Corporations versus Limited Liability Companies

By Jennifer Reuting

If this is your first venture, you may think of all corporations as massive multinational conglomerates, but that isn’t the case. Corporations have been around for centuries and, until the recent introduction of the limited liability company (LLC), were the only business structure that allowed entrepreneurs to start ventures without opening themselves up to heaps of personal liability.

Contrary to popular belief, a corporation isn’t much more difficult to form and maintain than a limited liability company.

You’ll notice that the vast majority of publicly traded companies are structured as corporations. This is because, unlike limited liability companies, corporations have automatic free transferability of ownership interests (called stock). They are also backed by hundreds of years of case law that removes questions as to the outcomes of lawsuits.

This is especially true in Delaware, where a court of chancery takes lawsuits involving corporations incredibly seriously and has worked hard to develop fair and accurate case law that directly supports and benefits the shareholders of the business. This is why most publicly traded corporations are Delaware corporations.

Creating a legal “person”

A corporation is different from a sole proprietorship or partnership in that it’s considered a legal entity unto itself, completely separate from its owners (called shareholders). In the eyes of the law, corporations are treated as if they were people, with distinct identities. Corporations are able to sue and be sued, and lawsuits must be brought against the corporation rather than the individual shareholders. (A limited liability company has a lot of similar characteristics.)

Maintaining a separation between you and your business becomes a big concern when you’re operating as a corporation. If this legal separation fails, a creditor could pierce the corporate veil and go after your personal assets to settle the debts and obligations of the business.

In order to maintain your corporation’s liability protection, you must be diligent about recordkeeping. This task includes drafting minutes that document the annual and special meetings of the shareholders and directors.

Even if you’re the sole shareholder, you still need to follow these formalities, and all major decisions affecting the operation of the business need to be made by formal resolution and properly documented. In addition, you must keep accurate financial records and refrain from commingling personal funds with those of your business.

Taking these steps to protect yourself may seem like a lot of work, but it’s worth it in the long run. Limited liability companies have fewer recordkeeping requirements but also less case law that substantiates that recordkeeping isn’t required. If you decide that a corporation is the route for you, then you’ll want to sign up for an online service that automates and stores your company recordkeeping.

This service enables you to relax, knowing that you’re one important step closer to your corporate veil holding up in court. You’ll also have fewer intercompany disputes because all major decisions will be made according to procedure and accurately documented.

A corporation protects its owners from lawsuits and creditors; however, it doesn’t protect the business from the liabilities of the owners like an LLC does. So if a shareholder of a corporation is sued for personal reasons, her ownership (stock) of the corporation is considered a personal asset of hers and can be seized by the judgment creditor.

Depending on the level of your personal exposure to liability, the fact that a corporation lacks this dual protection (which is inherent in a limited liability company) may end up being a huge prohibiting factor for you.

Dealing with the blow of double taxation

Like the courts, the Internal Revenue Service considers corporations to be entities separate from their owners. Corporations are the only entities that are subject to their own taxation. The company’s profit (or loss) does not flow through to the owners of the business, but instead remains in the corporation and is subject to corporate income tax.

From there, you can distribute the profits to the shareholders in the form of dividends. This is where things can get a bit tricky. After the profit is distributed to the shareholders, it’s taxed again at the shareholder level. Because the same profits are taxed twice — both at the corporate level and at the individual shareholder level — this is commonly referred to as double taxation.

As scary as it sounds, double taxation doesn’t have to be a bad thing. If you wish to retain the profits in the company rather than distribute them, then only the company will pay taxes, and you’ll actually pay less in taxes than if your business was subject to the pass-through taxation of a partnership or sole proprietorship. LLCs can elect corporate taxation, and in some cases, this is the right thing to do.

When a corporation issues dividends to its shareholders, it doesn’t have the same flexibility that a limited liability company enjoys. Dividends in a corporation must be issued in proportion to the shareholders’ ownership interests.

Unfortunately, the corporation’s losses cannot be passed on to the individual shareholders to help offset their other income. Even though the losses do need to stay in the corporation, this isn’t such a bad deal for small businesses that intend to turn a profit soon.

Corporate losses can be used to offset corporate profits in other years (so you don’t pay taxes on that portion of profits), up to 2 years retroactively and up to 20 years in the future.

The IRS recognizes corporations as separate taxable entities. So, unlike in partnerships and sole proprietorships, you can’t transfer assets into and out of a corporation as easily without creating a taxable event.