corporations. Some of the reasons why incorporating in Delaware is so popular are:
1. Low Cost of Incorporation: Delaware has a low cost of incorporation. In addition, no corporate functions need to be held within the state; therefore the founders, shareholders and directors need not visit Delaware to perform any business functions.
2. Low Annual Franchise Tax: The annual franchise tax on Delaware corporations is among the lowest of all the states.
3. No Minimum Capital Requirement: There is no minimum capital requirement for Delaware corporations. Some states require at least a $1,000 capital investment to incorporate.
4. Favorable Tax Treatment: There is no corporate income tax for Delaware corporations that are not transacting business in the state. Shares of stock owned by persons outside of Delaware are not subject to Delaware taxes.
5. No Minimum Number of Participants: One person can hold all officer positions of the corporation (president, secretary, and treasurer) and serve as the sole director. Therefore, if only one person is forming the company, they do not need to bring in other people to “fill out” the corporation.
6. No Residency Requirement: Shareholders, directors, and officers of Delaware corporations need not be residents of Delaware.
7. Efficient Legal System: Delaware maintains a separate business court called the Delaware Court of Chancery that exclusively uses judges appointed for their knowledge of corporate law. This avoids the possibility of having a case in front of a jury unfamiliar with corporate law. Because of this system, Delaware has a well-developed body of law that allows the Court of Chancery to deliver predictable and consistent legal decisions. Delaware also has corporation friendly anti-takeover statutes that limit the ability of other corporations to institute hostile takeovers.
There are many advantages to incorporation in California if your company is located in California and plans to do business there. California corporations avoid having to prepare forms and pay filing fees to qualify to do business in other states. The company will also avoid being potentially exposed to taxation in more than one state, as long as it conducts its business in California.
Nevada Corporate Planners can help you to quickly and easily incorporate in all fifty states.
Dictionary of Terms
When you form your corporation, you can determine what the minimum price per share of stock is going to be. “No par stock” means that you have not set a price on the value per share. This is actually the safest and most flexible way, as you’re not committing yourself to placing a price on an unknown quantity.
In a corporation’s Articles of Incorporation, one of the first articles discloses how much stock is authorized (available to distribute to different people). Each state has different required filing fees based on the amount of authorized stock. Most states don’t really have a limit, but some do. In Ohio, for example, the maximum amount of stock you can have and still pay the minimum filing fee is 850 shares. In Nevada, it’s $25,000 worth of stock. (You can either declare a $1 price per share, or you can have no par value, which they will view as $1 per share. In other words, the $1 per share is the minimum price set; it could be worth more. No par value allows the most flexibility, and is the most conservative way to value the stock. If you want to change the par value later, you must amend your Articles of Incorporation.
The amount of stock available to issue to shareholders.
The amount of authorized stock that has actually been issued to the shareholders and that represents ownership of the corporation.
When an investor puts money up for a corporation, the corporation should ALWAYS DISTINGUISH whether the funds are an investment in the corporation, or whether they are a loan to the corporation. If the funds are an investment, stock should be issued in exchange. If the company does not distinguish between the two, confusion can result down the road when the company’s value substantially grows (or drops) as to whether the investor deserves simple repayment with interest, or an increase or decrease on his/her money commensurate with the company’s new value.
Common stock is typically issued as either voting or non-voting stock. Normally, most companies issue common voting stock, and therefore, “common stock” by default generally means voting stock. A company may have both, however, and would then specify (for example), “25,000 shares of common stock that is made up of 10,000 shares of voting and 15,000 shares of non-voting stock.”
A document that records actions that the directors (or in some cases, stockholders) “resolve” to take on behalf of the corporation. Resolutions may be included as part of the minutes of either directors or stockholders meetings, or they may be included separately into a Resolutions section of the corporate record book.
The degree of business activity that must be present before a taxing jurisdiction has the right to impose a tax on the corporation’s income. There are several ways to avoid creating nexus.
For example, instead of providing a company office in another state for sales personnel (thus creating nexus), a corporation could provide sales reps with an office allowance instead of an actual office. If nexus is established by conducting training sessions or seminars in a state, the corporation could instead send the personnel to a nearby state in which the activity would not create a tax nexus.
