When I had to create an international corporate entity for a U.S. based LLC company, the foreign corporate regulators were perplexed when I cited that the U.S. parent company was a Limited Liability Company (LLC). They were accustomed to U.S. versions of Inc., Corp. or Company filing international corporate registrations but what was a LLC? Or its cousin, Subchapter S corp.? For many countries’ regulators, I discussed with them the distinguishing charateristics. Let us begin with a standard corporate entity – or better described as the C corp.
A C corp. is a legal separate entity, created by registration with a Secretary of State in any 50 states within the United States. To maintain its legal existence, the C corp. must pay its annual taxes and strictly manage the company under its Bylaws. It must create a Board of Directors and issue shares. As a separate entity, it must survive as such. It has assets which forms its corpus and its income is its lifeblood. Whenever the C corp. is being sued, the litigant has only has access for recovery to the assets to the C corp., not to the shareholders. The officers and shareholders would never have their personal assets at risk. There is an exception – piercing the corporate veil – and that occurs when the formality of C corp. management had never been maintained.
Another important characteristic of the C corp. is tax structure. C corp. has a separate tax rate, different from the individual. And if the C corp. has employees, the employees are taxed separately with the individual rate. Hence, if there is only a single employee within the C corp., the individual is being taxed as a corporation and as individual – or commonly known as double taxation. Meanwhile, individuals or small businesses wanted the protection of their personal assets by using the C corp. entity, but did not want to inherit the double taxation treatment. Then they lobbied to change that tax regime for C corps.
So the U.S. Congress, in its infinite wisdom, created the Subchapter S corporation for small business enterprises looking for the protection of the C corp. without paying the corporate tax rate, just the individual rate.
States instead developed their counterpart, the Limited Liability Corporation. Of course, the Europeans were confused – where they still had long established corporate entities. Now they were reviewing two different corporate entities not existing within their borders. And the LLC and the Sub S are different in how they are created as well as their operations.
A Subchapter S corporation is created by registering the standard C corp. with a State but filing an IRS form converting that C corp. into a Sub S corporation. It is a tax restructure that permits shareholders to avoid double taxation by allowing the corporate income flows directly to the shareholders. Congress did set some additional rules to remain a Sub S corp. There would be limited number of shareholders and only one class of shares, the tax advantage only applies to U.S. citizens, and other restrictions — e.g., shareholders who work for the company must be paid a salary. Since the company has regular shareholders, it also maintains the standard C corp. governance rules and structure including Bylaws. And the individual personal assets do not face any risk under this legal structure.
LLC is a state created animal. Instead of shares, it distributes units. As a substitute for Bylaws, it relies on an operating agreement. The operating agreement provides some framework for an officer to manage the LLC but nowhere as strictly disciplined as a C corp. Bylaws. Of course, it allows pass through of taxes to individuals. Unit holders are not necessarily employees. There are no limit to the unit holders or the number of units. And, like a C corp. or the Sub S, the personal assets of the unit holders are not at risk.
Again the LLC and Sub S entities are meant for small, family owned companies that needed to avoid the double taxation. They are not designed for larger corporate entities. In fact, there are no LLC or Sub S companies publicly traded on NASDAQ. Therefore, an ISO program would make sense in the long run for a C corp. since the long term objective is to award shares which value will increase when publicly traded.