A common question when forming a business entity is: What’s the difference between a limited liability company (an LLC) and a corporation?
Let’s first turn to a discussion about business entities. This may seem like an academic exercise, however, it’s a good way to understand the primary differences between an LLC and a corporation.
Flexibility and Formality of Business Entities
On one end of the spectrum is the least formal and most flexible kind of business, a sole entrepreneur who has not formed any business entity. There’s only one person making all decisions for the business and no state filings or internal documents are required. There is no limited liability for the sole entrepreneur.
A partnership is two or more persons in business together, like two sole entrepreneurs tied together. There is no limited liability and both are liable for the acts of each other. There are no formal requirements and the relationship is flexible. There are usually default state laws about partnerships and an option to more formally document the relationship.
An LLC is somewhere between a partnership and a corporation. An LLC can be structured much like a partnership, where owners share decision-making. Or more like a corporation, where a board of directors decides. Unlike a partnership, the LLC has limited liability, and it also has more formality. It requires state filings and internal documentation.
A corporation is the most formal and rigid. It has limited liability and requires state filings and internal documentation. A corporation can only be managed by a board of directors, who can delegate day-to-day management to officers. Owners (shareholders) do not take part in decision-making.
With this understanding, we can already see some differences between LLCs and corporations, and differences in flexibility and formality.
Differences between an LLC and Corporation
As discussed, an LLC can be structured more like a partnership, where owners participate in the management of the company. It can also be structured more like a corporation where an individual or individuals manage it like a board of directors. On the other hand, a corporation can only be managed by a board of directors with shareholders taking no part in management.
Both an LLC and a corporation require various kinds of internal documentation. First, both need what is the constitution of the company. For an LLC, an operating agreement, and for a corporation, bylaws. An operating agreement is very important for an LLC because it dictates how the company operates. Bylaws tend to be more tied to state law, with less variability. Both also require documenting decision-making. For example, corporations have specific requirements about when shareholders vote. Whereas, an LLC depends on how management is structured.
Both require state formation filings and some kind of periodic state filings/fees to maintain the business.
So the primary difference between an LLC and a corporation is formality and flexibility. An LLC can be structured in a variety of ways, more like a partnership or more like a corporation. A corporation tends to be more formal and rigid. These differences don't make one type better or worse than the other. It comes down to what works best for your business. It's also generally best to receive input from a lawyer and tax advisor on your decision if you can, too.
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About the author
Marcus Harjani is a business and intellectual property lawyer and Legal Officer of Foundry Law Group who regularly works with entrepreneurs navigating a variety of legal issues. He is also a member of the Board of Directors at Business Impact NW.