1. Public Law No. 86-272: prevents the states from taxing/regulating interstate commerce when the only connection with another state is the solicitation of orders for sales of tangible personal property that are sent outside the state for approval or rejection and, if approved, are filled and shipped by the business from a point outside the state. (This protects only the sale of tangible personal property.)
2. There is a federal limitation on a state’s right to impose income tax on a foreign corporation.
3. States are generally free to regulate intrastate commerce.
A corporation may issue interests in itself that are commonly known as securities. There are several types:
Debt securities, in which the corporation is in debt to the person holding the security, are solicited from public sources are called “bonds” or “debentures.” Bonds/debentures have maturity dates, when the corporation must pay back the face value to the bond holder. The corporation must also make periodic interest charges, calculated as a percentage of the face value of the bond.
1. Corporations can deduct interest payments on debt, while dividends to stockholders are not deductible;
2. Debt repayment has priority over equity contributions. Bills must be paid before distributions;
3. Repayment schedules can be predicted and planned for;
4. Repayment is not taxable income to the debt holder;
5. In the event of the business’ failure, losses are treated as ordinary business bad debt deductions, instead of capital loss from worthless stock;
6. Debt investors have less liability than stockholders. (There is less chance of using Alter Ego Theory on debt holders.)
1. If a corporation has too high of debt-to-equity ration and the debt holders are insiders, the courts might rule that the debt is actually hidden equity ownership;
2. The IRS takes a close look at shareholder loans in order to identify disguised dividends;
3. Corporations with marginal equity may have the claims of stockholder-creditors subordinated by a court.
Equity securities are securities in which the holder has purchased an ownership interest in the business. A corporation issues equity security; it is known as shares of stock in a corporation. To issue stock is to sell corporate securities. When stock is issued it is called “outstanding shares.”
1. Greater potential for growth. Equity securities provide opportunity to raise more money than is possible through debt financing, since most debt financing requires security against corporation assets;
2. Corporations with equity financing are in a stronger financial position;
3. Equity financing eliminates cash-flow problems that can be created by requirements to make interest payments on debt.
1. Dividends are not deductible expenses for the corporation, while they are taxable to the shareholder. This results in double taxation on corporate profits;
2. Dividends are paid only after the corporation has met its other obligations, including debt repayment;
3. Dividends may not be paid consistently;
4. Shareholders more likely to have Alter Ego Theory applied in attempt to pierce corporation veil.
A corporation may not sell its shares for less than stated par value of stock. However, once a third party purchases stock from the corporation, the stock may be sold for whatever price is desired. A corporation may receive only money, property, or service rendered for payment when selling stock.
Any attempt to improperly transfer assets for avoiding lawsuits and liens.
Fraud-in-law or constructive fraud occurs when there is a gift or sale of the debtor’s property for less than fair market value, in face of a known liability, which renders the debtor insolvent or unable to pay creditor.
Fraud-in-fact or actual fraud occurs when creditor proves that the debtor intended to hinder, delay or defraud its creditors.
Creditors must act within a specific time frame to challenge a transfer under fraudulent conveyance statutes. Most states have statute of limitations of four years after the transfer is made or the debt incurred, or one year after it could have reasonably been discovered, whichever occurs last.
Any transfer of assets needs to be supported by legitimate business reasons, and the transfer must be made prior to any event or situation that results in a lawsuit. Where a transfer is found fraudulent, the court can force transfer of asset to creditors. If the party who receives the fraudulent transfer is an innocent third party, unaware of intent, he/she can place a lien against the transferred asset up to the amount paid.
An agreement between shareholders of a privately held corporation and the corporation itself, made to govern the operations of the corporation and to define how shares of stock will be transferred. In small corporations, such an agreement can be used to set estate tax value of stock, define what happens if a shareholder is disabled, restrict the transfer of stock to outsiders, and the like. It can also protect the corporation against a disqualifying act and provide other mechanisms for maintaining and ending S Corporation status.
