What is the Difference Between an LLC and a Corporation?
One of the first steps when starting a new business is to decide whether you should form an LLC or a Corporation. Understanding the differences between the two will ensure the structure you choose for your business is the right one. There are five major considerations to take into account: Ownership, Management, Liability, Taxation, and Ongoing Compliance.
The owners of an LLC are called “members.” Each member owns a “membership interest” in the LLC, which just refers to their percentage of ownership. The LLC has the flexibility to distribute the percentage membership interest to each member as it sees fit. There’s no requirement to distribute ownership evenly between the members. There’s also no requirement to have the membership interest reflect the member’s actual financial contribution to the LLC. Each member’s membership interest is outlined in the LLC’s Operating Agreement. If the LLC only has one owner, or member, it is a Single Member LLC, and the single member owns 100% of the LLC.
LLC members can be individuals, other corporations, or any kind of trust.
The owners of a corporation are known as “shareholders.” Shareholders can be individuals, institutions, or other corporations. The percentage of ownership each shareholder has in the corporation is reflected in the number of shares of stock assigned to them. Shareholders can transfer shares, purchase additional shares of stock to own a larger percentage of the Corporation or sell shares of stock to own less.
LLCs can be managed by its members or a group of managers. In a member-managed LLC, the owners oversee the day-to-day operations of the business. In a manager-managed LLC, one – or a few people – run the business.
A corporation is managed by both a board of directors and corporate officers. The board of directors represents the shareholders and makes decisions about distributing dividends, hiring and firing personnel, and compensation of company executives. The corporate officers are responsible for the company’s day-to-day operations.
Although shareholders are owners of the corporation, they are not involved in the decision and operations of the business. However, shareholders have the power to elect directors and can be elected as a director or appointed as an officer. The rules governing a corporation are set out in the company’s bylaws.
Both LLCs and Corporations offer limited liability protection. This means your personal assets are protected if your business ends up in a lawsuit or with substantial business debts.
An LLC is liable for the debts and liabilities only incurred by the LLC. This means the LLC’s creditors can go after the LLC’s bank accounts and any property owned by the LLC, but they generally can’t touch the personal assets of the owners of the LLC.
Corporations themselves do not have limited protections, but the corporation does shield the shareholders’ personal assets from being used to resolve business debt or becoming an issue in a lawsuit against the corporation.
One of the biggest differences between an LLC and a Corporation is how they are taxed.
An LLC is taxed as a “pass-through” entity. The profits are “passed through” to the members. Therefore, the LLC itself does not pay federal income tax. Any of the LLC’s profits or losses are reported on the member’s individual tax returns, not on the LLC’s tax return (it doesn’t have one). The losses and/or operating costs of the LLC can also be deducted on the individual owner’s tax returns, making filing taxes easier than doing so for a Corporation.
In addition, the IRS allows the LLC owners to choose the way the LLC is taxed. The four options are: sole proprietor (for Single Member LLCs), partnership, corporation, or S-corporation.
Unlike an LLC, a Corporation files its own tax return. Corporations are taxed as a separate entity from their shareholders. Corporations pay tax on their profits, and also pays tax on any dividends it distributes to its shareholders (and the shareholders have to report and pay personal income taxes on these dividends).
A Corporation is also limited as to the way it is taxed. By default, corporations are taxed by the IRS as C-Corporations. If a Corporation wants to avoid paying taxes on dividends and then have the shareholders also pay personal income tax on those dividends, the Corporation can elect to be taxed as an S-Corporation. The S-Corporation doesn’t pay corporate income tax in this case. The profits pass through to each shareholder, and the shareholder pays individual taxes on their share of the profits. To be taxed as an S-Corporation, there are also additional qualifications that must be met.
LLCs have very few “internal” compliance requirements. Basically, keeping the Operating Agreement up to date with amendments as needed, issuing membership interests, and holding annual meetings in accordance with the Operating Agreement is good practice.
External requirements (those required by the state) are also fairly simple. Most states require the LLC file an Annual Report, Statement of Information, or Biennial Report, along with an annual fee or a franchise tax. As long as the state filings are kept up to date, and all taxes are paid on time, the LLC will remain an active business entity (“in good standing” with the state).
Unlike LLCs, Corporations have more stringent inherent requirements:
- Bookkeeping: Corporations must establish and maintain their records and books. These include corporate minute books, shareholder records, and accounting ledgers.
- Board of Directors: The shareholders must elect a Board of Directors, who decide how the company runs.
- Board Meetings: An initial meeting involving the Directors and Shareholders is usually required, and then board meetings must be held at least annually thereafter.
- Meeting Minutes: Corporations must also keep official records of all decisions and actions discussed and resolved in their meetings.
Corporations also have external requirements. They, too, must also file an Annual Report, Statement of Information, or Biennial Report, along with the state-required annual fee/taxes. However, Corporations are subject to additional requirements, depending on state law. For example, some states require the Corporation keep their meeting minutes on file for a certain amount of time. Some states require shareholder meetings to be held on an annual basis. Many states require that the Corporation tracks and keep records regarding any sale of stock within the corporation, regardless of whether the business is publicly traded or not.
Considerations for Choosing an LLC or Corporation
|Ownership||*Flexibility to assign membership interests to the members.
*Membership interest amount does not have to reflect the owner’s financial contribution to the LLC.
*Owners can be individuals, other corporations, and any kind of trust.
|*Ownership percentage is directly reflected by the number of shares owned.
*Shareholders can be individuals, institutions, or other corporations.
|Management||*Managed by the members (owners) of the LLC
*Managed by a manager/group of managers assigned by the members to oversee the operation of the LLC.
|*Managed by a Board of Directors and the Corporate Officers.|
|Limited Liability||*Protects the owner’s assets (home, bank accounts, and other personal property) from being used to pay off business debts after bankruptcy or a lawsuit.||*Protects the shareholders from being personally liable for business debts.|
|Taxation||*Pass-through taxation so each member reports the profits/losses on their individual tax return.
*Flexibility with regard to choosing how the LLC is taxed: As a sole-proprietor (for Single Member LLCs), or as a partnership, C-Corporation, or S-Corporation.
|*Taxed as a separate entity from its shareholders, and files its own tax return.
*Can choose to be taxed as a C-Corporation or S-Corporation (as long as it meets additional requirements).
|Ongoing Compliance||*Few “internal” compliance requirements (keeping Operating Agreement current).
*Few “external” compliance requirements (filing a state annual report / paying state annual fee/taxes).
|*More complex “internal” compliance requirements.
*Subject to additional “external” compliance required by the state than LLCs.