One of the most important decisions anyone who is starting a business must make is which type of entity to use. There are many entities from which to choose.
The Corporation vs. the LLC: A comparison of entities and statutes
Corporations and LLCs are statutory entities. These two entities, and the statutes that govern them, are similar in some ways and very different in others. The purpose of this white paper is to assist business owners and legal professionals in understanding these similarities and differences. It does so by comparing and contrasting corporations and LLCs — and the statutes under which they are formed and operated — in a number of areas — including formation, management, ownership, compliance issues, doing business in foreign states, and dissolution.
1. The entity characteristics of corporations and LLCs
When comparing and contrasting business entities, the discussion generally focuses on the following five characteristics — (1) liability, (2) control, (3) transferability of interests, (4) continuity of existence, and (5) taxation.
Liability, as an entity characteristic, refers to whether the owners of the business entity are personally responsible for the business’ debts and obligations — or whether the entity provides limited liability for its owners. Both corporations and LLCs shield their owners from personal liability based on their status as owners. This limitation of liability is provided for in all corporation and LLC statutes.
The control characteristic refers to who will manage the entity’s business and affairs — its owners or a management group that can act without the owners’ approval.
Corporations and LLCs differ in the control characteristic. Control of the business and affairs of a corporation is vested by statute in a board of directors. The shareholders are, for the most part, passive investors.
LLCs, on the other hand, may be controlled by either their members or by managers. Although the LLC statutes have default rules vesting control in all members, they allow the LLC to opt out of the default rule and provide for managers.
(c) Transferability of interests
Transferability of interests refers to whether the entity’s owners have a default statutory right to sell or transfer all of their interests to a third party who will then become the owner — or whether there are restrictions on the ability to sell, such as having to obtain the consent of the other owners.
Corporations and LLCs differ in this characteristic as well. 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.
In an LLC, on the other hand, the member’s financial rights may be transferred without restriction.
However, there are statutory default rules that place restrictions on the transfer of the remaining interests — including the right to participate in management. Furthermore, the assignee of the financial rights does not become a member. The default rule in most states is that in order for an assignee to become a member, the consent of all of the remaining members will be required.
(d) Continuity of existence
Continuity of existence deals with the issue of whether the entity has the statutory right to exist perpetually — or whether it dissolves by law upon a change of owners or the end of a set term. Both corporations and LLCs are entities with continuity of existence.
When comparing the way entities are taxed, the main concern is whether the entity is a “separate legal entity” for federal income tax purposes or a “pass-through” entity. A corporation by default is a separate entity and pays corporate income taxes. It can be a pass-through entity if it qualifies as an S corporation. By default, an LLC with one member is disregarded as an entity and an LLC with more than one member is a pass-through entity.
However, an LLC can choose to be taxed as a separate legal entity that pays taxes on its income.
(f) Opting out of default rules
It is important to note that the way corporations and LLCs are defined in reference to these characteristics is based upon the statutory default rules.
However, corporations and LLCs are free to opt out of default rules in their formation or governing documents. For example, shareholders or members may agree to be liable for a corporation’s or LLC’s debts. Similarly, a shareholder’s right to sell his or her shares may be restricted, while members may be given the right to freely sell their membership interests.
2. Formation of corporations and LLCs
The basic steps in forming a corporation and an LLC are similar. They include (1) choosing a state of formation, (2) choosing and reserving a name, (3) appointing a registered agent, (4) drafting and filing the formation document, and (4) drafting a governance document. But there are some important differences.
(a) Choosing the formation state
Selecting the formation state is an important step because the entity is organized pursuant to that state’s corporation or LLC law, and it has to comply with the provisions of that statute throughout its existence. Although important for both entities, it may be more of a consideration for corporations because corporation laws have more mandatory provisions than LLC laws
(b) Name considerations
In choosing a name it is important to remember that both the corporation and LLC statutes place restrictions on the choice of name. They require a word, phrase, or abbreviation that indicates whether it is a corporation or LLC. They also generally prohibit the use of words or phrases that will confuse the public. In addition, the name must be distinguishable from other names on the filing office’s records.
(c) Formation documents
A corporation’s formation document is generally called articles of incorporation. An LLC’s formation document is generally called articles of organization. Although both of these documents serve to create the named entity, there are important differences between the other functions of articles of incorporation and articles of organization.
(i) Articles of incorporation
In most states, very little information is required to be set forth. It is not unusual for the statutes to require the articles of incorporation to only set forth four items of information — the corporation’s name, number of authorized shares, name and address of initial registered agent and office, and name and address of each incorporator.
However, the articles of incorporation can also contain many other provisions that will govern the management of the business, and the powers, rights, and authority of the directors and the shareholders.
Through careful drafting, the articles of incorporation can be used to meet the specific needs of the corporation, its management, and its shareholders. Furthermore, many provisions governing the corporation will be effective only if included in the articles of incorporation. In the absence of such provisions, the corporation will be subject to the statutory default provisions.
(ii) Articles of organization
The LLC acts, like the corporation laws, do not require many provisions.
However, unlike articles of incorporation, 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 generally set forth in the LLC’s operating agreement.