A type of business entity contrasted to corporations and characterized by:
1. Limited Liability to protect owners from being personally liable for debts of the business;
2. Pass-through taxation to avoid the potential of double taxation of C Corporations;
3. No restrictions on permitted owners, eliminating the restrictions of S Corporations;
4. No restrictions on active participation to ensure that unlike limited partnerships, all owners could be active in managing the business without jeopardizing their initial limited liability protection;
5. Operational flexibility to let owners structure the management in a way that satisfies the concerns and requirements of each business;
6. When founding members liquidate assets from an LLC, it is generally not a taxable event for the LLC. With the C Corp it is taxable at the corporate level and shareholder level.
7. An LLC is more desirable and flexible than an S Corp because pass-through losses under an LLC can be allocated separately to members;
8. An S Corporation does not allow for a step-up in tax basis of the S Corporation’s assets on the death of a shareholder and can result in shareholder tax liability upon liquidation. Finally, there are restrictions on shareholders that exist in an S Corporation. These can all be avoided by the LLC.
9. An LLC has distinct advantages over a Family Limited Partnership. The members of an LLC can actively participate in the management of the LLC without losing the limited liability protection. Not so with an FLP. In an FLP, a general partner is appointed to handle all management decisions without participation of the limited partner(s).
10. Hence, the general partner has full and complete personal liability for any debts or obligations of the partnership itself. In an LLC the manager is not personally liable for the debts or obligations of the LLC.
11. An interest in the LLC is personal property and a creditor who seizes an LLC interest by way of a charging order cannot automatically reach the assets of the LLC. (LLC must be taxed as a partnership)
12. A creditor who seizes an LLC interest does not automatically become a member and is therefore not entitled to exercise management powers with respect to the LLC.
13. There are no corporate formalities
Assets to be placed in LLC: Safe assets (those which do not create lawsuits, ie Insurance policies, Valuable patents/copyrights, Securities, Investments); also Equity in Furnishings, Equipment and other forms of personal property which can cause a lawsuit and in all forms of Real Estate.
COMPONENTS: Articles of Organization, Operating Agreement, Ownership Interests which may be in certificate form (similar to stock)
ISSUES TO BE ADDRESSED IN AN OPERATING AGREEMENT:
1. Member Managed or Manager Managed
2. The LLC’s Capital Structure
3. Member’s Withdrawal Rights
4. Rights to Transfer Membership Interests
5. Member’s Rights
6. Financing Mechanisms
7. Duration of Life
8. Whether members get specific distributions to pay taxes on income earned but not distributed
A sole proprietorship is the simplest form of business. It’s not a separate entity. Instead, as a sole proprietor, you own the business and you are directly responsible for its debts. Just remember that whenever you do something the “simplest” way, it’s typical for your results to be directly proportional to the effort required.
Management and Control: As the business owner and sole proprietor, you retain complete management and control over your company. However, the price you pay for total management and control is near totalrisk for personal liability incurred through the acts of your agents or employees.
No Formalities: With the exception of complying with applicable licensing requirements, you’ll find no formalities required of a sole proprietorship. However, when you conduct business under a name that does not show your surname, or that implies the existence of additional owners, your state may require that you file a fictitious business name statement and publish notice. If your name is Joe Smith and your business is called “Joe Smith’s Services” you won’t have to file. If you name your business “Joe’s Services”, “Smith’s Services” or “Smith and Sons”, chances are good that you will have to file. And, if you want to deduct your expenses, you’ll still have to log them into a diary format on a timely and consistent basis-no matter which entity form you choose.
Transferability: As the owner of a sole proprietorship, you can sell your business at will.
Duration: The sole proprietorship remains in existence for as long as you are willing, or able, to stay in business.
A general partnership is a business entity in which two or more co-owners engage in business for profit. For the most part, the partners own the business assets together and are personally liable for business debts.
Liability for a Co-Partner’s Debts: Each general partner is deemed the agent of the partnership. Therefore, if you, as a partner, are apparently carrying on partnership business, all of your general partners can be held liable for your dealings with third parties.
Liability for a Co-Partner’s Wrong Doing : Each partner may be held jointly and severally liable for a co-partner’s wrongdoing or tortuous act (e.g. the misapplication of another person’s money or property).
Sharing Profits: If you don’t have a formal partnership agreement, profits are shared equally among partners. A partnership agreement, however, usually provides for the manner in which you and your partners will share profits and losses.
