(This article is part of a series. You may also want to read our guide How To Incorporate in California.)
A corporation and a limited liability company (LLC) both offer liability protection. The main differences between them reside in how the ownership of each business entity is arranged, and how income is disbursed. In practical terms, this comes down to management and taxation.
Both a corporation and an LLC protect their owners from personal liability for the actions of the company, such as debts and lawsuits. However, neither legal entity is intended to shield an individual from criminal liability.
A corporation can be bankrupted, and its owners - the shareholders - can find their stock holdings in the company worth nothing. But legal actions generally can't reach any further, or "pierce the veil" of corporate protection, to claim the personal assets of individuals.
The LLC is at root a partnership, but one that has been given the same liability protections as a corporation. Owners of a company formed as an LLC - the members - can generally only be reached by legal claims to the extent of their capital contributions in the company, and no further.
A corporation has a defined management structure, with a board of directors handling management decisions and officers handling daily tasks. The shareholders elect directors and vote in major corporate decisions, but are otherwise separated from the actions of the company. Corporate governance requires regular meetings, with minutes to be recorded.
An LLC is more flexible in management and governance. No meetings or minutes are required, no officers beyond one managing member are required, and members can be designated as managers very simply through the entity's operating agreement. Also, voting rights and income distributions can be custom-tailored to each individual member through the operating agreement, regardless of capital contributions made.
By contrast, corporate voting rights and profits received as dividends, as well as priority of claim on the company's assets, all flow from different classes of stock issued by the corporation, and shareholders are constrained in this regard to the stock they hold. Creating custom stock classes can be done, but it's a more elaborate process than the LLC's simple ability to amend its operating agreement.
On the other hand, transferring ownership in a corporation is as simple as transferring shares of stock – buying, selling, gifting and inheriting are standard legal actions. With an LLC, transferring ownership values or rights between existing members, removing members or adding new members requires a change in the operating agreement, to be approved by the voting membership. Death, survivorship and succession require careful planning with an LLC.
A corporation lives forever. It has no expiration date as an entity and from its formation is regarded as existing in perpetuity unless dissolved. An LLC is more dependent on its state law. From its roots as a partnership, it was originally created with an expiration date of no more than 30 years. Now it typically can be designated as a perpetual entity during its formation.
An unlimited number of persons or legal entities can own shares in a corporation, and similarly an LLC can have unlimited membership of persons, or entities such as other LLCs or corporations, etc.
A corporation is taxed at the prevailing corporate tax rate, by the IRS and most states, on all earnings left after its deductible expenses are allowed. After it pays its taxes, a corporation then pays dividends to its shareholders, who are in turn individually taxed on this income. This is the "double taxation" of corporations.
Unlike the corporation, an LLC itself is not taxed. All of its earnings pass through untouched to its members. But while corporate dividends are taxed only at a single prevailing rate, income distributions from LLCs are taxed as self-employed income, subject also to self-employment tax, Social Security and Medicare taxes.
A corporation can only pass profit to its shareholders. An LLC can pass operating losses as well. LLC members can thus receive losses that are deductible from any other income they may receive from outside the LLC. While a corporation can retain some of its earnings for a future time and withhold dividend payments, an LLC must pass through its profit and loss each year.
Benefits such as group insurance are tax-deductible expenses for shareholder-employees of a corporation but not for members of an LLC. A corporation can typically offer the best benefits such as retirement plans, stock options and employees stock purchase plans.
The different income possibilities of the corporation and the LLC are further enlarged by the tax elections that a company can make with the IRS, which are then typically mirrored by a state taxing authority. Tax elections allow a legal entity to be treated as a "tax entity", which is not a created entity but simply a taxing designation.
A corporation by default is a C corporation tax entity. It can elect to be taxed as an S corporation, which allows profit and loss to flow directly to its shareholders in the manner of the LLC. This election brings with it certain limits on shareholders and stock.
An LLC has even more choices. By default it's a partnership tax entity, but it can elect to be taxed as either a C corporation (subject to double taxation) or as an S corporation. The single-member LLC is by default taxed as a sole proprietorship and can likewise elect to be a C corporation or an S corporation tax entity.
It's should be apparent that the differences between a corporation and an LLC offer a great mix of potential advantages and disadvantages to every individual business. No single rule of thumb can apply to determine which entity is best. To make the right decision can require tax, investment, legal and estate planning, in consultation with qualified professionals.
For the small business and sole proprietor especially, the savings and gains to be realized from conducting business as a particular legal or tax entity can make a difference of several thousand dollars per year. Typically this easily outweighs the cost of professional advice.
No matter which business entity you choose, SunDoc Filings can help you with your required business filings in California or any state.
Note that nothing in this article can be construed as legal, tax or accounting advice.