(d) Governing documents
In addition to the formation document, a corporation and an LLC will have a governing document. A corporation’s governing document is called bylaws. An LLC’s governing document is generally called an operating agreement. As was the case with the formation documents, there are important differences in the function and content of the governing documents of a corporation and an LLC.
The 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.
Typical bylaw provisions include: (1) the location of offices, (2) the rules governing the holding of shareholders' and directors' meetings, (3) the election and removal of directors, (4) the size of the board of directors, (5) the titles and duties of officers, and (6) the creation and duties of directors’ committees.
(ii) Operating agreement
The operating agreement 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.
Typical issues addressed in the operating agreement include, but are not limited to (1) who will manage the LLC, (2) the powers and authority of managers or managing members, (3) rules for holding meetings, (4) members’ names, capital contributions, and percentage interest, (5) the allocation of profits, losses, distributions, and voting rights (6) admission of new members, (7) members’ right to withdraw, (8) the members’ right to inspect book and records, (9) the members’ right to assign their interests, and (10) how the LLC will be dissolved.
(e) Organizational meeting
Another difference in the way corporations and LLCs are formed is the need to hold an organizational meeting. The corporation statutes require an organizational meeting to be held after the articles of incorporation are filed, in order to complete the organization of the corporation. The LLC statutes, in contrast, do not require the holding of an organizational meeting.
Corporation and LLC statutes differ in their management provisions. The corporation statutes prescribe who manages a corporation and impose certain rules that management must follow in conducting business. The LLC acts provide much more flexibility in how LLCs are to be managed.
All business corporation acts provide that a corporation’s business and affairs will be managed by or under the direction of a board of directors. A board of directors may consist of one or more members who must be natural persons. The statutes also provide that directors are elected by shareholders at their annual meeting.
Although the board has the power to make all decisions on a corporation’s behalf, many business decisions are actually made by the corporation’s officers. Generally, the titles and duties of each officer are set forth in the bylaws.
Shareholders do not have the power to act on a corporation’s behalf. They affect the corporation’s management by voting to elect and remove directors and approve or reject certain major transactions.
(b) Limited liability companies
An LLC may be member-managed or it may be manager-managed. Managers and managing members may be natural persons, or — unlike directors — they may be entities.
In contrast to the corporation statutes, the LLC acts have default rules providing that the company will be managed by its members. In a member-managed LLC, each member has equal rights in the management and conduct of the company’s business, unless the operating agreement provides otherwise. Every member is an agent of the LLC for the purpose of conducting its business and affairs and may bind the company by his or her actions.
Management of an LLC may also be vested in one or more managers. The LLC must provide for manager-management in its operating agreement, and, in some states, in its articles of organization as well.
In a manager-managed LLC, the members’ role may be similar to that of a shareholder, with the member being able to vote on certain major actions but having limited say in business decisions.
4. Shareholders vs. members
How does being an owner of stock in a corporation compare to being an owner of a membership interest in an LLC? By virtue of acquiring their stock or membership interests, shareholders and members receive certain benefits, rights, and obligations. This section will describe the benefits, rights, and obligations that are associated with corporate stock and LLC membership interests.
(a) Benefit of limited liability
One of the key similarities between corporations and LLCs is that corporate shareholders and LLC members receive the benefit of limited liability. The statutes provide that corporations and LLCs are entities with their own legal existence separate and apart from their owners and are responsible for their own debts and obligations.
(b) Rights to dividends and distributions
Shareholders have a right to dividends.
However, it is the board of directors that decides, at its discretion, if and when a dividend will be declared. The shareholders do not have a say in whether dividends will be paid. When a corporation pays a dividend, it distributes it to shareholders equally on a per-share basis.
Shareholders also have the right to receive distributions of the corporation's assets after the corporation liquidates. Shareholders share the net assets in proportion to their share ownership. A corporation may have a class of preferred stock that will receive the net assets before other classes of stock.
LLC members may also receive a dividend (or an interim distribution of assets, as it is known). In contrast to shareholders, members generally have to approve interim distributions. Distributions may be allocated equally, based on the value of the member’s capital contributions, or split almost any other way the members choose that is set forth in the operating agreement.
Members also have a right to liquidating distributions of LLC assets. These distributions will be allocated as provided in the operating agreement.
The default statutory rule is that shareholders and members may freely sell or transfer their right to receive dividends and distributions.
(c) Right to vote
Shareholders have the right to vote for directors and for changes in the corporation's structure that would materially affect their ownership such as proposals to amend the articles of incorporation, to merge, convert, and to dissolve the corporation.
In a member-managed LLC, the members can vote on matters affecting the LLC's business and affairs.
In a manager-managed company, however, members have the right to vote on certain major issues only.
The statutory default rule for a corporation is that when shareholders sell their stock, the buyer receives the same voting rights that the seller had. But, the default rule of the LLC statutes is that members cannot sell or transfer their voting rights to third parties without the consent of the other members.
(d) Right to inspect books and records
Both shareholders and members have the right to inspect certain of the entity’s books and records. This includes the formation and governing documents, a list of shareholders or members, and accounting records. For some records, the corporation and LLC acts require that the shareholder’s or member’s purpose for demanding the records must be related to the person’s interest as a shareholder or member.
