One of the most important and difficult decisions you will make as a business owner is determining which entity is the best vehicle for your business. It is important to understand the tax consequences, management, and ownership structure of each entity before taking the first steps of forming your business.
The similarities and differences between corporations and LLCs are described below and will help you decide which business structure is right for you, depending on a number of factors.
LLC vs. Corporation: What’s the Difference?
Limited liability companies (or “LLCs”) and corporations (denoted by “Inc.” at the end of the business name) are a common choice for many small business owners when they want to protect their personal assets.
There is often confusion between these two types of entities. Sometimes LLCs are mistakenly referred to as “limited liability corporations,” however, there is no such entity.
While LLCs are also formed officially by registering with the state, LLCs are not corporations and do not need to be incorporated. The Limited Liability Company offers the personal liability protection of a corporation but adds more tax flexibility as well.
Related: What is an LLC?
Corporations can either be a C Corporation (or “C Corp”) or S Corporation (or “S Corp”) under Internal Revenue Service (IRS) rules. The main characteristics are the same, but an S Corp has a certain number of restrictions in exchange for better tax benefits.
There are many similarities between corporations and LLCs. For instance, both entities provide limited liability protection for the owners or shareholders by operating separately from the individuals who run the business. Incorporation evolves your business from a sole proprietorship or general partnership into a separate legal entity that stands on its own. When you form an LLC, you also create a business entity with its own legal existence separate from its founders and members.
The ownership structure differs greatly between LLCs and corporations. Essentially, corporations are controlled by shareholders, who are individuals with possession of the company’s shares of stock.
In contrast, LLCs are owned by their members (the term used for referring to owners of an LLC). LLC members own an interest in the assets of the company based on their initial contributions. The members decide how to manage the business operations of the company. This ownership is demonstrated simply through the LLC’s balance sheets, formation documents, and operating agreement.
Owners in corporations demonstrate their ownership interest by the number of company shares they own individually. C Corps allow an unlimited number of shareholders, and there is essentially no restriction on who can hold these shares. There can also be different classes of shares. S Corps, however, can only have one class of stock, and all shareholders must be U.S. citizens or lawful residents.
Corporations and LLCs also have very different management structures. Management for each entity is governed both by statute and the internal governing documents. The formation document for LLCs is called the Articles of Organization (in some states, this is known as the “Certificate of Formation”). The governing agreement made between members is known as an Operating Agreement. The counterparts for these documents for a corporation are known as Articles of Incorporation and Bylaws, respectively.
Due to the complex structure of corporations, bylaws tend to have more technical language to detail the rights and responsibilities of all officers and directors. There are prescribed meetings and other formalities necessary to maintain compliance as a corporation. Many of the provisions contained in bylaws are required by statute.
Corporations must have a board of directors appointed, and their role is to manage the business and approve all major company decisions. It is also the job of the board to appoint officers tasked with daily operations and management of the business. Shareholders do not have much responsibility in terms of management other than electing directors and voting on certain major transactions, such as mergers.
LLCs have fewer requirements to stay compliant within the state. There is no requirement for annual meetings or the issuance of shares in LLCs. The operating agreement mostly establishes internal rules for how the business will be managed. These rules can be written to fit almost any desired management structure. For this reason, LLCs provide business owners with more overall flexibility in management than corporations.
LLCs can either be member-managed or manager-managed. Member-managed LLCs are operated by all members participating equally in the decision-making. Manager-managed LLCs have members who are silent in management decisions while managers are tasked with daily operations. The role of managers in this structure is similar to that of directors in a corporation.
If all owners want to participate actively in the management of the company, forming an LLC is probably the best choice of entity for your business. However, if you are hoping to attract passive investors to fund your endeavor while the business is managed by more qualified officers, starting a corporation will meet your needs.
One of the main reasons to form a corporation or LLC for a small business is to avoid personal liability for the business’s debts. Both corporations and LLCs exist as separate legal entities apart from the owner. The entity itself is seen as the owner of all business debts, assets, and other obligations. Because of this, the owner’s personal assets are shielded from creditors. The only liability shareholders or members have for business obligations is limited to their investment in the company.
