Some of the businesses in the world are corporations (Inc.) while others are limited liability companies (LLCs). Each has its own advantages and works best in a particular situation. You will not find any reputable source telling you that one or the other is better in every situation. Instead, you must compare the two and consider some key factors to choose the right type of business structure. When you're finished, view our page on forming an LLC in New Mexico.
Limiting Liability
Whether you choose an LLC or a corporation, you will get protection for limited liability. This is one of the major advantages of forming a business entity. Each type of business is its own existence legally. Since the corporation or LLC owns the business, it is liable for liabilities and debts, not the shareholders or members.
The differences arise in the way that the entity (a limited liability company or corporation) protects against its owner’s liabilities and debts.
With a corporation, a shareholder’s judgement creditors may attach the stock of the shareholder, assuming their rights. Those rights can include things that shape the company’s direction, like votes for directors. In the case of shareholders with controlling interests, it is even possible for creditors to theoretically vote and dissolve a corporation.
In an LLC, there may be better protection of the entity. This is due to the fact that multiple states have LLC laws limiting the assets a judgment creditor of a member can get via a charging order. This term refers to court orders that require LLCs to pay the creditor distributions instead of the members. The creditor of a member cannot take over that member’s LLC ownership, including an inability to obtain membership that includes management rights.
Management & Control
There are also differences in control and management between corps and LLCs, including who can make both long-term and short-term decisions.
In a limited liability company, the members determine the LLC management. The default management method in the majority of states is management that includes all members. This can be changed to a manager-managed structure in the operating agreement of the LLC. In that situation, management may be similar to the management of a corp, but with less formality. Because LLCs are flexible, they can also include the formalities of corporations if members prefer.
With corporations, control and ownership are separate. Shareholders have limited rights to governance but own the corp. The limited rights for governance include electing the board, removing directors in certain situations, and voting on transactions that impact ownership and economic rights. These transactions include dissolution, asset sales, or mergers.
Overall, the directors of a corporation are in charge of the company’s strategic direction. They also set policies and appoint officers to run daily affairs.
Funding
The next area of difference is in the options as well as opportunities related to funding.
Corporations find it easier to attract passive investors since management has control and ownership has economic rights. This is enhanced by the fact that a majority of venture capitalists have governing documents that prevent investments in LLCs, and they prefer to make investments in corporations. Additionally, corporations find it easier to provide stock options, which attracts talents. They also find it simpler to get bank financing, something of particular importance for businesses that require a lot of capital.
LLCs must make investors members to get an equity investment. This gives the investors more rights than they would have as a shareholder of a corporation. LLCs can also include passive members, but most people who decide on an LLC investment will do so to have some control. Additionally, venture capitalists and banks are disinclined to give LLCs money, sometimes requiring owners to guarantee debts personally. Doing so could eliminate the limited liability.
Earnings & Distributions
In terms of making money, financial rights for distributions vary between LLCs and corporations.
Within a corporation, distributions depend solely on the proportion of the shares owned. The allocation of losses and profits vary by corporation type. Furthermore, directors get to decide if dividends are paid, without any input from the shareholders.
Distributions in LLCs depend on the organization’s operating agreement. This may or may not include a correlation between the percentage of distribution and the percentage owned. Additionally, an operating agreement determines the allocation of annual losses and profits, which does not need to be based on ownership interest. To round it out, members can decide if dividends are distributed.
Tax Consequences
A final aspect of consideration is tax consequences, both for the business and the owners.
Corporations are separate entities that pay taxes. As such, corporations pay tax for corporate income, after accounting for losses, credits, and deductions. Shareholder dividends are distributed after taxes, leading to double taxation. There are methods of reducing this double taxation that tax advisors can assist with.
With an LLC, members can choose to be taxed like C corporations or as pass-through entities. The default for single-member LLCs is disregarded, or it is as a pass-through if there are multiple members. However, a limited liability company can choose to change its taxation to that of a C corp or an S corp.
Conclusion
The decision of forming an LLC or corporation should not be taken lightly. We generally find an LLC is the best fit for our clients. The tax flexibility, simplified operations and better protection from personal creditors make corporations less advantageous except for very large companies or those with many investors.