Even if your dream of starting your own business is still in the imagining stage, you probably already know that you need to protect yourself from liability — that is, legal and/or financial obligations such as lawsuits and debt collectors — by making your company a separate legal entity such as a limited liability company (LLC) or a corporation. But what’s the difference between these two business types, and which one is right for your company? It’s an important decision that will affect ownership, management, taxation, and more.
A corporation is a type of business that exists as a separate legal entity from its owners. In most cases, that means that the owners, who are called “shareholders,” aren’t personally responsible for the business’s debts. Most corporations are also a separate tax entity, meaning that the business itself is taxed on its profits; however, the shareholders are also taxed when they receive their share of those profits. Corporations have a rigid management structure and more government paperwork than other business types.
An LLC is also a separate legal entity, providing liability protection to its owners, who are called “members.” But, unless the members specify something different, the LLC itself isn’t taxed on its profits. The profits are only taxed when they’re distributed to the individual members. LLCs also have a much more flexible management structure and fewer regulations than corporations.
It helps to know the difference between a legal entity and a tax entity. The legal entity refers to how the state, courts, and others view your business, while the tax entity refers to how the business will be taxed.
This brings us to one of the reasons that approximately 90% of our clients choose LLCs over corporations: the dreaded Double Taxation. The IRS taxes the profits of a C corporation (the most common form of corporation) twice. The corporation itself is first taxed on the profits, and then the individual shareholders are taxed on their personal tax returns for any profits they receive from the corporation.
However, the IRS treats an LLC like a sole proprietorship or general partnership for tax purposes, meaning that the business itself isn’t taxed on the LLC’s profits. Instead, the individual LLC owners members only pay taxes on their share of the profits on their personal tax returns. This is called “pass-through taxation.”
Although the IRS taxes LLCs this way by default, you also have the option of being taxed as a corporation if you file the appropriate paperwork. Although this means double taxation, there are some cases where an LLC could benefit from being taxed this way.
Corporations have a strict structure requiring a board of directors who deal with managerial responsibilities and corporate officers who handle daily operations. It’s still legal in all states to have a one-person corporation, someone who wears all of those hats, but the corporation still has more government-established guidelines it must follow.
An LLC is much more flexible in how it’s managed. Any single member or group of members can manage it, making for a more centralized management structure. In cases like this, the member-managers are heavily involved in running the business. However, if the members are primarily investors, they might opt to hire a manager to handle day-to-day operations, or appoint one or more members to fulfill that role.
The ownership of a corporation comes in the form of shares issued to shareholders. This is a fairly rigid structure in which each shareholder’s percentage of ownership is directly reflected by how many shares they own.
An LLC treats its ownership as a percentage owned by each owner, called a “member.” The percentage of the business owned is called the “membership interest.” LLC members are free to determine ownership percentages among members as they wish, without regard to how much capital each member contributed. They can specify this in the operating agreement, a document LLC members use to spell out the rules for how the LLC will be run and organized.
In the same way, members can specify how they want company profits to be distributed among themselves. The percentage of profits each member receives doesn’t necessarily have to reflect the members’ ownership percentages.
Although legal requirements for reporting and bookkeeping vary from state to state, generally speaking, corporations have greater requirements for both. A corporation is required to have (and give notice of) an annual shareholder meeting. In addition, corporate minute books must be maintained to track certain actions. A public corporation (one that sells stock to the public) has even more reporting requirements.
In contrast, LLCs have far fewer requirements for both reporting and bookkeeping. Many states require both LLCs and corporations to file annual or biennial reports to update the state government about basic information about the business, but these usually aren’t that complicated.
Unlike corporations, LLCs are not recognized outside the U.S. That makes doing business in other countries difficult.
LLCs have a harder time raising capital for the growth of a business because, unlike with corporations, the owners can’t issue shares of stock to attract investors. Many investors are more likely to be attracted to investing in the more familiar form of corporations. Having a corporation will also allow you to do an IPO, which is not possible with an LLC.
