There are many different types of business entities, including corporations, general partnerships, limited partnerships, limited liability partnerships, limited liability companies, and even sole proprietorships. Historically, the most popular type of entity was the corporation, but in the last twenty years, the limited liability company (“LLC”) has become the entity of choice. The key reasons for this shift are that an LLC provides its owners with limited liability protection (like a corporation) and more favorable tax treatment (like a partnership). Also, since the rights and obligations of LLC owners are largely contractual, an LLC provides its owners with greater flexibility in structuring management, voting, and economic terms. The corporation, however, remains an important entity, and may provide its owners with favorable tax treatment by electing to be treated as an S corporation for tax purposes.
This resource summarizes some of the general advantages and disadvantages of (1) a corporation taxed as a C corporation, (2) a corporation taxed as an S corporation, and (3) an LLC taxed as a partnership (with two or more owners) or a disregarded entity (with one owner). It then reviews the more important characteristics of these types of business entities and their tax treatment.
Summary of Business Entity Advantages and Disadvantages
C Corporation
Advantages
Disadvantages
Owners have limited liability.[1]
C corporations pay income taxes, and then their shareholders pay income taxes when they receive dividends from the corporation; therefore, there is double taxation.[2]
Multiple classes of stock are permitted with different economic interests (e.g., common and preferred stock).[3]
C corporations must observe corporate formalities such as annual meetings and written minutes.[4]
There are no restrictions on number, type, or citizenship of owners.
Owners may freely transfer shares of stock (unless otherwise restricted in writing).[5]
Incentive stock options for employees are permitted.
Corporate law is well settled.
S Corporation
Advantages
Disadvantages
Owners have limited liability.[6]
There is a maximum of one hundred shareholders.[7]
Owners may freely transfer stock to permissible types of owners (unless otherwise restricted in writing).[8]
S corporations must observe corporate formalities such as annual meetings and written minutes.[9]
Incentive stock options for employees are permitted.
There is only one class of stock permitted, although there may be voting and nonvoting shares.[10]
There is one level of taxation, shared pro rata among owners based on their ownership percentages.[11]
Only U.S. citizens, resident aliens, estates, and certain types of trusts may be owners; no entities (except single-member LLCs owned by a natural person and treated as a disregarded entity for tax purposes) may be owners.[12]
Corporate law is well settled.
Owners pay income taxes on the corporation’s income, even if they do not receive cash (“phantom” income).[13]
Limited Liability Company
(taxed as a pass-through entity, such as a partnership)
Advantages
Disadvantages
Owners have limited liability.[14]
A person may become a member only with the consent of all members (unless otherwise agreed in writing).[15]
Multiple classes of membership interests are permitted, including profits interests.
LLC law is not as developed as corporate law.
There are no restrictions on number, type, or citizenship of owners.
Offering incentive equity to employees is more complex and not well understood by employees.
Management is flexible (management structure can mimic a corporation, a partnership, or a hybrid)[16]
Self-employment taxes apply for owners who are active in the LLC.[17]
There is one level of taxation, shared pro rata among owners based on their ownership percentages or agreement (may elect to be taxed as a C corporation or an S corporation)[18]
Owners pay income taxes on the LLC’s income, even if they do not receive cash (“phantom” income).[19]
There are no “corporate” formalities.[20]
Business Entity Characteristics
C Corporation
S Corporation
LLC
Formation
Method of Formation
File certificate of incorporation with the state.[21]
File certificate of incorporation with the state.[22]
File certificate of formation with the state.[23]
Governing Documents
Certificate of incorporation; bylaws; and, if desired, shareholder agreement
Certificate of incorporation; bylaws; and, if desired, shareholder agreement
Certificate of formation and operating agreement
Designation of Owners
Shareholders
Shareholders
Members
Number of Owners
One or more shareholders
One to one hundred shareholders, with spouses (and family members) counted as one shareholder[24]
One or more members
Eligible Types of Owners
No restrictions
Individual U.S. citizens and resident aliens only; estates and certain trusts; no corporations, LLCs (unless a disregarded entity with a natural person as the member), or other business entities[25]
No restrictions
Capital Structure
No restrictions on number or types of classes of stock (e.g., common stock and preferred stock)
One class of stock only, with both voting and nonvoting shares allowed[26]
No restrictions
Owners’ Personal Liability
Liability is limited to the shareholder’s capital contributions to the corporation.[27]
Liability is limited to the shareholder’s capital contributions to the corporation.[28]
Liability is limited to the member’s capital contributions to the LLC.[29]
Transfer of Equity
Shareholders may freely transfer stock, unless restricted in the certificate of incorporation, bylaws, or shareholder agreement.[30]
Shareholders may freely transfer stock, unless restricted in the certificate of incorporation, bylaws, or shareholder agreement; but transfer to the wrong type of owner (see eligible types of owners, above) will cause the corporation to lose its S corporation status.[31]
Economic rights may be transferred; full rights (i.e., voting and management) may be transferred only with approval of all members, unless otherwise provided in the operating agreement.[32]
Management
Identity of Managers
Centralized management. Shareholders elect directors, and directors appoint officers.[33]
Centralized management. Shareholders elect directors, and directors appoint officers.[34]
Very flexible. Members can specify the management structure in the operating agreement to mimic a corporation, a general or limited partnership, or a hybrid; generally, all members may manage or delegate management to managers in the operating agreement.[35]
Persons with Authority to Bind the Company
Officers and board of directors as a whole[36]
Officers and board of directors as a whole[37]
Generally, any member (if member-managed) or manager (if manager-managed), or as otherwise provided in the operating agreement[38]
Voting
Based on number of voting shares.[39]
Based on number of voting shares.[40]
Based on members’ profit percentages, unless otherwise provided in the operating agreement.
For N.J. LLCs, each member has an equal vote, unless otherwise provided in the operating agreement.[41]
