What’s the Difference Between an LLC vs. Corporation?

The LLC and the Corporation are the most prestigious types of legal entities in the USA, conferring many benefits to those who take advantage. But there are significant differences between the LLC and the Corporation, though many make the mistake of treating them both as a kind of corporation.

The LLC is not a Corporation but is a hybrid entity with distinct benefits. The choice of starting an LLC or a corporation is profound. The following are the main differences by category.

LLC/Corporation Differences by Category

Formation

The LLC is ‘formed’, while the Corporation is ‘Incorporated’. The terms used for the creation of both legal entity structures are different. To form an LLC, the ‘members’ (or member) will file ‘Articles of Organization’ with the state. They will also draft an Operating Agreement which serves to mandate how the LLC will be managed. This does not have to be filed, and it is technically possible (though very risky) to run an LLC without an Operating Agreement. It could easily lead to a legal dispute and gross operational inefficiencies.

To incorporate a corporation, the board of directors will file a Certificate of Incorporation/Articles of Incorporation. The names and terms can vary from state to state. The corporation will also need to have a series of bylaws, which dictate how the business is supposed to operate.

The actual formation/incorporation process is very straightforward. The documents contain only basic information and can be filed online, for a fee. It should not take longer than one or two weeks to form either an LLC or a Corporation. Setting up an LLC is especially straightforward.

Cost of Formation and Maintenance

All things considered, it is about the same to create and maintain an LLC and a corporation. Keep in mind that the costs vary greatly state by state, but they are about the same for each legal entity type.

For example, to form an LLC in California, you will have to pay about $800 in an annual franchise tax along with a $70 filing fee. The state of information costs $10 a year. If you have an office in a different state, this will typically cost $150 per year. If you do business in a different state, you will also need to file an annual report there and pay the additional cost. The cost of initially forming an LLC/Corporation in California is about $220.

Depending on your home state and how many states you do business in, the cost of maintaining an LLC/Corporation can vary greatly. For a single state, expect to pay between $300 – $700 annually (California is one of the most expensive states).

Taxation

Taxation is one of the most complex yet important areas in terms of distinguishing between the corporation and the LLC. The most prominent difference is that the LLC is a Pass-Through Entity, while the Corporation suffers from Double Taxation. This means that the LLC members are taxed on their income statements. There is no taxation at the LLC level. The LLC is taxed as a partnership (or sole proprietorship, if it’s a single-member LLC).

But the Corporation itself gets taxed. And then the share dividends received by shareholders are then taxed. Corporate tax rates can vary between 12% – 30%, depending on the country of domicile. Many corporations elect to incorporate in areas such as the Cayman Islands and Ireland for the low rates of taxation. While double taxation can seem like a major issue, there are many Federal tax deductions available. The current rate of Corporate tax in the USA is 21%.

S-Corp Taxation

However, it can get even more intricate. The LLC can elect to get taxed as an S-Corporation. The primary benefit is that the S-Corporation shareholders can gain taxed benefits as they are construed as both employees and owners of the legal entity. Most LLCs will not take this route. It has implications for Social Security and Medicare tax reporting. LLCs owners must pay self-employment taxes, mainly Social Security and Medicare, while corporate shareholders do not have to pay this tax.

Both the LLC and the Corporation will pay tax on their profits. For the LLC, this is called ‘Net Income’. For the Corporation, this is called ‘New Earnings’.

Profit & Loss

Profit & Loss distributions are similar to the taxation structure outlined above. As Pass-Through Entities, the profits and losses are ‘passed’ to the members on personal income statements (IRS Form 1040). This is more straightforward, as whatever the LLC made or lost is transferred directly to the members/owners.

The Corporation may elect to either reinvest the money earned or to pay it out in dividends. The corporation is a distinct legal entity from the owners’ shareholders. It is the corporation that pays income taxes on its profit/loss. The LLC does not pay income taxes.

Ownership

With an LLC, the company is owned by ‘members’. With a Corporation, the corporation is owned by shareholders. Of course, in practice, the board of directors who created the company will be the major shareholders. The difference is that the Corporation board of directors will have a lot of outside interests to report to, such as shareholders who want to get paid dividends.

Ownership is a pivotal consideration in deciding whether to start an LLC or a Corporation. After all, if you don’t own your own company, you won’t make any profits. There are many stories of founders who have been ousted from the corporation that they created. With the Corporation, the shareholders are free to transfer their shares as they wish. It can be owned by outside investors/shareholders. The Corporation will continue to survive even if the founders have passed on.

The LLC is a little more flexible in terms of ownership. The Operating Agreement can be customized to dictate ownership criteria. For instance, it might stipulate that even though one member did not make as strong a financial contribution as the others, that the profits are to be distributed evenly.

Unless otherwise stipulated in the Operating Agreement, if a member leaves the LLC it must be dissolved. In other words, the LLC is completely tied to the original owners. However, an LLC can be owned by trusts and other corporations. It is all governed by the Operating Agreement.

It is easier to transfer ownership in a corporation in comparison to an LLC. This is, in fact, a primary advantage of the Corporation, permitting outside investment and an easier mechanism to raise capital. Corporations can also add different kinds of stock classes, either ‘preferred’ stock or ‘common’ stock.

Management

Again, the LLC will shine through here as it is just so flexible in terms of management. The entity does not have to be managed by the members. Any member can act as a manager. There are generally two forms of LLC management. ‘Member Managed’ is where the members themselves act as the managers (most common). ‘Management Managed’ is where the members stand on the sides and hire professional managers to run the business. It can often happen that the LLC starts as Member-Managed and then transitions to Management-Managed.