Duration: Technically, a partnership terminates upon the death, disability, or withdrawal of any one partner. However, most partnership agreements provide for these types of events by allowing the ownership rights of the departed partner to be purchased by the remaining partners.
Management and Control: In the absence of a partnership agreement, each general partner has an equal right to participate in the management and control of the business. Disagreements in the ordinary course of partnership business are decided by a majority of the partners. Disagreements of extraordinary matters and amendments to the partnership agreement require the consent of all partners.
Transferability: Unless otherwise provided in the partnership agreement, no one can become a member of the partnership without the consent of all partners. However, as a partner, you may assign your share of the profits and losses, and your right to receive distributions (“transferable interest”). Further, a partner’s judgment creditor may obtain an order charging the partner’s “transferable interest” to satisfy a judgment.
In a Limited Partnership, one or more “general” partners manage the business while “limited” partners contribute capital and share in the profits but take no part in running the business. General partners are personally liable for partnership debts, while limited partners incur no liability with respect to partnership obligations beyond their capital contributions. One way to reduce the personal liability of a General partner is to form a second entity to serve as the General partner of a limited partnership. Typically, you can use an S Corporation or LLC as the General partner. When that happens, the amount that the General partner can lose is limited to the value of the assets in the S Corporation or LLC. This method brings more operating expense to the limited partnership, but that can be overcome with an LLC taxed as a limited partnership. The purpose of a limited partnership is to encourage investors who will be risking no more than the capital they have contributed.
Another potential problem with the limited partnership is that limited partners can lose their limited liability protection if they become too actively involved in managing the business. This potential means that limited partnerships are not suitable for activities where all the partners are heavily involved in the business.
Duration: Death, disability, or withdrawal of a general partner dissolves the partnership unless the partnership agreement provides otherwise, or unless all partners agree, in writing, to substitute a general partner. Note that the death or incompetence of a Limited Partner has no effect on the partnership.
Formalities: You’ll find that setting up and operating a limited partnership brings with it the same formalities as when you’re starting a small, for-profit corporation. Most states require that you file a certificate with the Secretary of State, who applies restrictions on the use and availability of partnership names, and sets forth statutory requirements that dictate how you add new limited partners and replace general partners.
The label “C Corporation” refers to a regular, state-formed corporation. To form a corporation, you must file Articles of Incorporation and pay the requisite state fees and prepaid taxes with the appropriate state agency (usually the Secretary of State).
Management and Control in Corporations: Normally, a corporation’s management and control are vested in the board of directors who are elected by its shareholders. Directors generally make policy and major decisions regarding the corporation, but do not individually represent the corporation when dealing with third persons. Instead, officers and employees, to whom directors delegate authority, conduct all dealings with third persons.
Shareholders: Shareholders are the owners of a corporation. Other corporations, such as an LLC, or foreign individuals or foreign companies, may own a C-corporation. S-corporations aren’t granted this same leeway.
Board of Directors: The Board of Directors is responsible for the corporation’s management and policy decisions. There are, however, a few instances when the shareholders are required to approve the actions of the Board of Directors, such as an amendment to the Articles of Incorporation, the sale of substantially all corporate assets, or the merger or dissolution of the corporation.
Corporate Officers: Corporate officers, elected by the Board of Directors, are responsible for the day-to-day operational activities of the corporation. Corporate officers usually consist of a President, Vice-President, Secretary and Treasurer.
Number of Persons Required: In most states, one or more persons may form and operate a corporation. Some states, however, require that the number of persons managing a corporation be at least equal to the number of owners. For example, in certain states, if your corporation has two shareholders, it must also have a minimum of two directors.
Fringe Benefits: Corporations may offer employees unique, and deductible, fringe benefits. Also, a C-corporation employer can deduct the cost of a qualified educational assistance program, and employees can exclude up to $5,250 of such benefits from taxable income each year-but there is a restriction on this benefit. No more than 5% of the amounts paid by the employer may be provided for employees who are also more than 5% shareholders. Corporate-defined benefit plans often afford better retirement options and benefits than those offered by non-corporate plans.
