When starting a business, one of the first decisions you must make is the type of legal structure to create. Two popular entity structures are a corporation and limited liability company. Both offer owners protection from personal liability, but other entity-specific implications exist that you must consider in light of your personal needs.
If you choose to form a corporation, every owner of the business receives an allotment of shares of the corporation that represent an ownership interest in the business. A benefit to this form of ownership is the ease at which a shareholder can transfer an interest. Most states allow a corporate shareholder to transfer all rights in the corporation with the share. However, the ease at which you can transfer shares may have an adverse effect on the remaining shareholders. Other shareholders may not be able to maintain a consistent management team when there are frequent sales of corporate shares.
LLC Membership Interest
The owners of an LLC each receive a membership interest in the business that is not represented by transferrable shares. Most state laws provide owners the right to actively participate in business operations and a legal claim to a portion of the LLC’s assets and earnings. The default rules applicable to LLC interest transfers preclude a member from transferring his entire interest. The member may sell or exchange the financial interest in LLC assets and earnings, but not the right to manage the business. These barriers to full interest transfers may be advantageous to remaining members who want to ensure that the departure of a member does not disrupt business operations. The restriction on the transfer of full membership rights only adversely affects the transferee who purchases the interest insofar that he may not actively engage in protecting the investment. However, the operating agreement of the LLC may stipulate rules that are contrary to a state’s transfer regulations if there is unanimous member consent for the clause.
A corporate business entity must adhere to all federal corporate tax requirements. This requires the filing by the corporation of an annual tax return on IRS Form 1120 and the payment of tax on all earnings. It is the sole responsibility of the corporate organization to adhere to all requirements. The shareholders have no responsibility to report business earnings. However, when the corporation issues a dividend of after-tax earnings, the shareholder must pay a second level of income by reporting the dividend on a personal tax return.
The IRS provides members of the LLC flexibility in choosing the type of taxation the business is subject to. All single-member LLCs must report and pay tax as a sole proprietorship and all other LLCs as a partnership. Both forms of taxation use pass-through principles. This imposes a single level of income tax on business earnings at the member level. Each member must report her allocable share of business earnings on a personal tax return. Alternatively, all LLCs have the option to elect corporate tax treatment by completing IRS Form 8832.