Does your business have a larger customer base? Is there an increased risk of liability or loss? Would you profit from exclusive tax benefits?
If you answered yes to these questions, then you need to form a formal business structure like an LLC or corporation. LLCs are the most popular structure to form because of the flexibility, simplicity, and low cost. However, forming a corporation can also benefit you depending on your situation.
Keep reading as we explain the differences between corporations and LLCs, and how to choose between the two.
What is a Corporation?
A corporation is a legal entity that is separate and distinct from its owners. Corporations retain most of the rights and responsibilities that individuals possess: they can enter contracts, loan and borrow money, sue and be sued, hire employees, own assets, and pay taxes.
This entity is a more formal business structure, therefore it has more legal requirements that are pertinent to your business success.
There are three different types of corporations:
C Corporations – Because of the taxes, C Corps are often best for businesses that have employees, a storefront, or regularly sell products. The perk associated with forming a C Corp is that there can be any number of shareholders.
S Corp – This type of corporation is best for businesses with large start-up costs because of the flow-through taxation. It offers the structure and protection of a corporation but is flexible for shareholders.
Nonprofit – Similar to a traditional corporation in structure but generates no profits. These corporations are tax exempt and can receive funding through multiple sources such as private donors and grants.
Advantages of a corporation
From protecting your reputation and personal assets to gaining capital, there are several advantages to becoming a corporation. Remember the structure you choose and benefits you receive depends on the specific setup. Here are just a few advantages you will receive:
Separate legal entity - A corporation provides more liability than any other business entity. If a corporation is sued, shareholders are not held personally responsible for the debts.
Limited liability – Shareholders are only liable up to the amount of their investment. Personal assets are protected regardless of what happens with the corporation.
Source of capital – A luxury that corporations have that other business entities do not is the ability to easily raise funds through publicly traded stock. This helps the business in times of need and helps with growth.
Tax benefits – If you form a S Corp, and have your income distributed appropriately, you are subject to tax benefits. Income incurred by the owner will be taxed under self-employed tax, but the rest will be taxed at its own level.
Ownership transfers – If you’re a shareholder and want to sell your shares, it’s not difficult to transfer ownership through a corporation.
Disadvantages of a corporation
Just as with every business decision, there are advantages and disadvantages. Here are a few disadvantages to forming a corporation:
Costs – Forming a corporation of any kind is more costly and time-consuming than any other business entity.
Taxation – If you form a C Corp, you are subject to double taxation. This can be avoided, but it’s best to talk with a legal expert to see if this is the best option for you.
Reporting – Corporations must keep (and file) accurate records of income, shares, and other tax documents.
Management – Depending on how you set your corporation up, there may be a management team operating without any real direction from an owner.
What is an LLC?
A limited liability company (LLC) is a business structure in the United States whereby the owners are not personally liable for the company's debts or liabilities.
Limited liability companies are hybrid entities that combine the characteristics of a corporation with those of a partnership or sole proprietorship.
Advantages of an LLC
Limited Personal Liability – When you properly form an LLC, you’re protected from the creditors and other liabilities.
Tax Advantages – You can deduct (or write off) your legitimate business expenses from your LLC’s income. This can significantly lower the profits reported to the IRS and help you in the long run.
Flexibility – In many states, an LLC can elect management flexibility and choose tax flexibility because the LLC itself doesn’t pay federal income taxes.
Privacy Protection – There are a few states that allow business owners to form an Anonymous LLC for added privacy protection. Anonymous LLCs are formed to help prevent people from easily looking up (and finding) ownership information on the internet.
Perpetual Existence –LLCs have the capability of surviving and thriving in the event of death or other major life events as long as the paperwork is filed correctly.
Disadvantages of an LLC
Some added complexity – An LLC has more administrative requirements than other business entities. Depending on the nature of your business and how you choose to file things, there are more details that need to be added to the paperwork.
Formation Costs - If you’re a small business or freelancer just getting started, things can get pricey in the beginning.
