When it comes to choosing a legal entity for their business, many opt between an LLC or a corporation (Inc). But which entity type is the right one for your business?
Understanding the differences between an LLC and a corporation can be overwhelming, especially if you’re just getting started. Let’s explore how an LLC compares to a corporation (Inc.) when it comes to taxation, ownership and compliance requirements. First, we'll start with a quick definition of what it means to incorporate a corporation or form an LLC.
When you incorporate a business, you evolve from a sole proprietorship (if you are the sole owner) or general partnership (if you have no owners) into a company that’s formally recognized by its state of incorporation. In other words, it becomes a legal business entity of its own — separate from the individuals who founded it and the shareholders who will own it over the course of its existence.
Similarly, when you form an LLC you are forming a company with its own legal existence—separate from its founders and members (as the owners of LLCs are called).
It’s important to remember that whether you incorporate—or form an LLC—it is the corporation or LLC that owns the business. You own the corporation or LLC.
No matter which you choose, there are many benefits to forming an LLC or corporation rather than owning the business personally. So long as you 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.
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 you from the personal risks involved if a lawsuit were to arise concerning your business—safeguarding your personal assets.
However, neither a corporation nor an LLC will protect you in the event of your own malpractice or malfeasance. In both cases, you'll want business insurance to protect yourself.
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 you. 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.
As for 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 you incorporate, your corporation, by default, will be taxed under Subchapter C. Your 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 your corporation qualifies, you 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.
When you form your LLC, it will be taxed, by default, like a sole proprietorship or a partnership.
However, you can elect to have your LLC taxed like a C corporation and even an S corporation if the LLC meets the requirements of Subchapter S.
Read more about the taxation implications of LLCs and corporations.
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, 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 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. So if you want to have an S corporation, you will have to deal with several restrictions.
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.
Corporations distribute any profits to their shareholders based on the number of shares they own. These shares are easily transferable to others (unless the shareholders have an agreement restricting transfer)—making 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. Or, they can issue preferred stock with a right to dividends and distributions that have priority over common stock.
However, this is not so if you want to be taxed as an S corporation. The tax law requires S corporations to have one class of stock. This is one reason why venture capitalists choose C corporations when they offer funding to a business. Investors often want preferred stock in exchange for their investment.
LLCs can share or divide profits among its members as it chooses. For instance, if one member of the LLC invests more heavily in the firm than others, they 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 consent of the other members is required before someone new becomes a member.
Recordkeeping is a fundamental requirement for both LLCs and corporations. Various records, including the governing documents, shareholder and member lists, and certain tax returns, have to be maintained.
However, most states impose fewer compliance requirements on LLCs. Corporations are required by corporation laws to hold an annual shareholder meeting, keep minutes, and records of actions. Director meetings and the minutes of the board meeting are required to be maintained.
LLCs, on the other hand, aren’t required by the LLC laws to hold annual meetings.
Most states also 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.
As you decide which business structure is best for you, try our Incorporation Wizard to compare multiple business types by multiple key considerations.
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