Stocks also make the process of buying and selling parts of the business much easier. Transferring ownership of an LLC is usually a much more complicated process.
Both LLCs and corporations provide some benefits for their owners. For many, the primary reason for entering into an LLC or a corporation — as opposed to a sole proprietorship or general partnership — is to protect the owners from personal liability. Those wishing to sue or collect debts from your company will usually be limited to coming after the corporation or the LLC, not you as an individual.
You may have passion for your new enterprise and be willing to invest a good chunk of your savings into launching it, but that doesn’t mean you want to invest every cent you have and every cent you’ll ever make into it. Fortunately, both LLCs and corporations keep your income and losses and your business’s income and losses separate. If you’re saving for Susie to attend dental school or veterinary school so she can become a dentist or veterinarian or horse dentist, you don’t have to worry about the business’s debts eating into that money.
With both a corporation and an LLC, your company becomes a state-recognized entity. Not only is that distinction important on an official government level, but you’ll likely find clients and others more willing to take you seriously when you have that “Inc.” or “LLC” behind your company’s name.
Outside of actual car commercials, was the term YMMV (your mileage may vary) ever used more appropriately than for taxes? While certain aspects of Inc vs LLC can be more broadly categorized as pluses or minuses, the tax aspects will depend largely on your individual circumstances.
For example, an LLC usually can’t employ its own members, while a corporation can employ its shareholders. When it comes to self-employment taxes — money set aside for Social Security and Medicare — LLC members must pay these for themselves, while a shareholder paid as an employee of the corporation will have these taken out of their paycheck.
If an LLC member would benefit from being an employee of the LLC, they still have a couple of options. They can apply to be taxed as a C corporation, meaning they’d be subject to double taxation and the other aspects of that form of taxation. Or, the LLC could apply to be taxed as an S corporation.
One option for taxes that you may be able to use as either an LLC or corporation is to file as an S corporation. An S corporation is not really a separate kind of business entity, but a tax election status. It’s often a way for C corporations to avoid double taxation because it allows them to be taxed like a pass-through entity.
An LLC could also benefit from filing as an S corporation because it can save the members money on self-employment taxes. LLC owners normally pay self-employment taxes (about 15.3%) on all profits. This is more than the taxes they’d pay when working for someone else because their employer would pay part of them.
Instead of paying self-employment taxes on all their profits, owners of an S corporation can pay themselves a salary and only pay self-employment taxes on that salary; the business owners then avoid paying self-employment taxes on the remaining profits.
This can save the S corporation owners a substantial amount of money. However, the IRS expects you to pay yourself at least a “reasonable” salary so that you’ll still pay something in self-employment taxes.
S corporations do have some restrictions, though. An LLC or C corporation can be taxed as an S corporation if they fill out the right forms with the IRS and meet the requirements, which include having:
The tax issues around this and all tax issues for corporations and LLCs can get very complicated very quickly, so you’ll want to sit down with a qualified accountant to see which option makes the most sense for your business.
Generally speaking, C corporations (the most common kind of corporation) pay more taxes than LLCs. This is usually because of double taxation. A C corporation may be able to avoid double taxation by filing as an S corporation.
In most cases, yes, though the method and complexity will depend on your state’s laws and your specific circumstances. At the very minimum, the members of the LLC will have to be in agreement and also follow the terms that were set out in the operating agreement.
By default, the IRS taxes LLCs as pass-through entities, meaning that they’re taxed like sole proprietorships and general partnerships. However, you have the option to be taxed as either a C corporation or an S corporation, provided you complete the necessary paperwork and meet all the requirements.
Which entity type you choose will depend on your specific circumstances. You’ll need to weigh factors such as how much personal liability you’re willing to assume, how you want to be taxed, how you want the business to be managed, and how much government red tape you can handle.
You can form a corporation by yourself, just as you can have a single-member LLC. Depending on your state, you may have to wear multiple hats as the sole owner of the corporation.
LLCs share similarities and differences with C corps. You can review the specifics in our LLCs vs. C Corps piece.
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