Corporation vs LLC: What’s the Difference?
The main difference between an LLC and a corporation is that an LLC is owned by one or more individuals, and a corporation is owned by its shareholders. No matter which entity you choose, both entities offer big benefits to your business.
One factor that many business owners take into consideration when choosing whether to form a corporation or LLC is taxes. An LLC is taxed as a pass-through entity, whereas corporations are taxed as a separate legal entity.
This means an LLCs taxes depend on the total income of the owner. While corporations are responsible for paying taxes on profits and dividends paid to shareholders – a process known as double taxation. This can often be avoided if a corporation has less than 100 shareholders and files an S Corp election.
Management structure is also a factor to take into consideration. An LLC offers a flexible structure, while corporations are stricter. LLC’s can elect to be manager-managed (investors don’t play any active roles in the business) and member-managed (the owners run all operations.)
A corporation has a board of directors which manages the profits, corporate officers who handle the daily operations, and shareholders. To maintain structure and balance, the rules, or corporate bylaws, of any corporation are made by the directors after the business entity is formed.
Although both LLCs and corporations have owners, the definitions and concepts are different. LLCs have no limitations when it comes to members and members have interest in the assets of the business.
As a corporation, owners are known as shareholders and have stock in the business. If you want to form an S Corp, you’re limited to 100 or less shareholders.
Unless an LLCs operating agreement denies members the right to distributions (or dividends), then they will be allocated equally. The amount can be based on any way the members choose, but it’s often based on the capital contributions of the members.
As a corporation, the board of directors decides the amount of dividends and when it will occur. Shareholders do not have voice in determining dividends, but when distributed, they are paid equally.
Can an LLC elect to be taxed Like a corporation?
There’s no option for being taxed as an LLC when it comes to federal income tax. Therefore, as an LLC, you have a few choices on how you want to be taxed.
You can choose to be taxed like a sole proprietorship, a partnership, a C Corp, and if you qualify, an S Corp.
By default, an LLC with one member is taxed as a sole proprietorship. An LLC with more than one member is seen as a partnership. However, the option that provides the most savings for business owners that have a higher payroll tax is an S Corp.
Sole proprietorships, partnerships and S corporations are all pass-through entities, but they’re not taxed the same. An S Corp has more restrictions than others, such as having less than 100 individual U.S. only owners.
If you choose to form an LLC, you can also choose to be treated as an S corporation by filing an Entity Classification Election form. This form will cause your LLC to be taxed as a C corporation. Therefore, it’s essential to file a Form 2553 to elect an S corporation tax structure.
Who is a Corporation or LLC best for?
From how the business is formed and business ownership to profits and losses to income taxes, there are some big differences to consider between an LLC and corporation.
An LLC is the most flexible entity, allowing for a single-owner business, a partnership, or a multi-member structure. There is not a limit to the number of members you can have, and the laws can be managed with an Operating Agreement set by the members. LLCs can be managed by all members or one elected manager. LLC owners also have the flexibility to modify their rules as they see fit for business.
Corporations have a stricter management structure – this includes a board of directors, officers, and shareholders – each responsible for a certain aspect of the corporation.
Most major corporations are C Corps, while smaller businesses are S Corps. The big difference is that C corporation shareholders are subject to double taxation. However, double taxation can often be avoided by spreading profits out to employees as benefits.
If you want to form a business with one or more people as owners, an LLC may be best for you. An LLC also allows members to have equity interest in the assets of the business.
Any individual currently operating as a sole-proprietorship, or a business partnership, should consider forming an LLC. The two biggest reasons are for legal protection and tax benefits. Additionally, having an LLC attached to your business name makes you more “official” and professional.
However, if you’re looking for a more structured business formation with a board of directors and shareholders who have shares of stock in your business, a corporation is right for you.
Every business situation presents unique obstacles. It’s best to consult with an experienced lawyer who can advise you on structure and tax decisions, as well as ensure all requirements are met when filing.