However, in the vast majority of cases the choice is actually between just two of those entities — the corporation and the limited liability company (LLC).

Corporations and LLCs are statutory entities. These two entities, and the statutes that govern them, are similar in some ways and very different in others. The purpose of this white paper is to assist business owners and legal professionals in understanding these similarities and differences. It does so by comparing and contrasting corporations and LLCs — and the statutes under which they are formed and operated — in a number of areas — including formation, management, ownership, compliance issues, doing business in foreign states, and dissolution.

When comparing and contrasting business entities, the discussion generally focuses on the following five characteristics — (1) liability, (2) control, (3) transferability of interests, (4) continuity of existence, and (5) taxation.

Liability, as an entity characteristic, refers to whether the owners of the business entity are personally responsible for the business’ debts and obligations — or whether the entity provides limited liability for its owners. Both corporations and LLCs shield their owners from personal liability based on their status as owners. This limitation of liability is provided for in all corporation and LLC statutes.

The control characteristic refers to who will manage the entity’s business and affairs — its owners or a management group that can act without the owners’ approval.

Corporations and LLCs differ in the control characteristic. Control of the business and affairs of a corporation is vested by statute in a board of directors. The shareholders are, for the most part, passive investors.

LLCs, on the other hand, may be controlled by either their members or by managers. Although the LLC statutes have default rules vesting control in all members, they allow the LLC to opt out of the default rule and provide for managers.

Transferability of interests refers to whether the entity’s owners have a default statutory right to sell or transfer all of their interests to a third party who will then become the owner — or whether there are restrictions on the ability to sell, such as having to obtain the consent of the other owners.

Corporations and LLCs differ in this characteristic as well. A corporation’s shareholders may freely sell or transfer their shares of stock. There is no statutory requirement that the other shareholders have to consent before a person buying shares may become a shareholder.

In an LLC, on the other hand, the member’s financial rights may be transferred without restriction.

However, there are statutory default rules that place restrictions on the transfer of the remaining interests — including the right to participate in management. Furthermore, the assignee of the financial rights does not become a member. The default rule in most states is that in order for an assignee to become a member, the consent of all of the remaining members will be required.

Continuity of existence deals with the issue of whether the entity has the statutory right to exist perpetually — or whether it dissolves by law upon a change of owners or the end of a set term. Both corporations and LLCs are entities with continuity of existence.

When comparing the way entities are taxed, the main concern is whether the entity is a “separate legal entity” for federal income tax purposes or a “pass-through” entity. A corporation by default is a separate entity and pays corporate income taxes. It can be a pass-through entity if it qualifies as an S corporation. By default, an LLC with one member is disregarded as an entity and an LLC with more than one member is a pass-through entity.

However, an LLC can choose to be taxed as a separate legal entity that pays taxes on its income.

It is important to note that the way corporations and LLCs are defined in reference to these characteristics is based upon the statutory default rules.

However, corporations and LLCs are free to opt out of default rules in their formation or governing documents. For example, shareholders or members may agree to be liable for a corporation’s or LLC’s debts. Similarly, a shareholder’s right to sell his or her shares may be restricted, while members may be given the right to freely sell their membership interests.

The basic steps in forming a corporation and an LLC are similar. They include (1) choosing a state of formation, (2) choosing and reserving a name, (3) appointing a registered agent, (4) drafting and filing the formation document, and (4) drafting a governance document. But there are some important differences.

Selecting the formation state is an important step because the entity is organized pursuant to that state’s corporation or LLC law, and it has to comply with the provisions of that statute throughout its existence. Although important for both entities, it may be more of a consideration for corporations because corporation laws have more mandatory provisions than LLC laws

In choosing a name it is important to remember that both the corporation and LLC statutes place restrictions on the choice of name. They require a word, phrase, or abbreviation that indicates whether it is a corporation or LLC. They also generally prohibit the use of words or phrases that will confuse the public. In addition, the name must be distinguishable from other names on the filing office’s records.

A corporation’s formation document is generally called articles of incorporation. An LLC’s formation document is generally called articles of organization. Although both of these documents serve to create the named entity, there are important differences between the other functions of articles of incorporation and articles of organization.

In most states, very little information is required to be set forth. It is not unusual for the statutes to require the articles of incorporation to only set forth four items of information — the corporation’s name, number of authorized shares, name and address of initial registered agent and office, and name and address of each incorporator.

However, the articles of incorporation can also contain many other provisions that will govern the management of the business, and the powers, rights, and authority of the directors and the shareholders.

Through careful drafting, the articles of incorporation can be used to meet the specific needs of the corporation, its management, and its shareholders. Furthermore, many provisions governing the corporation will be effective only if included in the articles of incorporation. In the absence of such provisions, the corporation will be subject to the statutory default provisions.

The LLC acts, like the corporation laws, do not require many provisions.

However, unlike articles of incorporation, articles of organization rarely provide more information than that necessary to serve the document’s notice function. Instead, provisions governing the LLC’s business and affairs, and the rights, duties, and authority of members and managers are generally set forth in the LLC’s operating agreement.

In addition to the formation document, a corporation and an LLC will have a governing document. A corporation’s governing document is called bylaws. An LLC’s governing document is generally called an operating agreement. As was the case with the formation documents, there are important differences in the function and content of the governing documents of a corporation and an LLC.

The statutes provide that bylaws can contain any provision, not inconsistent with law or with the articles of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or powers, or the rights or powers of its shareholders, directors, officers or employees. But despite that broad statement, bylaws generally cover a narrow range of issues dealing with the corporation's internal management.

