The Popularity of the LLC
An LLC has become an increasingly popular entity type because it has a very favorable attributes compared to other business entities, principally because it limits its members’ liability for its obligations, it is very flexible, it can have a structure as simple or as complex as desired and its members can achieve pass-through income tax treatment, even if they are active in managing the business, without affecting their limited liability.
This article compares the LLC entity type with C Corporations and S Corporations. We’ll look at the differences and similarities in how each is formed, operated, and taxed.
The LLC Was Slow to Gain Acceptance
LLCs have been available as an entity type in the United States only for about the last 20 to 25 years. They were initially slow to gain acceptance and popularity because of the absence of clear regulations by the IRS regarding how the LLC would be taxed. The early LLCs were generally required to have multiple members and could not have a perpetual duration like a corporation. Once the IRS adopted clear regulations on how an LLC would be taxed, the LLC was permitted to have a perpetual duration and could be formed by a single member. The LLC has gained increasing popularity ever since.
How an LLC Compares to a Corporation
LLC and Corporation Formation and Operation
The formation requirements for a corporation and an LLC are very similar. Both entities come into existence on the execution and filing of an organizational document with the Secretary of State. For a corporation, it is typically called Articles of Incorporation. For an LLC, it is typically called Articles of Organization.
Articles of Incorporation vs. Articles of Organization
The Articles of Incorporation must set forth both the type of shares that the corporation will be permitted to issue, and the number of shares that it will be authorized to issue. These are not required for an LLC’s Articles of Organization, but the LLC Articles must describe whether the LLC will be managed by its members or managed by one or more managers.
Corporation Bylaws vs. LLC Operating Agreement
A corporation must adopt written bylaws by which the corporation will be operated and managed. The bylaws are the corporation’s governing document and contain detailed provisions regulating the corporation’s internal affairs. The members of an LLC must enter into an operating agreement to govern its internal affairs and the conduct of its business. In contrast to the bylaws of a corporation which must include certain provisions, an LLC is not required to include any particular provisions in its operating agreement, which need not be in writing. However, it is always advisable to have a written operating agreement.
How Corporation and LLC Statutes Compare
State statutes regulating corporations are generally very comprehensive and detailed. They contain very specific provisions dealing with the rights and powers of shareholders, directors, and officers of the corporation. LLC statutes, on the other hand, are generally less detailed and leave certain issues to be covered by an operating agreement between the members. Corporation statutes have been refined over many decades and interpreted by numerous court decisions. Corporations are therefore perceived as very stable and predictable entity types. As a relatively new entity type, LLC statutes are still evolving and court decisions interpreting state LLC statutes are still very limited in many states.
A corporation may be used to operate any type of lawful business. An LLC is often restricted from conducting a banking, insurance, or trust company business, but otherwise may operate any type of lawful business. Licensed professionals may operate in a corporate form, but several states prohibit licensed professionals operating through an LLC, though many states have adopted statutes permitting the formation of a Professional LLC.
Comparing LLC and Corporation Management
The corporate structure consists of shareholders, directors, and officers. Shareholders are the owners of the corporation and have very limited rights with regard to the operation of the business. The directors are the governing body of the corporation responsible for determining major policy decisions and appointing the officers of the corporation. Every corporation must have a president, chief financial officer, and a secretary. The officers are responsible for running the corporation on a day-to-day basis.
In contrast, the LLC management structure may be much more flexible. It may be managed directly by the members, the members may appoint one or more members as officers to run the business, or the members may appoint one or more managers (who need not be members) to run the business.
In a corporation, each director has a single vote. In an LLC, the operating agreement may create nearly any management structure and may allocate management voting rights based on ownership or other factors.
Comparing Limited Liability of Owners in a Corporation and LLC
LLC members and corporate shareholders ordinarily are shielded from personal liability for company obligations. Nevertheless, both members of an LLC and corporate shareholders may be personally liable under some circumstances, such as when they personally guarantee an obligation or when they engage in tortious or wrongful conduct.
There may be a misconception that an LLC provides superior personal liability protection to a corporation. This often arises because the words “limited liability” are contained in the LLC name. This is not the case. On the contrary, many state statutes define the limited liability protection afforded to members in an LLC as being the same as afforded shareholders in a corporation.
LLC Advantages Over Corporations in How it’s Taxed
A corporation has two tax classifications available to it. It may be taxed as a C Corporation or, if it meets the requirements, as an S Corporation. A C Corporation files its own tax return and pays taxes on its profits at the business level. An S Corporation also files its own tax return, but it is informational only with the profits and losses of the business being passed through to the shareholders to report on their personal tax returns based on their ownership percentages.
The principal advantage of an LLC over a business corporation that is not an S Corporation is the different tax treatment afforded the LLC. Both a single member and multiple-member LLC have “pass-through” tax treatment, unless they choose to be taxed as a corporation. This tax treatment avoids the double taxation of profits that applies to a C Corporation.
The LLC Tax Advantages Over an S Corporation
No Restriction on Who May Be Owners
An LLC also has advantages over an S Corporation, even though both are “pass-through” tax entities. To qualify for S Corporation tax status, a corporation must meet certain requirements. The shareholders must be individuals (who are not nonresident aliens), estates, or certain types of trusts, there can be only one class of stock, and there is a maximum of 100 shareholders. There are no such requirements for an LLC. There is no limitation on the number of members, the members may be individuals, other entities, nonresident aliens, estates or trusts, and there are no restrictions on the type of equity interests for the members.
LLC Advantage in Profit and Loss Distributions
The profits and losses that are passed through to the shareholders of a corporation must be in proportion to their ownership percentages. In an LLC, however, the operating agreement may provide for disproportionate allocations of profits and losses and do not have to be based on ownership percentages.
Penalty Taxes Affecting Corporations Only
LLCs also are not subject to certain penalty taxes that may be imposed on C Corporations. These include accumulated earnings taxes and personal holding company taxes.
Losses of a C Corporation are retained at the corporate level. Losses of LLCs and S Corporations flow through to the members and S Corporation shareholders, and may be used by them to offset other income, subject to certain rules regarding basis and passive loss limitations.
Possible LLC Tax Advantage on Liquidation
There are typically no adverse tax consequences in an LLC on liquidation. An LLC member generally will not recognize gain unless the distribution of cash exceeds the member’s adjusted basis in the LLC. However, C Corporations are subject to potential double taxation on liquidation.
Potential Self-Employment Tax Advantage of S Corporation
Where the members in an LLC and the shareholders in a corporation are both actively involved in the operation of the business, the S Corporation pass-through tax treatment may offer an advantage over the LLC pass-through taxation. All of the profit distribution to the LLC member will generally be deemed to be earned income and subject to the imposition of self-employment taxes, primarily Social Security and Medicare taxes. These SE taxes have a combined rate of 12.4%.
The shareholders in a corporation have more flexibility in determining a reasonable salary commensurate with the services they provide to the corporation, which may be less than their share of profits for the year, so long as the salary can be supported as reasonable under all the circumstances. In this situation, SE taxes will be paid on the salary received by the shareholder, but not on the portion distributed to a shareholder as profits.
While the growth of the LLC as an entity type was restricted in its early years because of uncertain tax regulations, it now enjoys widespread popularity because of the variety of tax classifications available to it and the superior flexibility it offers to members in defining their management structure. That said, it still finds some difficulty in being accepted in certain situations, such as where financing is involved, because of the complexity and uncertainty involved with many written operating agreements, and the less tested and predictable statutory structure of the LLC.