Just what IS a limited liability company? Part 3. It’s not a corporation.

[This is the third post in a seven-part series discussing the characteristics of limited liability companies and comparing them to the characteristics of corporations, general partnerships, and sole proprietorships. Here’s the entire list.

Part 1. Background on sole proprietorships.
Part 2. Background on partnerships.
Part 3. Background on corporations.
Part 4. LLCs are distinct legal entities, separate from their owners.
Part 5. A limited liability company’s owners are not liable for the LLC’s obligations.
Part 6. Options for an LLC’s management structure.
Part 7. Options for an LLC’s tax treatment.]

iStock_000006606955XSmall.jpgLet’s get back to our trek toward a discussion of the basics of limited liability companies. The first two types of business structures we’ve looked at — sole proprietorships and partnerships — have two significant features in common. First, the owner or owners are liable for the obligations of the business. Second, the business itself does not pay taxes. Instead, the income and other tax items are “passed through” to the owner or owners, who pay tax on the income. Things change with corporations, the third type of business structure.

Although corporations are not as old as sole proprietorships or partnerships, business organizations with at least some of the characteristics of corporations have been around for centuries. For example, the oldest corporation in North America, Hudson’s Bay Company, was incorporated in 1670.

Perhaps the most important feature of a corporation is that the owners of the corporation — called stockholders or shareholders — are NOT liable for the obligations of the business. And that’s very good news for people who owned stock in Lehman Brothers, which melted down into the largest bankruptcy in American history. Or, going back a little further to previous record holders, people who owned stock in Enron and Worldcom. Even though the people who owned stock in those corporations may have lost everything they invested, they were not liable to the corporations’ creditors, and they did not get pulled into the corporate bankruptcies. That protection against shareholders being held liable for the corporation’s obligations is sometimes called a liability shield or a corporate veil, and it doesn’t exist for sole proprietorships or general partnerships.

Taxation for corporations is also different. There are two different systems under which corporations can be taxed. The default system is found in Subchapter C of the Internal Revenue Code, and corporations taxed under Subchapter C are generally called (what else?) C-corporations. Unlike sole proprietorships and partnerships, C-corporations pay taxes at the corporate level. Then the shareholders pay taxes again on any dividends that the corporation distributes to them. That two-tier level of taxation is generally called (what else?) double taxation.

But there’s another option, at least for some corporations. If the corporation meets certain eligibility requirements — for example, it may not have more than 100 shareholders — it can elect to be taxed under Subchapter S. Corporations that have made that election are called (what else?) S-corporations, and they do NOT pay corporate taxes. Like partnerships, S-corporations are pass-through entities, with the corporation’s income taxed only at the level of the owners, although the tax rules that apply to S-corporations and those that apply to partnerships differ significantly in their details.

Corporations also differ from sole proprietorships and partnerships in another significant way. Sole proprietorships and general partnerships are controlled, and often managed on a day-to-day basis, directly by the owners. In contrast, corporations are controlled by a board of directors, who then delegate the day-to-day management of the company to officers and employees of the corporation. Technically, the only authority that corporate shareholders have to control the business is to elect the board of directors.

Of course, the owners of many small corporations do, in fact, control the organization and manage the business, but they do so by electing themselves to the board of directors and appointing themselves as officers. Even so, it is vitally important that the owners of a corporation do not cut corners with those formalities of corporate governance. Shareholder meetings must be held (at least on paper); directors must be elected; and officers must be appointed and act only within their authority as established by the articles of incorporation, bylaws, and resolutions of the board of directors. As I’ll discuss in future blog entries, business owners who ignore those corporate formalities run the risk of losing the protection of the liability shield. In essence, if the owners of a corporation do not honor it as a separate entity, apart from themselves, a court may not either. Creditors of a corporation who succeed in reaching the personal assets of owners who have neglected the corporate formalities are said to have “pierced the corporate veil.”

To reduce the burden of observing the corporate formalities, owners of smaller Indiana corporations may consider taking advantage of a provision in the Indiana Business Corporation Law that permits corporations with no more than fifty shareholders to dispense with a board of directors altogether and assume control of the corporation directly by putting special provisions in the articles of incorporation. In addition, dispensing with the board of directors also calls for provisions in the bylaws and possibly shareholder agreements that are outside the ordinary. Failure to include provisions that are appropriate for your particular business creates its own risk of losing the liability shield, as well as inviting disputes among the owners that may make it impossible for the business to operate profitably, or even to operate at all.

If you are an owner of a small, closely held corporation, and you would like to discuss your corporation’s tax status or corporate governance with an attorney, please feel free to call our Business Law Division in Fishers for an appointment.