The Corporation is far more rigid. The Corporation must have a Board of Directors that hires ‘Officers’ to run the company. The shareholders are the owners but have no say in the running of the business. It is the responsibility of the Board of Directors to represent shareholder interests. However, an individual shareholder can be elected as a Director or Officer. Other management details can be found in the Corporate Bylaws.

Compliance and Reporting Requirements

The Corporation has far more compliance and reporting requirements in comparison to the LLC. This is due to the nature of the business model. A Corporation has shareholders, who do not have a direct say in the operational management of the company. As such, they need to be protected. Which is why there are so many reporting and compliance requirements for the Corporation.

However, both entities will have numerous filing requirements. They both need to have a registered office/registered agent in each state they do business in. They must file an annual report each year and pay franchise taxes. For both entities, failure to do so may result in fines or dissolution. The exact requirements will differ from state to state. Members, owners, and shareholders have the legal right to inspect documents and records on the running of the company, should they so desire.

Both entities must maintain appropriate records. The Corporation must have an annual meeting each year with shareholders, and keep detailed minutes of what was recorded. The Board of Directors is held to a high standard of fiduciary care and can be sued for negligence if they fail to account for their activities (in serious instances only).

Dissolution/Liquidation

Dissolving a Corporation or LLC is straightforward. You simply file the ‘Articles of Dissolution’ for Corporations and the ‘Certificate of Dissolution’ for LLCs. Pay the fee and your Corporation/LLC is officially dissolved. If you fail to formally dissolve your LLC/Corporation, the results can be disastrous.

Dissolution is only the first step. You need to notify creditors of the dissolution. The IRS has to be notified, and they provide a useful checklist of steps to take when closing a business. All assets have to be liquidated and final distributions will need to be made to shareholders or owners. The dissolution process should have been accounted for in the Corporate Bylaws or the Operating Agreement.

LLC vs Corporation – Differences

The following is a table outlining the major differences between the Corporation and the LLC. It should serve as a rough guide to the differences. Keep in mind that there are many nuances to these legal entity types and each can be uniquely governed to alter such differences. The ByLaws and Operating Agreement do allow the founders a lot of flexibility.

Understanding Legal vs. Tax Status

One thing that trips people up when it comes to comprehending legal entity types is legal compared to tax status. While you can legally be viewed as an LLC due to your formation documents and legal filings, the IRS can treat you like a different legal entity based on your activity. Thus, we have both legal status and tax status.

You can form your company as an LLC or C-Corp, and then elect to get taxed as an S-Corp. But if you fail to meet the requirements of an S-Corp, the IRS will automatically revoke your S-Corp tax status and you will default to your original setting. It can be confusing to wrap your head around initially, which is why a good legal/accountancy team is always advised.

This is why it is often best to stick to a simple LLC structure in the beginning. The tax is passed on your income. As you gain business experience, you then have the choice to make wiser tax decisions down the line with the enhanced flexibility.

Other Differences Between the LLC and Corporation

There are some other differences between the LLC and Corporation that are worth mentioning.

• The LLC member can receive ‘dividends’ but these are commonly referred to as ‘distributions’. While share dividends have to be equally distributed, distributions can be split in any way that the members choose. In both cases, it is management that decides whether dividends/distributions are to be paid.
• While Corporations have been around for a long time, the LLC is a relatively new construct. As such, laws surrounding Corporations tend to be more uniform state by state, and case law on Corporation proceedings are extensive. This is not the case for LLCs.
• Members of an LLC have no restrictions in terms of the sale of their financial interests. However, statutory rules limit the sale of other interests, such as membership and voting. Approval is also required for the buyer of the financial interests to become a seller. In other words, there are increased restrictions on the transfer of ownership in an LLC in comparison to a Corporation.
• An LLC can make significant savings by opting to be taxed as an S-Corp. However, you have to know what you are doing, and this will only make sense in certain instances. There are drawbacks to the S-Corp that can hit you down the line if you are not careful.
• There are many differences between the C-Corp and S-Corp which are useful to note. The C-Corp is the default option. When people say ‘Corporation’, they mean the C-Corp. The S-Corp status is filed after the C-Corp has been formed. The S-Corp only relates to tax, and an IRS Form 2553 is used to file for S-Corp tax status

When to Choose the LLC?

The LLC is the legal entity of choice for the entrepreneur, simply because it is so flexible. If you want to maintain control of your LLC so you can have an active role in its management, then it is perfect.

The Operating Agreement can be adjusted to articulate how the LLC is managed and how profits/losses are distributed, affording you complete flexibility. It’s the default choice for entrepreneurs and business people. You can even elect to be taxed as an S-Corp if you feel that it’s an appropriate move.

When to Choose The Corporation

The Corporation is a rarer choice, and you should only do this if you are prepared to play the Corporate game of shareholders, directors, meetings, double taxation, and due diligence. Choose the Corporation if you have big aspirations and are in it for the long haul, with potentially vast profits.

If you have a big dream but need some additional capital and expertise, the Corporation might also be for you. However, the Corporation is more difficult to manage – you might wish to set one up with friends that already know how to manage one.

Conclusion

The primary differences between the LLC and the Corporation are the management and ownership. The Corporation has a more strict and rigid management model with an additional board of directors who appoint officers. This adds another ‘layer’ on top of the standard management.

The other major difference is the double taxation of the Corporation versus the pass-through taxation of the LLC. Ultimately, it is a personal decision that you need to figure out. Both business structures confer legal protection, investment opportunities, and the ability to make tonnes of cash, provided they are run efficiently.