Should I form a corporation or an LLC?
One of the biggest questions we get involves whether an entrepreneur should form a limited liability company (LLC) or a corporation when starting their business. We have previously written about different types of entities and provided an overview of several types of entities, including corporations and LLCs. This post focuses exclusively on the differences between corporations and LLCs.
Both corporations and LLCs allow business owners to take advantage of limited liability. This is probably the biggest reason to form a separate entity (rather than conducting business as a sole proprietorship or a general partnership) and both types of entities will limit the possibility of personal liability for equity holders. It is important to note that, in order to take advantage of limited liability, businesses need to maintain corporate formalities. This includes holding annual meetings, maintaining a separate business bank account, having appropriate internal governance and appointing officers and members of a managing body. Without these corporate formalities, individual business owners could lose their limited liability protection and be held personally liable for business obligations.
Equity holders in an LLC share in the ownership of the assets, profits and losses of the LLC. They are referred to as members.
Equity holders in a corporation own shares of stock in a corporation. They don’t actually own the assets; the corporation owns the assets and the holders own a portion of the corporation via their shares. They are referred to as shareholders or stockholders.
By default, an LLC is taxed as a pass-through entity. This means that members are only taxed once at the individual level and profits and losses are reported on individual tax returns for each member. Business owners can deduct losses on their personal tax returns. If there is only one member in the LLC, the IRS will automatically tax the LLC as a sole proprietorship and, if there are at least two members, the IRS automatically categorizes the LLC as a partnership. This doesn’t impact the limited liability protections we’ve mentioned above; instead, it creates a taxation structure that allows for pass-through taxation for the members (meaning the LLC never pays tax on its income, the members do). Some drawbacks to this structure are that some members (like investors) may not want the additional tax burden. And, members of the LLC cannot receive salaries; instead, they would receive distributions from the LLC directly.
A corporation is taxed (under Subchapter C) on annual earnings as a separate legal entity and the individual shareholders are also taxed on dividends they receive from the corporation. This is commonly referred to as “double taxation.” In a corporation, shareholders can receive salaries as employees. An LLC can elect to be taxed as a corporation.
In addition, corporations and LLCs may elect to be taxed as an S-Corporation. An S-Corporation isn’t a type of legal entity (i.e., you can’t file Articles of Incorporation with the Secretary of State to become an S-Corporation); rather, S-Corporations are a specific tax classification (under Subchapter S) which allow for pass-through taxation and the payment of salaries to employees to equity holders. However, there are some restrictions on who can hold equity in an S-Corporation so it may not always be an option for certain businesses (for example, an S-Corp cannot have institutional shareholders, often making it a bad choice for an entity seeking outside investment). A good corporate attorney and CPA can provide more insight into which structure is the most advantageous.
Corporations have rigid structure and management requirements. The shareholders will elect a board of directors that oversees high-level decisions. The directors appoint officers (such as a CEO or Secretary) who are responsible for specific day-to-day activities and can act on behalf of the corporation based on their duties.
An LLC can have much more flexible structure and can either be member-managed or manager-managed. In the former, each of the members participates in the management of the LLC and has the ability to act on behalf of the company. In the latter, a separate person or group of people is appointed to serve as managers of the LLC. In this structure, only the managers are allowed to act on behalf of the company and it is similar to the more formal corporation structure.
Corporations are perpetual by default which means that they are not automatically dissolved if all of the directors and employees leave the company. This can provide a significant advantage for shareholders who value consistency.
By default, LLC’s can automatically be dissolved under certain circumstances. These circumstances vary state by state but typically include the death or resignation of a member or failure to comply with applicable laws. Automatic dissolution can be a significant downside for members who want to maintain the LLC in spite of changing circumstances. If the LLC has an Operating Agreement, events triggering automatic dissolution can be limited and give the members some additional peace of mind.
Is it easy to change from one type to the other?
Converting from one entity to the other is relatively easy and straightforward with the help of an experienced corporate attorney. In each case, the managing body and equity owners will need to approve the conversion. The resulting entity will need formation documents including the official formation document filed with the Secretary of State as well as internal corporate governance documents (such as Bylaws or an Operating Agreement) and equity documents (such as Stock/Unit Purchase Agreements). As the business continues to grow and increases the number of equity holders, this can become a more complicated process so it’s important to think through long-term goals and how choosing the right corporate structure at the outset can complement those goals.