Legal Insight: Choosing Between a Corporation and LLC
January 31, 2012
Suppose you operate a company with two lines of business-a service business such as Six Sigma consulting, and a manufacturing business such as precision instruments. They have different customers, growth prospects, reinvestment needs, returns on capital and cash flow characteristics. They face different types of risks.
In the 9th of his 14 points, W.E. Deming taught managers to break down barriers among staff areas. In the example above, the units are distinct divisions in a conglomerate. For organizational and practical purposes, good management would separate them.
In the event of a lawsuit, formal separation would prevent liability from spilling over into the other division. Management can determine which unit earns a higher rate of return on invested capital and which is the better choice for reinvestment. Perhaps, management will decide that one division should be spun off.
How can management achieve this artificial separation? Good legal structuring techniques and corporate governance can handle this. Most businesses choose between forming a corporation and a limited liability company (LLC). To make an informed choice, professionals require a basic understanding of the differences between the two types of entities.
Corporations have been part of American business for centuries. They are chartered under state law and owned by shareholders. LLCs have been around only since 1977. They tend to be more flexible and have fewer formalities than corporations do. The owners of LLCs are called members.
Limited liability. Entrepreneurs form entities primarily to have limited liability. When people operate a business without an entity, they are sole proprietors. By forming a corporation or LLC and obeying the proper legal formalities, owners are relieved from personal responsibility for company debts and obligations.
Control. Corporations and LLCs differ with respect to how owners exercise control over their ownership interests. Corporate shareholders elect a board of directors that hires management. In large corporations, shareholders tend to be uninvolved in managerial decisions. In small closely held corporations, the same individuals tend to be shareholders, directors and managers. In LLCs, one or more members can manage the company, or they can hire an outside manager.
Transferability of interests. Very large companies tend to be structured as corporations. The structure enables them to more easily raise capital and transfer ownership interests. Unless the shareholders voluntarily contract to not sell or transfer their shares, they can do so, albeit securities laws may apply.
With respect to LLCs, members can freely transfer the financial rights attributable to their shares. On the other hand, their rights to transfer managerial and voting rights are usually restricted. State law and operating agreements often require remaining members to consent for an assignee or purchaser to become a full member.
Continuity. Corporations and LLCs exist in perpetuity. They survive the bankruptcy, retirement and deaths of their owners. Sole proprietorships die with the owner.
Taxation. Most entity choice decisions are driven largely by tax considerations. Thus, before choosing an entity, an entrepreneur or manager should consult with an accountant or tax professional who has experience with small businesses.
Regular corporations (C corporations) are separate legal entities. They file tax returns and pay taxes. Dividends paid to shareholders are taxed as well. This “double taxation” can be avoided if the corporation is eligible and elects to be taxed as an S corporation. An S corporation is a “pass-through entity.” It files informational returns with tax authorities but does not pay taxes. Rather, its shareholders report the profit or loss on their personal tax returns. Some corporations are ineligible to be S corporations. Sometimes, it does not make practical sense to become one and deal with the legal restrictions.
LLCs, like S corporations and partnerships, also are pass-through entities. Where the member is an individual, he is taxed like a sole proprietor. Where the member is a corporate owner, the LLC is treated like a division of the parent company.
Disclaimer: This column is for informational purposes and does not constitute legal advice.