Wednesday, October 26, 2011

Ask a Lawyer - What's the Difference Between a Corporation and an LLC?

In our last post, we provided the first in a three part response to the question, "Why Should I Hire a Lawyer to Help Incorporate My Business?"  The first part of our answer was to first consider whether every business ought to "incorporate," and what are the options available for small business owners to consider.  

This post provides part two of our answer - once a business owner makes the decision to form a limited liability entity, which form of entity should she choose?  For the majority of business owners, this comes down to a choice between a corporation, often an "S-corporation", and a limited liability company.  What's the difference?

First, note that both State law is essential to understanding how corporations and LLCs are formed, operated, dissolved, etc.  Each State is different, and some States are considered to have business statutes and supporting court opinions, that are more favorable to business owners than other States.  Delaware is the classic example of a State considered favorable to business owners, such that many businesses from all over the U.S. choose to be incorporated, or form the LLC, in Delaware.  Since we are located in Illinois, I will focus on Illinois law for the purpose of this post.  If an Illinois business chooses to form the entity in another State (such as Delaware), the business must still register with the Illinois Secretary of State as a "foreign" business entity doing business in Illinois.  

The corporation is the traditional limited liability business entity.  The corporation is owned by "shareholders," managed by a board of "directors," and operated day-to-day by its "officers."  The owners (shareholders) may or may not be directors and/or officers, and may or may not be actively involved in management and operations of the business.  The corporation is recognized by State law as a separate and distinct legal entity from its owners.  In a sole proprietorship or general partnership, the owners are personally liable for the business' debts and legal claims, but in a corporation, liability is limited to the corporation itself, with a few significant exceptions (one is called the "piercing the corporate veil" legal claim, in which the claimant argues that the corporation is really just a sham and an "alter ego" for the owner(s), such as by failing to separate bank accounts and failing to follow State law for the formalities of operating the corporation; the second exception is where the owners agree to take on personal liability by contract, such as signing a personal guarantee or cosigning a contract for the corporation).  

The limited liability company entity was created by State law to allow a form of business entity to have some characteristics of a partnership and some characteristics of a corporation, and still provide limited liability for its owners.  The owners of an LLC are called the "members."  LLCs are managed either by the members themselves (called "member-managed") or by an appointed Manager (called "manager-managed").  State law provides general rules regarding how LLCs operate, what fiduciary duties are owed by the members and managers to the other members, how and when would an LLC dissolve, etc.  These rules are effective by default, but almost all of them are subject to change if the LLC members create an "operating agreement" providing different rules.  One of the hallmarks of the LLC is flexibility for the members to stipulate by contract how the business will operate and be managed.  Having an well-written operating agreement that meets the specific intent of the members is one of the secrets to avoiding conflict and managing the LLC effectively over the long run.  

There is much more I could say on this topic, more than I can do justice to in this short post.  If you are a business owner and have decided to form a limited liability entity, either a corporation or an LLC may be a better fit for you.  Much depends on your specific circumstances, and it is advisable to seek a personal consultation with an attorney for this.  There are also tax and accounting implications to consider, so it is also advisable to meet with an accountant. The Illinois Secretary of State's website also provides a number of helpful publications and guides for the entity creation/registration process. Choosing the right entity, customizing the right documentation for your needs, and ensuring that State law formalities are followed to avoid the temptation to treat the entity as the owner's "alter ego," are the more nuanced, complicated aspects of forming and operating a new business entity.  There is a lot more to it (to do it right) than simply filling out and filing the forms.  But more on that in part 3 of this series.

10 comments:

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