Entrepreneurs have several options when determining which legal entity to use for a business. Two common structures are corporations and limited liability companies. Both types of entities offer similar levels of personal liability protection to owners; however, differences exist in the rights of each owners and the ease at which an interest in the business may be sold or exchanged.
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Business entities that use a corporate legal structure are the only types that issue stock to its owners. In a corporate entity, the stock represents a shareholder’s ownership interest in the business. The percentage of ownership of a particular shareholder directly relates to the amount of all outstanding shares and the number of shares the particular shareholders has. Generally, most states allow for shareholders to freely transfer their stock certificates. When you transfer a share of corporate stock, the buyer receives all voting and financial rights.
Member Interest Rights
Owners of an LLC each have a membership interest in the business that entitles them to a pro rata share of earnings and assets, and the right to actively participate in the management of the business. However, unlike corporate stock, you cannot transfer all membership rights to a third party. A non-member may purchase a member’s financial interest in the LLC, but does not receive any right to participate in firm business. The financial interest entitles the buyer to the same share of LLC profits and assets as the member has. This barrier to management provides assurances to current members that minimal disruption to LLC operations will occur from frequent ownership changes. However, most jurisdictions allow LLC members to draft an operating agreement that allows for the transfer of management rights.
The members of an LLC and the shareholders of a corporation both have a claim on the assets and earnings of the business. Shareholders of common stock may receive dividend payments from after-tax earnings at the discretion of the corporation’s board of directors. In contrast, LLC members may receive periodic profit distributions from the company. Although most jurisdictions do not require the LLC to distribute profits, if an operating agreement provides for a non-discretionary payment, a member has a legal claim to that distribution.
A corporate entity is solely responsible for reporting taxable earnings and the payment of federal income taxes, while shareholders have no obligation to report any business earnings. The shareholder however must pay personal income tax on dividends they receive during the year. In contrast, an LLC that has more than one member is treated as a partnership solely for tax purposes. Partnership taxation imposes the obligation to report and pay tax on business earnings on individual members. Each member must include on a tax return his pro rata share of LLC taxable earnings and pay the appropriate tax. Unlike a shareholder, the member must pay tax even if no distribution is made during the year.