One of the first and most important tasks when starting a new business venture is choosing a type of entity. In the vast majority of cases the choice will come down to forming a corporation or a limited liability company (LLC). Which one is appropriate for a particular business venture depends upon many factors and is determined on a case-by-case basis.
Determining whether a corporation or an LLC is the appropriate choice for a particular business requires an understanding of the differences between the two entity types. Although tax treatment is a key difference and should always be considered, there are also important differences between corporations and LLCs that have nothing to do with taxation. Here is a summary of five significant nontax differences:
1. Control of the business and affairs
Control of a corporation’s business and affairs is vested by statute in a board of directors. A board of directors can be dispensed with only in very limited circumstances, such as where every shareholder executes an agreement to do so, and a number of other statutory restrictions are followed.
LLCs may be controlled by all, some, or none of their members. The statutes have default rules vesting control in the members. However, they also allow the LLC to opt out of the default rule and provide for managers who, like directors, may make decisions without needing the owners’ approval.
CT tip: If the members do not want to be governed by statutory default rules they must provide otherwise in their operating agreement. The importance of having a carefully drafted operating agreement that addresses the issues of importance to the members cannot be emphasized enough.
2. Sales of interests
A corporation’s shareholders may freely sell or transfer their shares of stock. There is no statutory requirement that the other shareholders have to consent before a person buying shares may become a shareholder and receive all of the seller’s financial, voting and other ownership rights and interests. (This is one reason why owners of closely held corporations often enter into shareholder agreements).
In an LLC the members can sell their financial rights (the right to share in the profits and losses and receive distributions) without restriction. However, there are statutory default rules that require the other members to approve the sale of the remaining interests – including the right to participate in management. Approval is also required in order for the buyer to become a member, unless the operating agreement provides otherwise.
3. Articles of incorporation vs. articles of organization
Corporations and LLCs are created by filing articles of incorporation or articles of organization containing the information required by statute. In many states, very little information is required to be set forth.
These minimum requirements satisfy the articles’ “notice” function. That is, they provide the public with notice of the corporation’s or LLC’s existence.
A corporation’s articles of incorporation do not just have a notice function. Many of the provisions that will govern the management of the corporation’s business, and the powers, rights and authority of the directors and the shareholders will be effective only if included in the articles of incorporation.
An LLC’s articles of organization rarely provide more information than that necessary to serve the document’s notice function. Instead, provisions governing the LLC’s business and affairs, and the rights, duties, and authority of members and managers are set forth in the LLC’s operating agreement.
4. Bylaws vs. operating agreement
Bylaws may be thought of as a corporation’s rules and regulations. The corporation statutes provide that bylaws can contain any provision, not inconsistent with law or with the articles of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or powers, or the rights or powers of its shareholders, directors, officers, or employees. But despite that broad statement, bylaws generally cover a narrow range of issues dealing with the corporation's internal management.
In an LLC the operating agreement could be the most important document. This is an agreement members enter into that establishes the way the LLC will conduct business and that governs the rights, duties, powers, liabilities, and relations of members and managers. The operating agreement contains the kind of provisions found in a corporation’s bylaws, articles of incorporation, and shareholders’ agreements.
5. Meeting requirements
The corporation statutes require an organizational meeting to be held after the articles of incorporation are filed, in order to complete the corporation’s organization. The LLC statutes do not require an organizational meeting to be held.
In corporations, directors make their decisions at board meetings. For the decision to be valid, the appropriate notice, quorum, and voting requirements must be met. In contrast, LLCs may be managed more informally. In general, the LLC acts do not require management actions to be taken at meetings nor do they impose notice, quorum and voting requirements.
Every state corporation act requires a corporation to hold an annual shareholders’ meeting. LLCs are not required by statute to hold an annual members’ meeting.
To sum up, determining whether a corporation or a limited liability company is the more appropriate entity for a business venture can be difficult. Making the right choice requires a solid understanding of what a corporation is and what an LLC is, how they are alike, and how they differ. Consulting with legal and tax advisors can help business owners figure out which entity will best fulfill their goals.
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For additional information on differences among types of business entities, see: