An Overview of Legal Entity Forms for Small Business Owners - Part 2: The Distinctions Between Corporations and LLCs

Part 2. The Distinctions Between Corporations and LLCs

(This post is Part 2 of a 4-part series on legal entities. You can read Part 1 here.)

There are numerous differences between corporations and LLCs, ranging from nomenclature, management structure, and tax treatment. This section highlights just a few of the distinctions between the two entity forms.

A corporation is a business that has filed articles of incorporation with the Indiana Secretary of State (“IN SOS”). The business name must include the word or some abbreviation of “corporation” or “company.” Incorporation requires the company to have at least one shareholder. A shareholder is the “owner” of the business, and many small businesses are owned by only one or two shareholders. Incorporation also requires that the company have a board of directors (the people who run the company), but a small business can often indicate that it will operate without a board of directors, and instead be run by one or two officers. The Indiana Business Corporation Act is the portion of the Indiana Code that governs corporations. Among other things, it sets out a series of specific requirements for the bylaws (the rules of the company) and meetings of a corporation.

A corporation can be taxed in two ways: as a “C-corp” (the business is taxed on income and the shareholders are taxed on distributions from the company) or as an “S-corp,” provided they meet the requirements to qualify as an S-corp (the company pays no income tax and instead, the shareholders pay income tax on distributions). These terms refer to the Subsections of the Internal Revenue Code that state the rules for taxation of both types. Briefly, the main qualifications to be an S-corp (other than properly incorporating), are having fewer than 100 shareholders, having only one class of shareholders, having only individuals as shareholders, and having all shareholders be U.S. citizens.*

The Internal Revenue Service (IRS) considers a corporation to be a C-corp by default. Therefore, most small businesses take the extra step to file an election with the IRS to be treated as a S-corp so that they can be a “pass-through” entity and only pay taxes at one level (the shareholder level).

An LLC is a business that has filed articles of organization with IN SOS. It must have the words “limited liability company” or “LLC” in its name. The Indiana Business Flexibility Act is the portion of the Indiana Code that governs the formation and operation of LLCs. It largely sets forth default requirements for LLCs’ operating agreements (the  rules governing the management and operation of the LLC). However, the Act does not provide as many specific requirements for LLCs as are required for corporations. This is another way that LLCs have more flexibility than corporations to determine their management structure.

An LLC must have at least one member (the owner). LLCs may be managed by the members or by managers that are elected by the members. LLCs can also designate officers, if desired. The operating agreement may be very detailed or very general regarding who has the authority to manage the LLC and in what ways they can manage the LLC. Again, this is more flexible than the options available to corporations.

Many small businesses have only one member, a “single-member LLC.” If an LLC has two or more members, it is considered a “multiple-member LLC.” This distinction may seem irrelevant to the business owner, but one reason that it is important is that it sets the company’s “default” treatment by the IRS. A single-member LLC is by default treated as a “disregarded entity” by the IRS. This term is often confusing for new business owners, because it sounds as though the IRS refuses to recognize the business. Rest assured, “disregarded entity” is simply an IRS term-of-art that means the IRS is will ignore the company and continue to require the owner to pay taxes as if she were still a sole proprietor, unless the owner applies to be treated differently.

In comparison, a multiple-member LLC is by default treated as a “partnership” by the IRS. This means that the IRS will apply the same rules to the multiple-member LLC that it does to partnerships, again, unless the owners apply to be treated differently. Both single-member LLCs and multiple-member LLCs can take that extra step and elect to be treated as either C-corps or S-corps by the IRS. Remember, however, that an LLC that wants to be taxed like an S-corporation must also meet the same requirements apply to a corporation seeking S-corp status.

*Some limited exceptions related to trusts may qualify as “individuals,” but that is beyond the scope of this article.

Part 3 of this series, Choosing the Right Entity Form for Your Small Business .