LLCs vs. Corporations

The LLC has become more popular than the corporation as a preferred business entity for smaller businesses because the corporation has a number of technical and procedural requirements that are more complicated than the LLC.

Corporate laws are extremely complex and have much less flexibility in their implementation than LLC laws. Most states require corporate by-laws to specifically define the manner in which corporation will operate under its charter. The LLC operating agreement (the same as a corporate charter), however, allows LLC members to structure a company to suit their very specific needs. Corporate statutes and procedures favor large companies while small and medium-sized entities often find corporate laws extremely inflexible and a hindrance to designing and managing their business.

Additionally, corporate decision-making must follow procedural formalities that are too technical for small and medium-sized businesses. Many corporate decisions require stockholder approval and all important decisions must be formalized through detailed corporate board meetings and minutes. Any failure to observe these formalities could enable creditors to pierce the corporate veil and hold directors or shareholders personally responsible for debts and acts of the corporation. LLC managers (who function similarly to the director of a corporation) have broad leeway to make decisions without the technical formalities of the corporation (except in the case of situations that are clearly defined in the LLC's operating agreement. LLCs can be structured to provide the members any level of control over operational decisions without the hassle of protocol that is fundamental to the corporate entity.

A corporation has only two ways to be taxed—as a C corporation or an S corporation, both of which fall under IRS code. The C corporation is frequently undesirable because the entity pays tax on its profits and its stockholders are then taxed when they receive a distribution of profit (a stock dividend). To avoid double taxation many small corporations elect to be formed and taxed as S corporations, in which only the shareholders are taxed on corporate profits (pass-through taxation) in the event of a dividend distribution. That being said, a corporation must meet strict criteria to qualify for S corporation tax status and these requirements often constrict the operation or financing of the business. In contrast, a LLC may be taxed as a C corporation, S corporation or partnership if owned by multiple taxpayers or as a disregarded entity in the case of only one taxpayer. The taxation of partnerships is often seen as preferable to S or C corporate tax status because it avoids a C corporation's double taxation and the structural limitations required of an S corporation. Additionally a return of capital from the LLC to a partner/LLC member frequently doesn't cause a taxable event and a distribution of profit does not have to be proportional to an investor's ownership interest in the company. Bottom line: If a LLC chooses to be taxed as either a C or S corporation it may do so and corporations cannot choose to be taxed as a partnership or disregarded entity.

There are situations where a corporation is preferred over an LLC, despite the seemingly unattractive characteristics of the corporation. The primary benefit of a corporation is that its stock may be freely transferred without the consent of other shareholders or from corporate management, which is fundamental for any publicly traded company. Companies that anticipate a public offering of their stock should be a corporation. Any company that desires easy transferability of ownership or that has a complex equity structure would naturally prefer the corporate form of organizations. Some types of businesses (banks, insurance companies and public utilities, to name a few) are required by law to be corporations. Most other companies, however, would likely recognize the LLC, a limited partnership (LP) or limited liability partnership to be highly advantageous over the corporation.

The similarity of an LLC to an S corporation is that the owners of both entities entertain full limited liability and both entities are taxed as a proprietorship or partnership with pass-through taxation. The risk of a LLC member's financial loss (as with a corporation) is also limited strictly to a loss of investment. A primary Asset Protection advantage of the LLC over the S corporation is that the LLC provides more protective ownership options. For example, a family limited partnership (FLP), a trust, another corporation, and so forth can own LLC interests while S corporation shares cannot be owned by these types of entities. Stock ownership is primarily restricted to individuals in these types of formations and estate and Asset Protection planning become more complex with S corporation shares.

More importantly, an ownership interest in an LLC has significantly greater protection against creditors than shares in an S corporation, which can be seized by a stockholder's personal creditors through a fairly easy process. A member's interest in any LLC is protected from creditors in the same way that a partner's interest is via a limited partnership. A creditor can only obtain a charging order against the LLC interest, which provides the creditor only the right to receive distributed profits due the debtor partners—a significant strategic advantage of the LLC.

Additionally, because an LLC can choose to be taxed as an S corporation, many believe that the S corporation will become obsolete as a business entity. Eventually, the corporate structure may only be attractive to companies that plan to go public or have complex and large equity structures. An S corporation is limited to 100 shareholders and cannot go public, limiting it to a simple equity structure. Only in rare circumstances would a business form an S corporation instead of an LLC.

That being said, there are several advantages of an S corporation over the LLC, including the fact that an S corporation can be more tax advantageous if acquired by another business and S corporation owners pay employment taxes only on their salaries while LLC owners pay employment taxes on all profits. State taxes are also sometimes lower for an S corporation.

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