When distinguishing between a corporation and a limited liability company, several similarities and clear distinctions exist. Both corporations and LLCs establish separate entities apart from individuals. Both provide strong protections to shield owners from personal liability for company actions. In a corporation, the owners are called “shareholders.” In an LLC, these owners are called “members.” But what’s the distinction? Are they truly interchangeable?
Begin by comparing the basic structure of an LLC and a corporation. A corporation is owned by shareholders. Shareholders elect a board of directors—typically a President, Vice President, Treasurer, and Secretary—to oversee the company. Most corporations maintain stricter governance procedures than LLCs, outlined in their Articles of Organization and Bylaws. An LLC is owned by its members. Members may manage the LLC directly or delegate management to a manager. An operating agreement dictates the LLC’s operations.
Generally speaking, the shares of a corporation are easily transferable. Unless the shareholders have entered into an agreement restricting the transfer, a shareholder can sell, gift, or otherwise convey their interest in the company to another. Corporations can also issue different types, or classes, of stock. Some corporations, for example, might set up Class A voting shareholders and Class B shareholders who do not have voting rights. Note that this is only applicable for corporations that have made a C corporation tax election. An S corporation tax election only allows for one shareholder class. For a more complete discussion on the difference between an S corporation tax election vs. a C corporation tax election, see our discussion on “5 Things You Need to Know About S Corp Rules” and “When Does a C-Corporation Make Sense for Your Business?“.
In an LLC, this is not the case. Bringing on a new member with an ownership interest will require the approval of the other members and usually a capital contribution from the new member. The operating agreement will outline the exact process for bringing in a new member and any initial capital contribution that they will need to make to the company. Adding a new member is not as easy as simply purchasing a share of a corporation.
Another distinction is in how profits of the company are distributed to the owners. In a corporation, shareholders are paid dividends. The Board of Directors of the company determines the payment of dividends to the shareholders. In an LLC, the members instead receive distributions, not dividends, from the company. When and how those distributions are paid is governed by the operating agreement.
Once payments are made, taxes on these distributions (if an LLC) or dividends (if a corporation) are another area of potential overlap. An LLC may elect how it wants to be taxed and has the maximum level of flexibility to do so. If the LLC makes no choice, it is taxed as if it were a partnership (or disregarded by the IRS entirely in the case of a single-member entity). Distributions would be taxed on the members’ individual tax returns. The LLC may further elect to be taxed as a C corporation or as an S corporation (if they meet the strict requirements for an election).
In S corporations or LLCs that have elected to be taxed like S corporations, both are subject to just one level of taxation. An S-corporation is a so-called pass-through entity, whereby the corporate profits pass through the entity directly to the business owners. The owners then pay the taxes owed. Conversely, C corporations are taxed once at the corporate level when corporate taxes are paid, and then again by the owners when dividends are paid. There are several nuances to determining any tax elections that should be discussed more fully with your attorney to determine what is best for your situation.
Ultimately, it will depend on your specific situation to determine whether to organize your business as a corporation or as an LLC. I have highlighted here just a few of the similarities and differences between the two to take into consideration as you move forward with your legal and business planning. If you have questions or need help determining which structure is right for you, contact the attorneys at Way Law.