30 Sep Corporations and LLCs: What’s the Difference?
You’re an entrepreneur getting your new business up and running. Inevitably, you will run into a particular subset of questions regarding the set up of your business. As a law firm serving small businesses, here are the questions we receive time and time again:
- Should my business be a corporation or a Limited Liability Corporation (LLC)?
- What is the difference and which is better?
- What are corporations and LLCs?
Let’s break it down.
How are LLCs and corporations similar? Both LLCs and corporations are business entities — a structure that you choose and register for with the state and exists as a legal entity separate from the owners. Most people register in the state where their business is located, but that is not required but that decision will affect how your business will operate on several aspects. Both a corporation and an LLC offer the same liability protection. Any liabilities incurred will be the responsibility of the business and not the owners personally. A business obligation, if you will, completely separate from the person.
Now, for where they differ.
Business structure and ownership
A corporation is owned strictly by shareholders. This is the classic stockholder structure where the percentage of stocks owned equals the percentage of ownership. Shareholders will then elect a board of directors who then appoint officers (such as CEO, CFO, etc.), creating a hierarchy of command of how the business is run. This structure is easily scalable; if there is only one owner, said owner can be the sole shareholder, director and officer.
Having stocks has three main benefits:
- First, ownership is easily transferable. Just sell the stocks. Although, admittedly, outside of publicly traded corporations, there may not be a ready market for the shares of your small corporation.
- Second, it permits for investors. This allows for company growth and large amounts of capital can be raised for company projects and endeavors. This is done by selling shares of stock in return for capital investment.
- Third, it’s what the “big boys” do. The giant companies of Microsoft, Apple, Google are all publicly traded. Classifying your company as a corporation gives the same “air of prestige” and is good if you ever want to go public.
A corporation has its downsides as well though. The biggest downside to address is from a taxation perspective. There are actually two categories of corporations from a taxation stand-point: C corporations and S corporations.
C corporations are the default corporation and the key thing to note is the presence of double taxation. Your business will be taxed once at the corporate level and then once at the personal level. Let’s say the taxable income (revenue – operating expenses) comes out to $100,000. Corporate income tax will get docked out of that, at say, 25% (the actual rate varies, depending on how much taxable income there is, where the corporation is registered, and other factors. That leaves $75,000. If any of that $75,000 is distributed to shareholders, the shareholders will be taxed again when reporting these dividends as income. Double taxation does only kick in if profits are distributed to shareholders as dividends. However, hiding the profits as wages and salary will not work because the IRS does check and relabel excessive salaries and the like as taxable dividends.
So before talking about S Corporations, we must dispel a certain myth. You do not “form an S Corporation.” When you register your business with a state, you can only form a Corporation. You can choose to be taxed as an S Corporation or a C Corporation by filing a form with the IRS after your formation. You can change this choice later as well. From a liability protection viewpoint, a C Corporation and an S Corporation are the same, but they are different from a tax perspective.
From a taxation status, S corporations are not subject to double taxation, and are taxed only at the shareholder level. S corporations are a pass-through entity, meaning that any income, losses, deductions, and credits will “pass through” the business and will only be taxed to the shareholders. What that means is that the profits/losses are distributed to the shareholders and then taxed at that shareholder’s personal tax rates. The business files a special kind of tax return that reports how the profits/losses were distributed to the shareholders. There are some financial benefits to this structure for smaller corporations. S corporations are limited in that they are capped at 100 shareholders who all must be US citizens or legal residents (green card holders).
There is $30,000 of ordinary taxable income from Company X. Steve owns 50% of the stock. Company X will pay no corporate income tax but Steve will have to pay tax on his 50% of the income, $15,000, at whatever personal rate he is subject to, regardless of if the income is actually distributed to him.
This only skims the difference between S and C corporations. To truly determine which is more advantageous from a tax perspective, consulting an accountant to create a tax plan is highly advisable.
Corporations must hold an annual shareholder meeting, document the details and discussions, as well as file an annual report. Changes made to the business need to be voted on in a board of directors meeting before they can be made.
LLCs on the other hand are often considered the “best of all worlds” for their unique properties and are the most popular entity choice.
Business Structure and Ownership
Another advantage of an LLC is great flexibility with how the business is structured. LLCs are owned by individual(s) called members. Every member is an owner to the company; it can be a single member with full ownership or multiple members with split ownership. This is sometimes called membership interest. And according to Investopedia, “many states don’t restrict ownership, meaning anyone can be a member including individuals, corporations, foreigners and foreign entities, and even other LLCs” but banks and insurance companies are excluded. When there are multiple members, all members can participate in the day-to-day running of the business or a manager can be appointed. There are no shares, no directors, and members are responsible for establishing membership requirements, transfers, etc., which can help speed up the decision-making-to-execution process.
In addition to the same liability protection a corporation gets, LLCs get the most flexibility in that you choose how you would like to be taxed, aka your tax identity. The IRS does not care if the LLC is taxed as a corporation or partnership, though most LLCs do elect to be taxed as an S corporation. Again, consulting with an accountant is recommended.
When it comes to maintenance, LLCs have fewer recordkeeping requirements than those of corporations. For example, LLCs are not required to hold annual meetings or make a board vote on decisions. Some states do require the filing of an annual report.
So, which type is right for you?
Choosing the right form of business entity is going to depend heavily on your personal financial situation, business goals, presence of partners and what kind of people/entities they are, and other factors. While it is possible to move from one entity type to the others, it is not a simple process. So we strongly encourage you to speak to an attorney and an accountant to discuss the matter.
Here are some quick summary points on the structures:
- Fewer recordkeeping requirements
- More flexibility with taxes and structure
- Easy to set up with fewer documentation needs
To keep in mind:
- Not a good choice for businesses that want investors
- Trying to add ownership, changing to operating structure, and dealing with tax restrictions quickly becomes costly.
- LLCs do not have the same historic legal stability as corporations since they are newer, but there is a growing body of law that supports the flexibility of LLCs
- More significant legal stability
- Easier to raise capital and funding
To keep in mind:
- Double taxation issues for C Corporations
- Increased paperwork requirements and need for a Board of Directors
So hopefully what LLCs and corporations are and their differences are clearer. But which should you pick? Is one option better? The classic lawyer answer applies–it all depends. It depends on your goals, how you prefer to run a business, and of course, which is the better option financially.
If you are planning a business and want to talk about this with our attorneys, set a consultation by going here: MatttheLawyer Calendar Tool.
We look forward to chatting with you soon.
About the Author
Arabella Chen is a legal research and writing intern at the Johnston Business Law Group and an aspiring law student. She is currently a senior studying biology at Duke University and spends her time alternately researching global health impacts and legal concepts. Arabella graduated from Frederick High School where she spent four years on the Mock Trial team with Matt Johnston as the attorney coach, which sparked her interest in law. When not combing through journals or writing, Arabella can be found cooking (pesto pasta, anyone?) and riding horses anywhere she can manage.