Mike is running a successful business, yet now has a chance to diversify his assets and add to what he already has. It has been a long-time goal of his to create multiple streams of income. The question before him is what is the best way to do so for his additional businesses? He knew what made sense for his main business, yet he is not sure how to structure the new company.
This is a common challenge a lot of companies face as they look to expand. Whether it is how they manage their real estate portfolio, how to add different lines of business, how to start a nonprofit, or anything else, there are a lot of options. The most common are LLCs and Corporations. However, what is the difference between these two? Understanding the differences among corporations and LLCs will enable you to decide which structure best fits your situation. The biggest differences between them are: 1. How the Business is Formed, 2. Ownership, 3. Profits and Losses, 4. Management, and 5. Some Additional Key Areas.
- How the Business is Formed
A limited liability company (LLC) is formed by one or more business people, as owners of the company. The owners are called “Members,” and the Members file Articles of Organization and create an Operating Agreement for how the company will operate. See our prior post on the importance of the Operating Agreement. An LLC is considered a pass-through business structure because the profits and losses are passed on to the individual Members depending on each Members individual share of the company. The tax rate that each member pays for an LLC is based on the individual tax bracket of that member.
Whereas, a corporation is formed, i.e. incorporated, by filing corporate organization documents in the state where the corporation is located, and by designating shareholders, each with a specific number of shares. The corporation also creates a Board of Directors to oversee the corporate business and make important business decisions. This is a much more formal option, in which corporate formalities must be maintained. Please note, depending on your state, an LLC can be converted to a corporation, yet the reverse is generally not true. A corporation cannot convert to an LLC. If the goal is to go public within a short period of time, the intention is to enter into formal ownership of a company that you plan to have a long-term commitment, or if there is not an overwhelming need for flexibility, and maintaining corporate formalities is not a problem, then a corporation could be a great option. - Ownership
A main difference between LLCs and corporations is the ownership of the business. A corporation is owned by the individuals who purchase shares of the company, whereas the LLC is owned by the Members. Instead of shares, each Member of an LLC owns a designated percentage of the company, often referred to as the “membership interest”. Membership interest in an LLC may be more difficult to transfer than shares in a corporation. This is often why companies with a goal going public fairly soon, should keep an eye towards having a corporation. - Profits and Losses
Additionally, the profits and losses of an LLC are handled in a different way than a corporation. Because an LLC is a pass-through entity the profits and losses are passed through to individuals, while corporate profits and losses are held by the corporation. Pass-through businesses are those in which the profits and losses of the business pass through to the owners or shareholders. In other words, the business income is considered as the owner’s or shareholder’s income, and the owner/shareholder pays the tax on his or her personal tax return.
Corporations are separate businesses entities where the profits and losses of the corporation are held by the corporation and are not passed through to the owners directly. Corporations are taxed at the shareholder level and the entity level. - Management
Furthermore, both corporations and LLCs have a different management structure. Corporations must have a board of directors that set policies and oversee the business. These day-to-day affairs of a corporation are managed by its officers. The rights and responsibilities of the directors, officers, and shareholders are spelled out in the corporation’s bylaws. LLCs are a newer concept than corporations, and they are designed to be more flexible in the way they are managed. An LLC can be managed by its members or by a group of managers. Typically, in a member-managed LLC, the owners are heavily involved in running the business, while a manager-managed LLC usually has investors who don’t have an active role. - Additional Key Considerations
Another important consideration when deciding between an LLC and corporation is the tax implication. With the enactment of the Tax Cuts and Jobs Act, corporations now have a top corporate income tax rate of twenty-one percent (21%) as opposed to the old top rate of thirty-five percent (35%),and the corporate alternative minimum tax has been repealed. The corporation must pay an estimated income tax, applicable employment and excise taxes, and taxes on gains of appreciated assets, though shareholders, who are responsible for paying taxes on dividends. Thus, corporations are subject to double taxation in the form of taxation at the corporate level, and again when dividends are distributed to shareholders. Despite these mandatory taxes, corporations may deduct employee fringe benefits and reasonable compensation for officer and shareholder-employees; certain gains may be excluded or deferred, and certain losses may be carried. Unlike corporations, LLCs do not have a distinct federal taxation scheme, so each LLC is treated like another form of business. Single member LLCs are taxed as sole-proprietorship, whereas multi-member LLCs are taxed as partnerships; however, any LLC may elect for corporation taxation. Also unlike corporations, LLCs allow for the creation of a series LLC. A series LLC is created when one divides membership interests into separate classes.27 Though this is a statutory construction where specifics are dependent upon the state in which the LLC is formed, series LLCs statutes generally determine the rights of the holders of each series and protect assets of a particular series from the liabilities of the LLC as a whole, or another series within the LLC. In general, obtaining a “registered series LLC” status only requires on additional step beyond the initial LLC setup: the filing of a certificate of registered series such that each series has the attributes required to be classified as a “registered organization” under the Uniform Commercial Code.
Finally, LLCs are often the best option when dealing with real estate. LLCs offer limitations on personal liability in lawsuits related to the property at issue in such a way that the risk exposure for any claims is limited to only the assets owned by the LLC, rather than the assets owned by the member(s) of the LLC. Further, because LLCs are subject to partnership taxation as referenced above, LLC owners are able to enjoy the benefits of pass-through business taxation instead of the double taxation that would result if a corporation were used. Indeed, regardless of whether there is an individually owned or multi-member LLC, default IRS taxation law would allow all income and capital gains from a real estate transaction to pass through directly to the owner(s), who would then only be responsible for taxes at their respective individual tax rates. LLCs also offer more flexibility in delegating management responsibilities, lower registration and maintenance fees, and flexibility in distributing profits. Unlike LLCs, corporations are statutorily required to have officers and directors, which limits flexibility in management, and require increased fees based on the number of shares, while still requiring pro rate profit distribution. So long as the laws and regulations are complied with, and the Articles of Organization and Operating Agreement clearly detail the roles of all members, LLCs offer much more flexibility and limits on liability than corporations when real estate is at issue.
Please note that the above is general legal information. Please contact us at [email protected] directly for a complimentary consult that centers on specific legal advice for your legal matter. We look forward to working with you.
Works
Consulted:
- Jean Murray, LLC or Corporation- Which Should I Select for My Business, The Balance Small Business, (Oct. 6,
2018), https://www.thebalancesmb.com/what-is-the-difference-between-an-llc-and-a-corporation-397526. - Jane Haskins, Difference Between LLC and Inc., (Dec. 2014).
- William
G. Gale, Hilary Gelfond, Aaron Krupkin, Mark J. Mazur, and Eric Toder, Effects
of the Tax Cuts and Jobs Act: A Preliminary Analysis,Urban-Brookings Tax Policy Center (Jun.
13, 2018), https://www.taxpolicycenter.org/publications/effects-tax-cuts-and-jobs-act-preliminary-analysis/full. - Leslie
D. Corwin & Arthur J. Ciampi, Law Firm Partnership Agreements §
2.03, Law Journal Press (2019). - Jeff
Weaver, Forming an LLC for Real
Estate Investments: Pros & Cons, (Jan. 2014). - Thomas
A. Humphreys, Limited Liability Companies and Limited Liability Partnerships
§ 2.02(5)(h)(i), Law Journal Press
(2019).
