Differences Between LLC Membership Interests and Corporate Stock

Small business owners and entrepreneurs often use (and confuse) LLC and corporate terminology and concepts.  This is understandable as many people view the two types of business entities as being functional equivalents of one another.  With the flexibility offered by the Virginia LLC Act, it is not unusual for LLC owners to “incorporate” many corporate-like concepts into their LLC Operating Agreements.  One popular strategy is to describe LLC membership interests as “units” as if they were akin to shares of stock in a corporation.  In some respects, this is perfectly fine, but it can create confusion in some contexts and here’s why.

First, there is no concept of “units” in the Virginia LLC Act.    The Act defines an ownership interest in an LLC as a “membership interest” (specifically, “a member’s share of the profits and the losses of the limited liability company and the right to receive distributions of the limited liability company’s assets”).  So if you look in the Act to learn how it defines LLC units, you will not find anything.

Second, it is worth remembering that LLCs are different from corporations in several important ways.  Relatively speaking, the LLC structure offers more flexibility than corporations in crafting the economics, management, and governance of the entity through its Operating Agreement, which is simply a contract between an LLC and its owners.  More often than not, LLC owners will look to the Operating Agreement–as opposed to the LLC Act–for definitive guidance on their respective rights and obligations as an LLC owner.

Further, rights associated with corporate stock ownership are not typically bifurcated as can be the case with LLC membership interests.  If a shareholder sells a share of stock, the rights to vote, receive dividends, and have access to company books and records typically ALL transfers together as a single bundle of rights along with the share of stock.  Transfer of an LLC membership interest is different.  The right to receive distributions and an allocation of profits and losses will typically transfer upon a sale of the membership interest, BUT the transfer will not necessarily include the right to vote or participate in management unless the requisite percentage of owners (as designated in the Operating Agreement or the LLC Act) approves the transferee’s admission as a full-fledged member of the LLC.

Finally, LLCs can be classified in different ways for tax purposes.  Multi-member LLCs are typically taxed as partnerships (unless the LLC formally elects to be classified as a “C” or “S” corporation for tax purposes), so LLC profits and losses are allocated (i.e., pass through) directly to the members.  The LLC itself does not pay income tax.  For an LLC’s allocations of profit and loss to be respected for tax purposes, the allocation provisions in the LLC Operating Agreement must have “substantial economic effect” as defined in a complicated set of Treasury Regulations (grab a glass of warm milk late one evening and ask your accountant to explain).  One such requirement is that a capital account be maintained for each LLC member.  A member’s capital account increases when the member contributes cash or other property to the LLC, when profits are allocated to the member, and when a member assumes LLC liabilities.  A member’s capital account decreases when distributions are paid to the member, when losses are allocated to the member, and when liabilities of a member are assumed by the LLC.  The Regulations also require that when the LLC is dissolved and liquidates its assets, liquidating distributions to the members be made in accordance with positive balances in the members’ capital accounts.  In other words, at any given point in time, one member’s “LLC units” might be worth more or less than another member’s “LLC units” due to the fluidity of members’ capital accounts over the life of an LLC.

With corporate stock, each share is pretty much economically indistinguishable from another, so the accounting is much simpler from a capital perspective.  If a corporation is dissolved, the liquidating distributions per share of common stock will, generally speaking, be identical for each share of common stock.

In sum, while the LLC structure offers maximum flexibility to use whatever terminology you want when drafting an LLC Operating Agreement, the substance behind the chosen titles and terminology can get complicated, so LLC owners should keep their legal and tax/accounting advisors in the loop and on the same page when preparing formation documents for a limited liability company.