This protection does not extend to misconduct or gross negligence by the members or shareholders. In both types of entities, parties may be held individually liable under a legal concept termed “piercing the corporate veil.” Under this doctrine, courts will set aside the entity and hold the owners personally responsible. While this remedy is not often enforced, the courts make their determinations by looking at the actions of individuals operating the company as well as the legitimacy of the company’s independence from its owners.
There are many factors that courts use to evaluate the legitimacy of the company’s separate identity. The nature of the corporation’s complex structure may make it less vulnerable to piercing due to the degrees of removal of the shareholders from certain control of the business. LLCs, particularly those with single-members, often struggle with maintaining business accounts and assets separately from their personal finances and run the risk of personal liability. Despite the rigid structure inherent in corporations, anything but absolute compliance with corporate formalities or gross misconduct by shareholders can jeopardize the personal assets of owners.
Corporations must not only file the Articles of Incorporation but also create a board of directors, issue stock, hold annual shareholder meetings, and draft bylaws and shareholder agreements. In addition to these requirements, corporations must also file annual reports like LLCs.
The formal requirements for LLCs are significantly less burdensome than those for corporations. The initial formation is completed simply by filing the Articles of Organization with the state (the Secretary of State in most states). While an operating agreement is always suggested, most states don’t require it.
The annual compliance requirements for LLCs are as simple as filing an annual report and paying an annual fee and/or franchise taxes. In fact, many states have one document that satisfies both requirements. The annual report is a very basic document that contains the contact information for the company, the registered agent, and current members.
Failure to file an annual report and pay franchise taxes to the state can incur financial penalties and even lead to the automatic dissolution of a business, regardless of the type of entity.
Another major difference between corporations and LLCs is their tax treatment. Put simply, business profits and losses are “passed through” to the individual owner’s income tax return, while corporate profits and losses are held by the corporation.
Shareholders of a corporation receive dividends, and they are taxed on their dividend income. Members of an LLC are taxed on what they receive as their share of the profits each year, and they pay taxes on that share on their personal tax returns.
Corporations are taxed on both the entity level and the individual level. This means that because corporations are separate entities, they are taxed at the corporate rate on all company income, and the shareholders are taxed individually on the money they earn from the company. Corporate shareholders do not pay self-employment taxes. Shareholders in the company who also work as employees have Social Security and Medicare (FICA tax) deducted from their paychecks just like any other employee.
Filing an S Corp election eliminates the double taxation issue mentioned above in exchange for limitations on the number and nationality of shareholders. If you elect to be treated as an S Corp, each shareholder will be taxed on the individual level based only on what they each receive from the company. The corporation itself is not taxed on its overall income.
The profits and losses of an LLC and a corporation are handled differently. Although LLCs are separate entities for liability purposes, federal income taxes are handled at the individual level of each member.
An LLC is taxed as a pass-through entity by default. A single-member LLC is taxed like a sole proprietorship, and a multi-member LLC is taxed like a partnership. This means that the profits of the business are “passed through” to the owners (called members). Profits and losses are reported on the individual tax returns for the owners and not at the business level. As a result, filing taxes is often simpler for owners of an LLC. Any losses or deductions of the business can be deducted on personal tax returns, which can help offset other income. LLC members also pay self-employment taxes (which is a combination of (Social Security and Medicare tax) on their share of business profits.
An LLC can elect with the Internal Revenue Service to be taxed like a C Corporation or S Corporation as explained above, which may provide tax savings.
The method of payment and taxation should be significant factors in determining which entity you choose for your business.
When to Use an LLC vs. a Corporation
As you can see, there are many important differences between corporations and LLCs that should impact your decision regarding business formation.
In short, LLCs are usually the best option for entrepreneurs planning to do business alone or with a small handful of other members interested in actively participating in business operations.
Corporations are usually an ideal choice for startups that need to raise capital and attract investors.