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Business entity selection: Corporation and LLC compared

When forming a new company, business people are confronted with the issue of which type of business entity to select.

This article focuses on comparing the Corporation to the LLC, while recognizing that there may be other entity forms more appropriate to specific circumstances, including sole proprietorships, general partnerships, limited partnerships, trusts, and a pure contractual agreement.

The characteristics of an entity can be analyzed for the existence or lack of specific features. The most common features to consider are: i) limitation of liability, ii) tax treatment, iii) default rules in connection with organize structure and governance; including minority protections, fiduciary duties and succession planning, and iv) asset protection (reverse piercing).

Limited Liability

Both the Corporation and LLC are limited liability entities. This means that the liability exposure of the investors or owners of the entity are limited to the amount of capital committed or contributed to the entity. No matter what or how a liability the entity incurs, the investors/owners are shielded from this liability. Ordinarily, the shield can only be challenged pursuant to the corporate riel piercing doctrine, which usually requires exceptional circumstances. There is no significant distinction between the Corporation and LLC with respect to the limited liability feature.

Governance Default Rules

Simply put, the corporation has an extensive framework of statutory default rules with respect to the organic structure and corporate governance over the entity. These default rules can be considered a boon or a bane, depending on perspective, and depending on the ownership structure.

A single owner entity will notice two differences between a corporation and a LLC with respect to organizational structure and default rules. However, from the perspective of succession planning, a corporation offers the benefit of being able to insure the continuity of the business upon the death of the owner. The beneficiary of the shares of corporate stock can immediately appoint new directors and officers. The beneficiary of a membership interest in an LLC may not even be considered a member, calling into question, whether the LLC can even validly continue. Careful drafting of the LLC operating agreement is critical to avoid such pitfalls.

The analysis broadens when there are two or more entity owners. External and internal relations must be considered, how an agent can bind the entity. The corporation provides for a default set of rules whereby the shareholders must appoint directors, who in turn appoint officers. The officers are the agents of the corporation, capable of validly binding the corporation. Unless the corporate shareholder is appointed as an officer, he will be twice removed from the management of the corporation.

In contrast, each member of an LLC, that has not elected to be a manager managed LLC, is an agent of the LLC and can validly bind the LLC. This default rule can be modified by electing for manager managed structures, which shifts the agency from the members to a defined manager(s).

The owners of an entity also need to be clear on their respective fiduciary duties to one another. Ordinarily, a mere shareholder of a corporation does not owe the corporation and/or the other shareholder a fiduciary duty. However, in a closely held corporation where one or all of the shareholders hold an officer position in management, such manager will owe fiduciary duties to the corporation and its shareholders. These fiduciary duties are extensive and well established in common law. In comparison, by nature of membership in an LLC, the members each owe each other a fiduciary duty. However, these duties are statutorily defined and less expansive than the common law principles. Hence, the LLC offers more flexibility with respect to the Members ability to conduct business outside of the LLC. Further intended restrictions or relaxations of the principles should be covered in the operating agreement of the LLC.

The default rules of the LLC in general compared to the corporation, grant more autonomous. In the realm of minority protections, however, this can prove to be an onus to the minority owner. For example, in organic transactions, a minority owner may not have assessment and cash out rights that he might have under the corporate entity. Under certain circumstances a minority member could be divested of his voting and control  rights and be left with is capital locked up, entitled only to the economic benefit. These issues can be managed through careful drafting of the operating agreement. In short, the LLC offers business partners the ability to contractually arrange for the internal relations much more flexibly then a corporation.

Asset Protection

Limited Liability protects the owners from the liabilities of the business entity. What protects the business entity from the liabilities of the owner? The risk that the assets of the business entity might be marshaled against to satisfy liabilities of the owners is know as reverse piercing.

Tax Treatment

Avoiding double taxation is one of the most important planning factors when selecting a business entity. A C-Corporation has two levels of tax: one at the corporate level itself and the second upon distribution of earnings to the shareholders. Many businesses are able to avoid this by electing for S-Corporation status, which allows the entity to be treated as a partnership on hence taxed on the shareholder level only. Certain requirements must be satisfied to avail oneself of the sub-s election, e.g. must be a US citizen or green card holder. Hence, a non-resident alien could not form an S-Corporation.

The members of an LLC can elect (check the box) to treat the LLC for tax purposes as a corporation or a partnership. Accordingly, the LLC can be used to avoid double taxation. There are no restrictions regarding residency status.

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