Typical bylaw provisions include: (1) the location of offices, (2) the rules governing the holding of shareholders' and directors' meetings, (3) the election and removal of directors, (4) the size of the board of directors, (5) the titles and duties of officers, and (6) the creation and duties of directors’ committees.

The operating agreement is an agreement members enter into that establishes the way the LLC will conduct business and that governs the rights, duties, powers, liabilities, and relations of members and managers. The operating agreement contains the kind of provisions found in a corporation’s bylaws, articles of incorporation, and shareholders’ agreements.

Typical issues addressed in the operating agreement include, but are not limited to (1) who will manage the LLC, (2) the powers and authority of managers or managing members, (3) rules for holding meetings, (4) members’ names, capital contributions, and percentage interest, (5) the allocation of profits, losses, distributions, and voting rights (6) admission of new members, (7) members’ right to withdraw, (8) the members’ right to inspect book and records, (9) the members’ right to assign their interests, and (10) how the LLC will be dissolved.

Another difference in the way corporations and LLCs are formed is the need to hold an organizational meeting. The corporation statutes require an organizational meeting to be held after the articles of incorporation are filed, in order to complete the organization of the corporation. The LLC statutes, in contrast, do not require the holding of an organizational meeting.

Corporation and LLC statutes differ in their management provisions. The corporation statutes prescribe who manages a corporation and impose certain rules that management must follow in conducting business. The LLC acts provide much more flexibility in how LLCs are to be managed.

All business corporation acts provide that a corporation’s business and affairs will be managed by or under the direction of a board of directors. A board of directors may consist of one or more members who must be natural persons. The statutes also provide that directors are elected by shareholders at their annual meeting.

Although the board has the power to make all decisions on a corporation’s behalf, many business decisions are actually made by the corporation’s officers. Generally, the titles and duties of each officer are set forth in the bylaws.

Shareholders do not have the power to act on a corporation’s behalf. They affect the corporation’s management by voting to elect and remove directors and approve or reject certain major transactions.

An LLC may be member-managed or it may be manager-managed. Managers and managing members may be natural persons, or — unlike directors — they may be entities.

In contrast to the corporation statutes, the LLC acts have default rules providing that the company will be managed by its members. In a member-managed LLC, each member has equal rights in the management and conduct of the company’s business, unless the operating agreement provides otherwise. Every member is an agent of the LLC for the purpose of conducting its business and affairs and may bind the company by his or her actions.

Management of an LLC may also be vested in one or more managers. The LLC must provide for manager-management in its operating agreement, and, in some states, in its articles of organization as well.

In a manager-managed LLC, the members’ role may be similar to that of a shareholder, with the member being able to vote on certain major actions but having limited say in business decisions.

How does being an owner of stock in a corporation compare to being an owner of a membership interest in an LLC? By virtue of acquiring their stock or membership interests, shareholders and members receive certain benefits, rights, and obligations. This section will describe the benefits, rights, and obligations that are associated with corporate stock and LLC membership interests.

One of the key similarities between corporations and LLCs is that corporate shareholders and LLC members receive the benefit of limited liability. The statutes provide that corporations and LLCs are entities with their own legal existence separate and apart from their owners and are responsible for their own debts and obligations.

Shareholders have a right to dividends.

However, it is the board of directors that decides, at its discretion, if and when a dividend will be declared. The shareholders do not have a say in whether dividends will be paid. When a corporation pays a dividend, it distributes it to shareholders equally on a per-share basis.

Shareholders also have the right to receive distributions of the corporation's assets after the corporation liquidates. Shareholders share the net assets in proportion to their share ownership. A corporation may have a class of preferred stock that will receive the net assets before other classes of stock.

LLC members may also receive a dividend (or an interim distribution of assets, as it is known). In contrast to shareholders, members generally have to approve interim distributions. Distributions may be allocated equally, based on the value of the member’s capital contributions, or split almost any other way the members choose that is set forth in the operating agreement.

Members also have a right to liquidating distributions of LLC assets. These distributions will be allocated as provided in the operating agreement.

The default statutory rule is that shareholders and members may freely sell or transfer their right to receive dividends and distributions.

Shareholders have the right to vote for directors and for changes in the corporation's structure that would materially affect their ownership such as proposals to amend the articles of incorporation, to merge, convert, and to dissolve the corporation.

In a member-managed LLC, the members can vote on matters affecting the LLC's business and affairs.

In a manager-managed company, however, members have the right to vote on certain major issues only.

The statutory default rule for a corporation is that when shareholders sell their stock, the buyer receives the same voting rights that the seller had. But, the default rule of the LLC statutes is that members cannot sell or transfer their voting rights to third parties without the consent of the other members.

Both shareholders and members have the right to inspect certain of the entity’s books and records. This includes the formation and governing documents, a list of shareholders or members, and accounting records. For some records, the corporation and LLC acts require that the shareholder’s or member’s purpose for demanding the records must be related to the person’s interest as a shareholder or member.

The corporation statutes also generally provide that the corporation cannot restrict the shareholders’ right to inspect books and records in its articles or bylaws. In contrast, some LLC laws specifically give the LLC the right to impose restrictions on a member’s inspection right in the operating agreement.

The main obligation of shareholders and members is to pay, in full, the amount owed for their shares or membership interests. Shareholders, in general, do not owe fiduciary duties. A member in a member-managed LLC does owe fiduciary duties. Those duties may be set forth in the LLC statute or in the operating agreement.