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Monday, October 4, 2010

Corporation vs. LLC

Perhaps the most common question we receive from individuals looking to start a new business is: “What is the difference between a corporation and an LLC?” This is a very important question because understanding the differences between these two entities is essential to making the right choice for your new business. Or, in some cases, making a decision regarding whether to convert your existing company to a corporation or an LLC.

The first chart below addresses some of the important differences between Corporations and LLCs. The second chart below, which naturally flows from the first, lists some of the pros and cons of forming either entity.

These charts are not intended as a substitute for the advice of an attorney and a CPA. Many of the issues, especially the tax issues, are presented in a simplified form; therefore, in some situations the issue may be more complex with a different result than described below. You should speak with an attorney and a CPA about which entity is best for you based upon your needs and circumstances. Furthermore, these charts are based on the laws of the Commonwealth of Virginia. State law varies in the treatment of Corporations and LLCs
[SEE CHARTS BELOW]

























CorporationLLC
FormationCorporations are formed by filing Articles of Incorporation with the State Corporation Commission (the “SCC”).LLCs are formed by filing Articles of Organization with the State Corporation Commission (the “SCC”).
OwnershipCorporations are owned by “Shareholders”. Shareholders can be either individuals or business entities. Upon formation, each Corporation is authorized by the Commonwealth to issue a particular number of shares of stock. The Corporation then issues physical stock certificates to its Shareholders. The Corporation may elect to issue different classes of stock (i.e. common stock and preferred stock) which afford different rights to the Shareholders, such as voting rights and profit distribution rights.

If the corporation elects to be taxed under Subchapter “S” of the Internal Revenue Code (see below), it can issue only one class of stock. In addition, it can have a maximum of 100 shareholders, all of which must be individuals (with some exceptions) residing in the United States.
LLCs are owned by “Members”. A Member can be an individual or a business entity. A Member’s ownership interest in an LLC is usually referred to as a “Membership Interest”. Most LLCs do not require membership certificates; instead the percentage of an individual’s Membership Interest is documented as an attachment to the LLC’s Operating Agreement. The Operating Agreement can afford different rights to different Members, such as voting rights and profit distribution rights.
ManagementCorporations are typically managed by the Officers and the Board of Directors (“BOD”), who are elected by the Shareholders. The Officers (i.e. President, Secretary and Treasurer) run the day-to-day affairs of the Corporation and report to the BOD. Typically, the BOD votes on the major decisions of the Corporation.LLCs can be “Member Managed” or “Manager-Managed”. That is to say, the LLC can elect to have its day to day affairs controlled by a Manager or a Board of Managers, or can elect to have its day to day affairs controlled by all or some of the Members. Typically, Members vote on the major decisions of the LLC. LLCs can give the Managers common titles, such as President, CEO, etc., but is not required to do so.
GovernanceCorporations are governed by state law and the agreements of the Shareholders. State law governing corporations is well-developed, and typically addresses all aspects of corporate governance. Bylaws and Shareholder Agreements can also govern the Corporation if adopted by the Shareholders. With some exceptions, Bylaws and Shareholder Agreements will trump state law when inconsistent. If the Bylaws and Shareholder Agreement fail to address a particular issue, state law will control. LLCs are governed by state law and the LLC’s Operating Agreement. State law governing LLCs mirrors state law governing Corporations in many respects, but is not as well-developed or tested in Court. In almost all circumstances, an LLC’s Operating Agreement is what controls and governs the LLC. However, if the Operating Agreement fails to address a particular issue, state law will control.
Protection from Personal LiabilityA Corporation is an entity separate from its Shareholders. Shareholders cannot be personally liable for corporate debts unless a creditor is able to “pierce the corporate veil”. This is rare, but may occur when the Corporation was established to perpetrate a fraud, fails to follow the corporate formalities required by the Commonwealth or is merely an “alter ego” for the Shareholders (i.e. the Corporation does not actually operate as a separate entity). Shareholders must be careful to keep corporate affairs separate from personal affairs, and must be sure to sign “on behalf of” the Corporation whenever engaging in corporate transactions.An LLC is an entity separate from its Members. Members cannot be personally liable for corporate debts unless a creditor is able to “pierce the corporate veil”. This is rare, but may occur when the LLC fails to follow the legal formalities required by the Commonwealth or is merely an “alter ego” for the Members (i.e. the Corporation does not actually operate as a separate entity). Members must be careful to keep LLC affairs separate from personal affairs, and must be sure to sign “on behalf of” the LLC whenever engaging in LLC transactions.
TaxationCorporations are taxed under Subchapter “C” of the Internal Revenue Code, unless the Corporation elects to be taxed under Subchapter “S” of the Internal Revenue Code. If taxed under Subchapter “C”, the Corporation itself must pay a corporate tax on its net income. Shareholders must then pay personal income taxes on the distributions they receive from the Corporation. If taxed under Subchapter “S”, the income and losses of the Corporation “pass through” to the shareholders, based upon each shareholder’s percentage ownership in the corporation. No corporate tax is required for a Corporation taxed under Subchapter “S”. LLCs are taxed under Subchapter “K” of the Internal Revenue Code. The income and losses of the LLC “pass through” to the owners of the LLC based upon each Member’s percentage ownership in the LLC. No income tax is paid by the LLCs. Unless otherwise elected by the LLC, the LLC is taxed like a partnership and each member receives a “K-1” form each year from the LLC.
Ongoing FormalitiesCorporations must: (a) file annual reports with the SCC and pay an annual fee, (b) hold annual meetings, (c) must keep the SCC advised of the officers and directors of the Corporation, (d) comply with formalities found in the Virginia Code, and (e) comply with its By-laws. An LLC need only pay an annual fee to the SCC. The LLC’s Operating Agreement determines what formalities, if any, will be required by the LLC.
Case LawCorporations have been recognized as separate business entities for many years. Accordingly, there is well developed case-law which Courts will follow in the event of a corporate dispute or attempt to pierce the corporation. The LLC is a relatively new business form, and as a result, the Courts have not addressed all issues regarding LLCs. Nevertheless, it appears that the Courts will be following corporate case law precedent, where applicable.




CorporationLLC
Pros• Shareholders protected from personal liability.
• Well suited for large businesses due to the fact that it is easy to raise capital and take on investors by simply issuing additional stock certificates.
• Easy transfer of shares in case of sales.
• Well developed (and litigated) statutory and case law provides guidance to Shareholders and reduces risk of doing business.
• Uniformity between states with respect to laws governing Corporations.
• Members protected from personal liability.
• No corporate tax required. Income of LLC passes through to its owners.
• LLC is principally governed by an Operating Agreement. The Members can draft this document however they choose. This results in LLCs being very flexible with respect to management and distributions of profits/losses.
• LLCs typically require fewer formalities.
• CPA’s find tax advantages.
Cons• Shareholders must follow many corporate formalities.
• Not very flexible with respect to distributing profits/losses to Shareholders.
• Not flexible with respect to management.
• Must pay corporate tax unless a Subchapter “S” election is made. Requires significant planning to avoid double taxation.
• Less developed statutory and case law to guide Members.
• Lack of uniformity between states with respect to laws governing LLCs.
• Not well suited for large businesses with many investors or businesses with regular changes of ownership.