Many people are confused about the differences between an LLC (limited liability company) and a corporation. Corporations have been around for hundreds of years, but limited liability companies are a relatively new type of entity – prior to 1988, it was unclear how such entities would be taxed, so few states enacted laws allowing their creation. Texas adopted its first statute allowing the creation of an LLC in 1991.
Either an LLC or a corporation can shield the owners from personal liability for company debts (provided that you keep your personal funds separate from your company funds, and are careful about how you sign documents and advertise your business).
Although the most frequent reason that I hear for wanting an LLC instead of a corporation is that there is “less paperwork,” for most small businesses, the paperwork they’re referring to is literally two documents each year – records of a shareholders’ meeting and a directors meeting. For most small businesses, the shareholders are going to document a meeting once a year to elect directors – likely the same directors that were elected the previous year – and a directors meeting to appoint corporate officers – likely the same officers that were appointed the previous year. This means that the amount of operational paperwork difference between the two is minimal; the cost of setting up one or the other is the same, since the require the same steps.
The terminology used and governance of the company is a significant difference that often gets ignored. The owners of a corporation are called shareholders; the owners of an LLC are called members.
In a corporation, the shareholders elect directors, and the directors appoint officers. The officers (President, Vice President, Secretary and Treasurer) run the company. There should be Bylaws that set out how the company will be governed, and there may or may not be a shareholders’ agreement which governs the relationships between the shareholders, and may include restrictions on the ability to transfer company stock.
A shareholder with a certain percentage interest in the company has the same percentage interest in the profits and losses. However, a member of an LLC may have a different percentage interest in the profits and losses of the company that their ownership percentage. This means that the LLC framework is more flexible, which also means there are more ways things can be misunderstood or go wrong.
A corporation may be set up as either a “C” corporation – a C corporation is taxed on the profits, and shareholders are taxes on the distributions they receive, if any. This can result in double taxation, since the company is taxed on the whole profits, and the shareholders are taxed on the part of the profits they receive.
An “S” corporation files an informational return, and does not pay income taxes on its profits. Instead, the informational return tells the IRS the amount of profits allocated to each of the shareholders, and the shareholders pay taxes on their percentage of the profits, whether those profits were actually paid to the shareholder or not.
A limited liability company runs bit differently. An LLC may be run by either its members (owners) or a manager. If there is no manager, there will be at least one Managing Member who actually runs the company. Nevertheless, I see many LLCs that grant titles such as “President” or “CEO” to the people who run the company. In that situation, the title has no legal significance.
A limited liability company should have an Operating Agreement or Member Agreement, which governs the relationships between the members, and how the company is governed.
A limited liability company is taxed, by default, like a partnership – the same as an S corporation – but there is no need for the LLC to file a tax return. The cost of filing the company tax return may be the biggest difference between the two, so for a new entity without a lot of expected income, and LLC may be less expensive to maintain. The LLC may choose to be taxed like an S corporation, but if it does, it will not be able to make distributions to the members that are disproportional to their ownership interests.
There are a few situations in which the type of entity will matter – for example, IRS rules prohibit a non-resident alien from owning an interest in an S corporation, but they are allowed to own an interest in a limited liability company.
Both limited liability companies and corporations are now required to report their beneficial owners to FinCen – the Financial Crimes Enforcement Network – when they are formed and when ownership changes. This reporting requirement began in 2024, and penalties for not timely reporting can be steep. The stated purpose of this reporting requirement is to stop money laundering, though it’s difficult to imagine how imposing fines on people for failing to report information to a separate office of the federal government that the IRS already knows would stop money laundering.
Whichever type of entity you choose, be sure to treat it as a separate person – keep your personal funds separate from your company funds, and make sure that all contracts and advertisements reflect whether you are doing business for yourself personally, or for your company.
If you have questions or run into problems, call your favorite lawyer.
