Selecting Your Business Entity: Corporations vs. LLCs
Our firm has helped form hundreds of companies for every type of business operation: from consulting and manufacturing to international distributions. No matter the size of the company or the amount of funding that it has, every founder has to make an initial choice: whether to form a corporation (Inc.) or a limited liability company (LLC) under state law.
Is there one right form?
No, not really. There are very real differences between the two types of entities, and each founder or group of founders must analyze the various features before deciding between the two. Note that this article does not discuss general partnerships, limited partnerships, or sole proprietorships which are options for certain specific types of business. But for the purposes of this discussion, we will focus on the main two being utilized—an Inc. vs. an LLC.
In what ways are the different types of companies also similar?
Both corporations and LLCs provide limited liability for their owners. This means that either form of entity limits the risks of the business to the business itself and its assets while protecting the assets of the owners from those risks. However, either of these entity types can lose that protection if the owners fail to run the company separately; or mingle company and individual funds.
Either form of entity can be used for every kind of business operation; although corporations have been around since the 1600s and LLCs have only been in common use for about 30 years. This means that the laws and cases are much more developed when it comes to corporations.
Certain industries have their preferred form of entity. As an example, most real estate companies are formed as LLCs; while technology companies that intend to go public will almost always be formed as corporations. Additionally, most foreign-owned companies are usually formed as corporations since it is a format that is more familiar to international owners. Currently, over two-thirds of all new companies are formed as LLCs because of the flexibility they provide to managers and owners.
Taxes and tax elections
A corporation can only be taxed as a corporation— either a “C” or an “S”—while an LLC can elect to be taxed as a C corporation, an S corporation, or a partnership. However, once an election has been made, converting to a different form of tax entity will result in tax issues regardless of the form of entity. Either type can choose to be treated as a disregarded entity for tax purposes.
The distinction between selecting the form of business entity under state law versus selecting the entity type for tax purposes is a common area of confusion. Although LLCs are usually taxed as partnerships and that is the default tax election, they can also choose to be taxed as corporations.
Management and owners
Corporations must have a board of directors and officers under state laws that govern business entities. LLCs have more flexibility and can either be managed by their owners known as members or managers. LLCs can also be set up like a corporation and choose to have directors and officers. In general, corporations have more formalities that must be followed, whereas LLCs have more flexibility in how they are managed and operated.
The owners of a corporation, known as shareholders, only participate in certain decisions with most major decisions resting with the board of directors. Members of an LLC can run a company themselves or delegate some decision-making to the LLC’s managers and retain rights for themselves. In this regard, an LLC’s most important document is the operating agreement which outlines the various roles of members, managers, officers, and/or directors; and which divides the responsibilities and rights between them.
A corporation must establish the number of shares it can issue in its publicly filed Articles of Incorporation, and any changes to that share structure must be made by an amendment to the public filing. A corporation must issue shares. An LLC can choose to use ownership percentages for its members or issue shares like a corporation. The ownership structure is set out in the internal operating agreement which is not filed with any public body. Corporations are restricted under state laws on when and how distributions can be made to shareholders, including limiting distributions to be made from surplus funds or net profits. Additionally, different classes of shareholders in corporations must have the same rights. But members of LLCs can have differing economic and control rights which can be established in that all-important operating agreement.
The two most popular forms of business entities are corporations and limited liability companies. Corporations have a long history; but LLCs are the newer and more popular form of entity, and also provide more flexibility to its owners and managers. Each of them has its advantages and disadvantages. Accordingly, the founders should review the various differences before making the final selection.
Business Insights is hosted by the Law Firm of KPPB Law (www.kppblaw.com).
Sonjui L. Kumar is a founding partner of KPPB Law, practicing in the area of corporate law and governance.
Disclaimer: This article is for general information purposes only, and does not constitute legal, tax, or other professional advice.
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