Lower Marginal Tax Rates: C-corporations have overall lower tax rates than pass through entities like partnerships and S-corporations. Even at higher levels of taxable income, the current tax cost of operating as a C-corporation is generally lower than the tax cost of operating the same business in the form of a pass through entity. Specifically, a C-corporation will pay 21% percent Federal tax on profit, which is much less tax than you’d pay if that same level of profit flowed through a pass through entity to your personal tax return. The key is to avoid or reduce double taxation, which must be taken into account if you’re considering a C-corporation.
Corporate Formalities: If you want to retain the corporate existence, limited liability benefits, and special tax treatment, you must observe corporate formalities. If you’re the owner of a one-person corporation, you’ll find that you must wear different hats depending on the occasion. For example, as a one-person corporation, you will be responsible for being the sole shareholder, Director, and Officer of the corporation. You’ll have to hold annual meetings, take (and keep) corporate minutes of the meetings, appoint Officers, and issue shares to yourself.
Shareholder Liability for Corporate Debts: Where corporate formalities are not observed, shareholders may be held personally liable for corporate debts. So if you create a thinly capitalized corporation, commingle funds with employees and officers (using corporate funds to buy personal items and vice versa), fail to issue stock or hold meetings, or if you fail to follow other corporate formalities required by your state of incorporation, a court or the IRS may “pierce the corporate veil,” and hold the shareholders (you) personally liable for corporate debts. Domiciling your corporation in Nevada will help protect your corporate veil, perhaps better than your state of operations. Typically, your Nevada Corporation would register to do business in the state of operations as a “foreign corporation.”
Duration of a Corporation: As a separate legal entity, a corporation continues indefinitely. Its existence is not affected by death or incapacity of its shareholders, officers, or directors, or by transfer of its shares from one person to another.
Right to Counsel: While a corporation cannot be imprisoned, criminal action may result in fines and penalties that could harm shareholders, officers, and other persons, which gives a corporate criminal defendant the Sixth Amendment Right to Counsel. But beware! Because a corporation faces no risk of incarceration, it has no right to appointed counsel if it cannot afford to retain private representation.
Tax Losses: Tax losses incurred by a corporation are not passed through to the shareholders. Instead, a C-corporation’s net operating losses (NOLs) are used to offset corporate taxable income earned in the 2 years preceding the NOL year, or in the 20 years following the NOL year. You may be in a situation where you don’t need the losses personally, and it might be more advantageous to carry them over into the following year of the C-corporation, when taking the loss will be more profitable. NOLs are only one of several factors you should consider when examining the pluses and minuses of a C-corporation for your business.
Generally, S Corporations may have a maximum of 100 shareholders, and those shareholders must be individuals, although certain types of trusts and estates may qualify as a shareholder. Once your corporation makes the Subchapter S election to become an S Corporation, profits and losses are passed through and reported on the individual shareholders’ tax returns. This is the same basic “pass-through” treatment afforded partnerships and LLCs. The key distinction of the S Corporation is that profits and losses are not taxed at the corporate/business level like they are if the business operates as a C Corporation.
IRS Filing: The S Corporation must complete and file IRS Form 1120S to report its annual income to the IRS each year.
General Shareholder Requirements: ALL shareholders of the S Corporation must be U.S. Citizens or have U.S. Residency Status. If for any reason S Corporation shares are sold or transferred (even if by will, divorce, or other means) to a shareholder who is a foreign national, the corporation will lose its S Corporation status and will be treated as a C Corporation. This also means that C Corporations, foreigners, or LLCs taxed as limited partnerships cannot be owners of an S Corporation. This is important to know as it may affect your future investment options should your business require additional investors.
Only One Class of Stock: S Corporations may issue only one class of stock, which becomes a problem when you need investors.
Losing S Corporation Status: An S Corporation that loses its status may not re-elect S Corporation status for a minimum of five years.
Who Should Elect S Corporation Status: In general, if you want the limited liability of a corporation and the “pass-through” tax-treatment of a partnership, consider making the S Corporation election.
Adjust Basis: If a partnership makes an IRC §754 optional basis adjustment election, a purchaser of an interest of that partnership can “step up” the tax basis of his or her share of appreciated assets to reflect the purchase price. This privilege is NOT available to S Corporations and their shareholders.
Tax Year-End: S Corporations are generally required to use a calendar year-end for tax purposes (December 31st), whereas a C Corporation may use a fiscal year-end instead.