There are three basic forms of business entity: an LLC, a corporation and a partnership. Most other forms are either variations on one of those three, or the same entity with a special tax classification. Generally, a legal entity is formed and exists under state law, while its tax classification is governed by Federal law.
An LLC is a limited liability company, a form of corporation that became common over thirty years ago. LLCs are best thought of as partnerships that have certain features of a corporation, most importantly, limited liability for its members/owners. An LLC has many similarities to a corporation, but different terminology. For example, instead of shares of stock, an LLC has “membership interests”, which is just another term for equity in the LLC. Although membership interests are not “shares”, they look similar and serve the same purpose as stock in a corporation. Indeed, LLC membership interests are usually considered to be “securities” as defined in Federal and state securities regulations.
An LLC basically operates like a partnership, and the members can operate the LLC together, or they can designate one or more managers to do so. The manager is usually, but not always, a member. Typically LLC members will all agree to restrict the ability of a member to sell their membership interests without consent of the other members. Among other reasons, these restrictions prevent the remaining members from being “forced” into business with a new partner they may not want involved, for any number of reasons.
In most cases, an LLC with more than one member will have an operating agreement that basically serves as a contract among the members as to how the LLC will be managed. An operating agreement typically addresses such matters as voting, management of the LLC, approval of key transactions, the right to sell membership interests, admission of new members, distributions and capital contributions, among others.
One of the key advantages of an LLC is the relatively low burden of maintaining the entity, and the “pass-through” tax treatment of income to members. This means that the LLC usually does not pay taxes, but instead the members pay income or capital gains taxes on their distributions.
One disadvantage of an LLC is that venture capital firms typically will not invest in them. There are several reasons, but the common one is that VC firms do not want to have the risk and responsibilities that would come with being a “partner” with the LLC’s other members. This is not an issue for most closely-held LLCs, but for start-ups and technology companies that aspire to go public or attract high net worth or institutional investors, the LLC form can be an impediment. That said, if a VC firm is keen on investing in a particular business, it may be possible to convert an LLC to a C-corporation.
A corporation, or a “C-corporation”, is the oldest and most traditional form of business entity. Its owners are shareholders or stockholders, and the business is typically overseen by a board of directors, often referred to as the “Board”. Day-to-day management of the business, and execution of plans approved by the board, usually falls to executive officers. Depending on the size of the corporation, the “C-level executives” can include a President/CEO, a Chief Financial Officer, a Chief Operating Officer, and one or more Vice Presidents.
One of the key differences between a corporation and an LLC is that shareholders of a corporation generally play a passive role in its affairs. Shareholders are usually entitled to vote on certain key matters, such as election of directors to the Board or a sale or merger of the corporation. But generally, nearly all matters and decisions are made by management and the Board. In a closely-held corporation with only a few shareholders, some or all of them are likely to also serve as the officers and directors.
The biggest disadvantage of a corporation is tax treatment. Generally, profits are taxed twice; the corporation pays income tax on its net profits, and the shareholders pay taxes on dividends. This “double taxation” is not felt by shareholders of a large publicly-traded corporation, but for a small closely-held business, the tax penalty along is often enough to justify choosing an LLC instead.
A corporation has several advantages over an LLC or a partnership. As the most conventional form of business entity, there is a deep body of law to rely on that generally protects officers, directors and shareholders from personal liability for the corporation’s debts and liabilities. There are certain exceptions, including when shareholders have “abused” the corporate form (such as mixing personal and business expenses, or treating the corporation as the alter ego of its shareholders), or when a shareholder or director acts in bad faith or commits fraud. Some states also impose personal liability on shareholders for certain key obligations, such as employee wages. LLCs also have similar protections, but even now the law regarding LLCs is not nearly as developed as it is for corporations. In addition, a corporation is generally more attractive to institutional lenders and investors (assuming of course the underlying business is promising).
An S-corporation is actually just a C-corporation with a special designation under Subchapter S of the IRS Code. It is usually chosen for professional service providers with only one or a small number of shareholders (or partners). The S-corporation offers numerous tax advantages over an LLC or a C-corporation.
A partnership is a traditional form of cooperative venture by two or more partners. Depending on the nature of the business, the owners can all be general partners or some of them can be limited partners. General partners are in most cases personally liable for the debts of the partnership. Limited partners may have limited liability in some respects, but overall, there is no legal entity to shield partners from liability. Partnerships are similar to LLCs, but without the limited liability protections an LLC offers. There are now various forms of partnerships in most states that do offer limited liability.