LLC vs. Corporation

Limited Liability Company (“LLC”) vs. Corporation (C-corps and S-corps)

The concept of the “corporation” dates all the way back to the Roman Empire. For our purposes, however, you should just remember that corporations and LLC’s share THREE important characteristics: (1) they both have a legal personality with legal rights and obligations, like people; (2) they may both be owned by multiple people (or in the case of LLC’s, other LLC’s) whose ownership is securitized as stock or membership; and (3) they both limit the liabilities of its owners, who can lose nothing more than the capital already invested.

One of the most important legal steps you’ll take is forming your own corporate entity, which will usually be either a corporation or an LLC. We’ll discuss the differences between them but it’s worth noting that that LLCs tend to be more favorable.

Taxation

Corporations are taxed as either S-corporations (“S-corps”) or C-corporations (“C-corps”). What that means is that S-corps are taxed pursuant to Subchapter S of the Internal Revenue Code, and C corps are taxed pursuant to subchapter C.  If you form a corporation, you may choose for it to be taxed one of TWO ways. Either under: (1) subchapter C of the Code, or (2) subchapter S of the Code.

LLC’s on the other hand, may elect any one of four methods of federal income taxation. An LLC may be taxed: (1) as a sole proprietorship (if the LLC has only one member or only two members who are a husband and wife who own their interest as community property – see Revenue Procedure 2002-69); (2) under Subchapter K of the Code as a partnership (if there are at least two members), (3) under Subchapter C of the Code as a “C-corporation,” or (4) under Subchapter S of the Code as an “S-corporation” (if the LLC satisfies the requirements for Subchapter S taxation).

Note: If an LLC elects to be taxed under Subchapter S, it will have pass through taxation like an S-corp. But … if that’s the case, then the LLC’s distribution of profits is subject to an employment tax, while the dividends from a S-corp are not.

Asset Protection

The LLC is considered superior to a corporation when it comes to asset protection. Here’s why. Let’s say Mr. Creditor has a judgment against you for $25,000. If you hold stock in a corporation, Mr. Creditor can force you to sell that stock in order to satisfy the debt. In contrast, if you are a member of an LLC, Mr. Creditor is only able serve you with what’s called a “charging order.” A charging order (which is issued by from a judge) allows Mr. Creditor to get only the money or property that is distributed to you, the member. Thus, if the LLC never distributes anything to you, then Mr. Creditor won’t get anything, either.

Formalities

Unlike LLC’s which have no formal annual requirements, Corporations are required to: (1) hold annual meetings of shareholders, (2) hold annual meetings of the board of directors, (3) document the meetings of shareholders with minutes or resolutions, (4) document the meetings of the board of directors with minutes or resolutions, (5) file an annual report with the Arizona Corporation Commission, and (6) pay a $45 annual fee to the Arizona Corporation Commission. Should a corporation fail to fulfill these formalities, the Arizona Corporation Commission may dissolve the entity.

Note: At the very LEAST, your entity should have a separate checking account, its own EIN and an operating agreement (for LLC) or bylaws (for a corporation) – with regard to legal formalities – so that it appears to the rest of the world and the Court that the entity is separate from you, and not an “alter ego.” Otherwise, Mr. Creditor may be able to pierce the corporate veil and get to your personal assets in order to satisfy a judgment against your entity.

While we advise all of our clients to keep hold meetings and keep records, Arizona does not require LLCs to have meetings of members and managers or to document meetings with minutes or signed resolutions.  This ease makes an LLC superior to a corporation. If a creditor tries to pierce the company veil and hold the members liable for the debts of an Arizona LLC, the LLC will not be found wanting for failure to follow formalities if they are unable to produce meeting minutes or resolutions.  On the other hand, this could be a problem for a corporation that was legally obligated to keep those records.

Ownership

The owners of a corporation are called “shareholders” while the owners of an LLC are “members.” The difference between shareholders and members is significant. The members of an LLC may distribute ownership without regard to a capital contributions, so profits can be distributed just as freely (subject to the operating agreement). In sum, in an LLC, although a certain member may not have invested as much as another member, an LLC’s operating agreement may allow for an equal share of the profits among the members.

A C corp can do something similar, but doing so would require different classes of stock. In contrast, an S-corp must have only a single class of stock, with dividends distributed in proportion to a shareholders capital investment.

Operating/Managing/Running the Business

Any member of an LLC may be a manager – even another LLC. In contrast, a corporation must have a more formal corporate structure – there must be a board of directors for management (who represent the shareholders) and  officers (who run the business operations). The shareholders of a corporation are separate from the decision making process (except for some major decisions) and tend only to elect the board of directors. Of course, a shareholder can be elected as a board member or hired by the board as an officer.

Conclusion

Ultimately, most entities formed in Arizona are LLCs. Of course, we’ve advised clients to set up corporations as well, and they’ve become board members, officers and shareholders, or any combination thereof.  While there are many issues to balance in choosing between a corporation and an LLC, the LLC is generally the most popular entity to use in Arizona due to its flexibility (taxes, governance and distributions), increased asset protection and more relaxed formalities requirements.