LLC vs. Corporation: Which Works Best for Me?
There are many benefits to forming a Limited Liability Company (LLC) or corporation rather than owning the business personally. So long as they are in compliance with state law, both LLCs and corporations offer full limited liability to all of the owners of the business in every state. They also offer increased credibility with customers.
However, corporations and LLCs have many differences, too, and there are advantages and disadvantages associated with each type.
Forming an LLC: An LLC is formed by one or more business people, as owners. The owners, called “members,” file Articles of Organization to form the business. Then they agree on an Operating Agreement to use in managing the day-to-day activities and decide on each member’s percentage share of ownership.
Forming a Corporation: A corporation is formed (incorporated) by filing corporate organization documents in the state where the corporation is located. The corporation also creates a Board of Directors to oversee the corporate business and the board agrees on bylaws, operating documents. The corporation may be a stock corporation, with shares of stock and stockholders, the real owners of the business.
Both LLCs and corporations provide their owners with the benefit of protection against personal liability for business debt or lawsuits. This limited liability status typically protects the owner from the personal risks involved if a lawsuit were to arise concerning the business—safeguarding the owners personal assets.
However, neither a corporation nor an LLC will protect the owner in the event of the owners own malpractice or malfeasance. In both cases, business insurance is recommended to protect the owner.
A key difference between an LLC and a corporation is the way they’re treated at tax time.
An LLC is a pass-through business entity. Profits and losses of the organization go straight through to the owners. Business income equals personal income, so the owner pays the tax on his or her personal return, and it’s taxed at the individual rate. While a single level of taxation is a good thing, it doesn’t guarantee that being taxed as an LLC is better for the owner. In some circumstances, LLC owners can earn a substantially increased tax bill through the addition of the self-employment tax, currently at a painful 15.3 percent. And it can also depend upon whether the corporate or personal income tax rate is higher.
With corporations, there are two kinds for income tax purposes. There are C corporations—so named because they are taxed under Subchapter C of the Internal Revenue Code (IRC). And there are S corporations—so named because they are taxed under Subchapter S of the IRC.
When a corporation is formed, typically by default it will be taxed under Subchapter C. The corporation is a separate taxable entity with the business’ profits and losses taxable to the corporation, not to the owners. As a result, corporations are taxed at the corporate rate. Then, if the corporation distributes its profits to the shareholders, say in the form of a dividend, that is income to the shareholders which they have to report on their personal income tax return. It’s a double tax, and it can seriously cut into the real dollars earned in the end.
However, if the corporation qualifies, it can choose to have it taxed as an S corporation. An S corporation is a pass-through tax entity.
Although S corporations and LLCs have that in common Subchapter S has several restrictions—including a limit on the number and type of shareholders and classes of stock—that LLCs are not subject to.
Generally, when a LLC is formed, by default it will be taxed like a sole proprietorship or a partnership. However, the owner can elect to have the LLC taxed like a C corporation and even an S corporation if the LLC meets the requirements of Subchapter S.
Ownership and Management
The main difference between LLC’s and corporations is the ownership of the business. A corporation is owned by individuals who purchase shares, while the LLC is owned by individuals.
LLC owners have an equity interest in the assets of the business because they have made a contribution to join the business, shown in the business balance sheet as owners’ equity. LLCs afford a degree of flexibility in management that corporations don’t and can be managed by their owners (members) or a group of managers.
In contrast, corporate owners are shareholders or stockholders who have shares of stock. Corporations have a management structure set by the corporation law in their state of incorporation whereby directors manage the business and affairs (and oversee the major business decisions) and appoint officers who are responsible for the day-to-day running of the business. Shareholder management functions are very limited and include such things are electing directors and voting on certain major transactions like mergers.
In terms of ownership, neither the LLC laws nor the corporation laws in general have restrictions on the number of owners the business can have or who can be an owner. But Subchapter S of the Internal Revenue Code does. Under a S corporation taxation election, the corporation will have to deal with restrictions. Most notably, S corporations can have no more than 100 owners, and owners cannot be “non-resident aliens.” Additionally, with certain exceptions, S corporations have to be owned by individuals.
Profit sharing takes place in both LLCs and corporations, however there are differences.
Corporations distribute any profits to their shareholders based on the number of shares they own. Typically, shares are easily transferable to others (unless the shareholders have an agreement restricting transfer)— this makes corporations a good choice for businesses that seek outside investment or are considering a public stock offering.
Corporations can also issue different types of stock interests. For instance, they can have a class of common stock with voting rights and a class without voting rights.
However, this is not so for corporations taxed as an S Corporation. The tax law requires S corporations to have one class of stock.
On the other hand, LLCs can share or divide profits among its members as it chooses. For instance, if one member of the LLC has invested more in the firm than others, that member may be entitled to a larger share of the profits. However, it’s not as easy to transfer LLC membership interests as it is corporate stock. In most LLCs, the transfer of membership interest is dictated by the operating agreement.
Recordkeeping and Other Compliance Requirements
Recordkeeping is a basic requirement for both LLCs and corporations. Various records, including the governing documents, shareholder and member lists, and certain tax returns, must to be maintained.
However, most states impose fewer requirements on LLCs. Corporations are required by corporation laws to hold an annual shareholder meeting, keep Director meetings minutes and the minutes of board meetings. LLCs, on the other hand, aren’t typically required by the LLC laws to hold annual meetings.
However, many states do require both corporations and LLCs to file annual reports and pay annual fees. And both corporations and LLCs are required to appoint and continually maintain a registered agent and office.
Whatever type of entity you choose, you can schedule your free, personalized consultation so I can guide you through the process of creating and maintaining the legal form that is best for your type of business.
Questions about business law? Schedule a consultation so I can help you learn more.