The corporation statutes also generally provide that the corporation cannot restrict the shareholders’ right to inspect books and records in its articles or bylaws. In contrast, some LLC laws specifically give the LLC the right to impose restrictions on a member’s inspection right in the operating agreement.
(e) Obligations of shareholders and members
The main obligation of shareholders and members is to pay, in full, the amount owed for their shares or membership interests. Shareholders, in general, do not owe fiduciary duties. A member in a member-managed LLC does owe fiduciary duties. Those duties may be set forth in the LLC statute or in the operating agreement.
5. Compliance issues
This section describes some of the statutory requirements corporations and LLCs must comply with during their existence.
(a) Amendments to formation documents
If there is a change in the information set forth in a corporation’s articles of incorporation or an LLC’s articles of organization, the corporation or LLC must amend its formation document.
The corporation laws tend to have more specific provisions governing the procedure for adopting amendments than the LLC statutes.
However, both the corporation and LLC laws provide that in order for an amendment to become effective, a document — generally called articles of amendment — must be filed with the formation state.
(b) Registered agent and office
Another similarity between the corporation laws and LLC acts is that they require the maintenance of an agent for service of process in the state. Generally known as a registered agent, this agent may be an individual or a domestic or foreign corporation or unincorporated entity. The registered agent’s location is generally referred to as a registered office.
The name of the registered agent and address of the registered office must be set forth in the formation document and annual report. If the registered agent resigns, dies, is fired, or must be replaced for some other reason, the corporation or LLC must appoint a new one and notify the formation state. If the registered agent’s address changes, notice must be given as well. Notification of a change in the registered agent or office may be done by filing a notice of change, by amending the formation document, or by amending the annual report, depending upon the state.
Under most corporation statutes and some LLC laws, the failure to maintain a registered agent and office, or to notify the state of a change in a timely manner, will be grounds for the state to begin proceedings for administrative dissolution of the corporation or LLC.
(a) Voluntary dissolution of corporations
All corporation statutes allow corporations to dissolve voluntarily by the board of directors adopting a proposal to dissolve, submitting the proposal to the shareholders, and the shareholders voting in favor of the proposal. Most states have a default rule requiring the vote of a majority of outstanding stock to approve the proposal. After dissolution is approved, the corporation must wind up its affairs. It may not conduct any business other than that necessary to wind up.
Following the shareholders’ approval of the decision to dissolve, the corporation must make a filing with its state of incorporation. In general, a corporation will have to be up-to-date in its tax payments or the state will not file its dissolution documents. Some states also require the filing of a tax clearance certificate issued by the state tax department.
(b) Voluntary dissolution of LLCs
The LLC statutes contain a list of occurrences upon which an LLC must dissolve and wind up. These include, typically, a time or event set forth in the operating agreement and upon the consent of the number or percentage of members set forth in the operating agreement. Some states also provide that any time the LLC is without members it must dissolve. Following the event of dissolution, the LLC must wind up its affairs The LLC must also file a document, which may be called articles of dissolution, articles of termination, or articles of cancellation, among other names.
7. Doing business in foreign states
All corporation and LLC statutes provide that a foreign corporation or foreign LLC transacting business in the state must qualify to do business. The statutes relating to foreign corporations and LLCs are similar.
(a) Determining if a corporation or LLC is doing intrastate business
Few laws define the phrase “doing” or “transacting” intrastate business. Most statutes do, however, list activities that do not constitute doing intrastate business.
A typical corporation or LLC law provision includes, among activities, (1) maintaining, defending, or settling any proceeding, (2) carrying on activities concerning internal affairs, (3) maintaining bank accounts, (4) selling through independent contractors, (5) soliciting or obtaining orders that require acceptance outside the state, (6) creating or acquiring indebtedness, (7) securing or collecting debts, (8) owning property, and (9) doing business in interstate commerce.
(b) Penalties for doing business without authority
Corporations and LLCs transacting business in a state may not maintain a proceeding in any court of that state until they have qualified. Many states also impose monetary penalties on foreign corporations and LLCs that do business before qualifying.
(c) Qualifying a foreign corporation or LLC
Corporations and LLCs become qualified to do business in a foreign state by filing a document — often called an application for a certificate of authority or application for registration — containing the information required by the foreign state’s statute.
The corporation and LLC statutes also require supporting documents to accompany the application for authority or registration. The most commonly required supporting document is a certificate of existence from the home state. A few states require the filing of a certified copy of the formation document and all amendments thereto.
(d) Compliance issues
The compliance obligations for foreign corporations and LLCs are similar to those of domestic corporations and LLCs. In general, foreign corporations and LLCs must appoint and maintain a registered agent and a registered office in the state, file an annual report and pay a franchise tax or fee, and
amend their qualification documents under certain circumstances.
(e) Foreign withdrawal
A corporation or LLC that stops doing business in a foreign state can withdraw or cancel its authority to do business there. Withdrawal is accomplished by filing a document with the foreign state’s filing office. The document may be called, among other names, an application for a certificate of withdrawal, a certificate or statement of cancellation, or an application for surrender.