Corporations and S Corporations vs. LLCs

Limited liability companies (LLCs) and corporations are two ways of structuring a business. Both structures shield their owners from personal liability for the business's debts and other obligations. For example, if you are an owner of a corporation or an LLC that declares bankruptcy, creditors can't go after your home, your car, or any other personal assets you own. But they differ in the way they are owned and managed; how they are taxed; and the way they are governed by law.

What Is a Corporation?

A corporation, also known as a c-corporation, is a type of business structure that exists as a separate entity from its owners, who are called shareholders. The corporation pays its own taxes, can own property or enter a contract as an entity separate from its owners, and is responsible for debts or wrongdoing. Shareholders become owners by acquiring shares of stock in the corporation. They play a very limited role in managing the corporation, and they pay taxes only on the profit distributions they receive from the corporation.

What Is an LLC?

A business structured as an LLC is owned by one or more individuals or groups, known as members. LLCs are not separate from their members in the same way that shareholders are separate from the corporation. The LLC itself doesn't pay taxes. Members pay taxes on the LLC's profits on their personal income taxes, a process known as pass-through taxation. LLC members can run the company, although some LLCs choose different management structures.

What Is an S-Corporation?

Another type of corporation, an s-corporation, combines some elements of c-corporations and LLCs. Like c-corporations, an s-corporation is a separate legal entity, and shareholders have limited liability for the business's debts and other obligations. But shareholders in an s-corporation are responsible for paying taxes on the business's income in much the same way as members of an LLC.

How Ownership Works in a Corporation and an LLC

The rules for ownership, management, and other operations are spelled out for corporations in a set of bylaws. LLCs use an operating agreement to define responsibilities and rules of operation.

In a corporation, the number of shares of stock determines the percentage of the company a shareholder owns. Let's say a corporation issues 100 shares of stock and sells each share for $10. A shareholder who invested $250 would own 25 shares of stock or 25 percent of the company. If the corporation distributed annual profits to shareholders, this shareholder would receive 25 percent of the distribution.

LLCs don't issue stock. The operating agreement details the percentage of ownership and the share of profits (or losses) to which each member is entitled. A member's share of profits is usually based upon the percentage of ownership, but an LLC can divide up profits in a different way, provided it follows the IRS "Special Allocations" rules.

Ownership Is Unrestricted for Corporations But Not LLCs

Shareholders of c-corporations are free to buy, sell, or transfer their shares to anyone on the open market.

LLC members can invest in the company or sell their investment only according to the rules established in the operating agreement (or the rules set by state law when no operating agreement exists). An LLC's operating agreement might require members to sell their share back to the other members, or it might give the other members approval rights over any sale or buyer. A few states require LLCs to be dissolved and re-formed when a member leaves.

S-Corporations Restrict Certain Types of Ownership

While c-corporations can issue all their stock to a few individuals or thousands, to individuals or other businesses anywhere in the world, s-corporations can't have more than 100 shareholders, and their shareholders must be U.S. citizens. Ownership in s-corporations is also limited to individuals, and other business entities such as corporations, LLCs or partnerships can't own stock in the company.

How Corporations and LLCs Are Managed

In general, corporations must follow detailed state laws concerning management practices. LLCs are subject to fewer government rules about how they are managed.

How Corporations Are Managed

Corporations are required to have a board of directors and officers, such as a president and chief financial officer. The bylaws describe the rights and responsibilities of these executives, and most states require corporations to file their bylaws with the state.

Members of the board of directors are responsible for appointing the officers of the company and for overseeing and evaluating the direction of the business. A board of directors might get very involved if, for example, a corporation's profits fall or the business records a loss. But it usually won't participate in decisions like hiring, salaries, choosing vendors, and so on. Those day-to-day decisions are the responsibility of the officers of the company.

Shareholders might be asked to vote on decisions such as appointing new board members, but they typically don't get involved in the day-to-day management of the company unless they are also officers.

Corporations are required by law to hold annual shareholder meetings and to keep minutes of those meetings. They also must issue annual reports.

How LLCs Are Managed

The equivalent of corporate bylaws for an LLC is called an operating agreement. But unlike corporations, most LLCs are not required to file an operating agreement, although a few states do require LLCs to create one.

LLCs have a lot of flexibility in deciding how the company will be managed. In most states, they need not have a board of directors, company officers, annual meetings, or annual reports. An LLC might be managed by all, or just some of its members; and some LLCs hire an outside manager with no ownership in the company to manage it.

Though only a few states require LLCs to issue annual reports, most require other annual filings in order for the company to retain its LLC status.

How Corporations and LLCs Pay Taxes

The corporation, not the shareholders, pays taxes on the profits the business earns. But shareholders are required to pay taxes on any dividends that are paid to them. Many view this tax rule, known as double taxation, as a disadvantage of the corporate structure. Corporations are also allowed many tax deductions for business expenses that can offset the tax bill.

S-corporations, on the other hand, don't pay corporate taxes. Profits earned by the business are passed through to the shareholders (as is done with an LLC).

In an LLC, all the business's profits (and its losses) are also passed through to the members. Single-member LLCs are taxed as sole proprietors; they report and pay taxes on business profits on their personal income tax returns.

LLCs with more than one member can elect to pay taxes as a partnership or a corporation. When taxed as a partnership, LLC members pay taxes on the company's profits on their personal income tax return, based on their share of ownership.

When an LLC elects to be treated as a corporation for tax purposes, the LLC pays corporate taxes, and members pay taxes on any distributed profits. Members are not required to pay taxes on earnings that are retained, so profits that are re-invested into the company are not taxed.

How LLCs and Corporations Are Formed

LLCs and corporations are both formed by filing a document with the responsible state agency, usually the Secretary of State. Corporations file articles of incorporation and LLCs form articles of organization. (The documents might be called by different names in some states.)

The documents typically cover basic information about the business, such as the name and location of the company, the address of members (in the case of an LLC) or directors and officers (in the case of a corporation), the type of business, and its purpose. Corporations also need to provide the number of shares of stock they intend to issue.

Filing fees for corporations vary by state and sometimes by the number of shares the corporation issues. A business in Arizona might pay as little as $60 to file articles of incorporation, while Texas charges $300.

Fees for filing articles of organization for an LLC typically range from $50 to $100, depending on the state.

Corporations and LLCs are also subject to other annual fees, such as annual report filing fees, franchise fees, and business license fees.

Choosing Between a Corporate and an LLC Structure

Corporations and LLCs each offer the advantage of limiting the owners' personal liability. The entity that's right for you will depend on your needs. Here are some factors to consider:

LLCs have fewer formalities and offer more flexibility. In general, LLCs don't require you to hold meetings or issue annual reports. And they offer a lot of flexibility in managing the company, whereas corporations are required by law to have a specific management structure, hold meetings, and observe other formalities.

Tax compliance is usually simpler under an LLC. LLCs don't pay taxes unless the members elect to be taxed as corporations. Most members pay taxes on the business profits on their personal income tax filing. Corporations are subject to double taxation because the corporation is taxed on earnings, and shareholders pay taxes on the profit distributions they receive.

It's easier to attract investors as a corporation. Investors prefer corporations because they can buy into the business or sell their stock on the open market, without restrictions. Buying into or selling ownership in an LLC usually requires the approval of the other members, and other requirements might apply. S-corporations also have ownership requirements that make them less advantageous for investors.

Corporations have more options for providing employee benefits. Corporations can offer benefit plans like stock options that most LLCs can't. Tax deductions for many benefit plan expenses are also available to corporations, whereas LLCs can usually deduct only a portion of the expense of any benefits they offer.