How do I choose an entity type?
September 24, 2020
When starting a business, a business owner must first choose their entity type. Two of the most popular entity types are the limited liability company (LLC) and the corporation. Choosing between these two types of entities can be difficult for business owners who are not familiar with the unique features of each type. To choose the right one for your business, you should be aware of their similarities and differences.
Similarities Among Entity Choices
Limited liability companies and corporations are types of legal business structures—ways to legally organize a business under state law. Both of these legal structures provide limited liability. Limited liability means that a person or entity’s legal, and therefore financial, liability is limited. Owners are protected more under limited liability structures because they are not personally liable for the business’s liabilities or debts, although there are some exceptions. The objective of choosing an entity that provides limited liability is to protect business owners’ personal assets from being reached in lawsuits against the business or by the business’s creditors. LLCs and corporations both also require documentation to be filed with the state government at the time of formation. A fee to register the business entity must accompany the filing.
Differences Among Entity Choices
Despite significant similarities, LLCs and corporations also have several distinguishing characteristics. The LLC is a newer entity structure and provides more flexibility than the corporation. However, LLCs often mimic corporations in their planning and legal documentation to some degree. Here are some of the key differences between these two entities:
- Naming Requirements. This is a small but significant distinction between corporations and LLCs. In most states, statutory law requires that the name of an LLC end with the words “Limited,” “Limited Liability Company,” or an abbreviated form of those terms. In contrast, the name of a corporation must end with “Incorporated” or “Corporation. This distinction is important because your application may be rejected if you fail to comply with these naming requirements. Use care to ensure that your application is not disqualified due to what may seem to be a minor mistake.
- Ownership Structure. LLCs and corporations have different ownership structures. The owner of an LLC is typically called a member, and ownership interests can be defined by units (similar to shares of corporate stock) or by percentage. A state’s LLC statute may be a key factor in how members choose to define ownership or, in other instances, members may structure ownership as they like. Unlike a corporation, ownership interests in an LLC do not have to reflect a member’s contribution of money or property to the LLC. In cases where there are fewer owners, and there are fewer limitations as to how ownership interests are distributed, members may also opt to describe ownership in percentages. On the other hand, the owner of a corporation is called a shareholder or stockholder, and the units of ownership are called shares or stocks. The structure of the corporation transfers easily by dividing ownership into these units. LLCs with ownership interests consisting of units borrow this structure from the corporation, reflecting the LLC’s flexible nature.
- Management. LLCs and corporations also diverge in their management. LLCs typically take one of two basic structures: member-managed or manager-managed. In manager-managed LLCs, the members conduct the day-to-day management of the LLC. In manager-managed LLCs, one or more managers, who may or may not be members of the LLC, have the authority to make decisions for the entity. In manager-managed LLCs, unless otherwise dictated in the operating agreement or company formation documents, a member of the LLC can serve as a manager. An LLC’s operating agreement may even require that managers of the LLC be members. In corporations, by default, a board of directors has management authority. The board is answerable to the shareholders and is charged with the day-to-day management functions. The members of an LLC also have the flexibility to choose to create a board of managers similar to a corporation’s board of directors.
- Taxes. A major area of distinction between corporations and LLCs is the tax structure. LLCs, unless they choose to be taxed as a C corporation, enjoy pass-through taxation. This means that the LLC entity itself is not taxed; rather, the taxes flow through to the LLC’s owners. On the other hand, corporations are subject to double taxation. This means the corporate entity must pay taxes on corporate income, and the corporation’s shareholders must also pay taxes on the dividends they receive. 5.Maintenance. To maintain their legal status, both of these entity types require some degree of maintenance; however, the complexity of this maintenance differs. In most jurisdictions, LLCs require some form of regular reporting (annually in many states) to be filed with the relevant state agency. An LLC typically must also pay annual fees and taxes to maintain its legal status. By contrast, a corporation requires annual meetings of shareholders and the board of directors in addition to filing the annual report.
We Are Here to Help
Choosing between these two legal entities requires a great deal of consideration and depends upon your unique needs and goals. If you need assistance weighing the risks and benefits of each business type, please contact us today or schedule an appointment using our online scheduling. Our attorneys are ready and available to provide the analysis you need to make the best decision for you and your business.