One of the first steps in starting a new business is deciding on a business structure or entity type. Choosing the proper structure is imperative to your business’s success, as the right structure will suit your business needs, size and goals.
However, deciding on the right structure, be it a limited liability company or corporation, will also depend on the type of business you plan on creating, the tax consequences of forming that specific entity, and so on.
The following guide will explain the differences between an LLC and a corporation and ultimately help you decide the best business structure.
Limited liability company
A pass-through tax structure combined with limited liability protection.
According to the IRS, LLCs may choose whether they want to be taxed as corporations or partnerships.
In terms of maintenance, an LLC is one of the easiest entity types to maintain due to the minimal amount of formal annual requirements.
When it comes to business-related debts, the shareholders or owners have limited personal liability.
Corporations are considered separate taxable entities, and corporate profits are taxed among owners and the corporation.
In order to raise capital, stock may be sold. In order to maintain corporate status, meetings need to be held.
S corporation is ultimately a tax status. This means that any existing liability protections from your base entity carry over.
Additionally, S corporations are costlier to set up than sole proprietorships and partnerships. However, they do offer considerable tax savings.
S corporations require more formality and paperwork, whereas a limited liability company is one of the easiest entities to form and still offers similar advantages to S corporations.
Nonprofit corporations are created for charitable, religious, educational, scientific, or literary purposes.
All contributions made to nonprofit corporations are tax deductible. Additionally, nonprofits may attain tax-exempt status with the IRS.
In order to maintain a nonprofit or tax-exempt status, you’ll need to submit annual reports, record minutes of meetings, hold regular meetings, etc.
What is an LLC?
An LLC or limited liability company is a type of business that provides its owners (referred to as members) with limited liability protection.
This means that when the business incurs debt or obligations or is faced with lawsuits, the members’ personal assets cannot be used to pay off these debts.
A limited liability company is a hybrid business entity combining the characteristics of a sole proprietorship or partnership with corporations.
- Management flexibility: LLCs have a flexible management structure that allows them to choose how they manage the business. LLCs may be member-managed (run by the members) or manager-managed (run by a manager hired from outside the business).
- Credibility: LLCs have more credibility with suppliers, lenders, and clients than other business entities like partnerships or sole proprietorships. This is because LLCs are regarded as more formal business entities.
- Flow-through taxation: LLCs are not liable for corporate taxes. Instead, the company’s income and expenses are passed through to the members so they can report them on their individual income tax returns.
- Membership flexibility: LLCs may be owned by individuals, partnerships, trusts, or corporations, and there’s no restriction on the number of members an LLC can have.
- Limited compliance requirements: While LLCs are still required to adhere to annual reporting requirements, they are subject to fewer ongoing filings and compliance requirements imposed by the state compared to other types of business structures, such as corporations.
- Limited liability: In the event of lawsuits, malpractice, or business debts and obligations occur, creditors cannot seize the personal assets of members to pay off the company’s debts. This is because LLC members are not personally liable for negligence by the company or other members, for that matter.
- Higher formation and compliance costs: Forming a sole proprietorship or general partnership is cheaper than forming an LLC. LLCs pay higher filing fees for both the initial formation as well as the ongoing maintenance of the company.
- Transfer of ownership: Corporations have a much easier process to transfer ownership than LLCs. This is because, in an LLC, all members must consent to the addition of new owners or members or changes in percentages of ownership of current members unless the operating agreement clearly states that they don’t have to.
What is a corporation?
A corporation is considered a separate legal entity created by shareholders, stockholders, or individuals to generate profit. Corporations are allowed to own assets, enter into contracts, borrow money from banks and other financial institutions, and remit state and federal taxes.
To form a corporation, you’ll need to go through a legal process called incorporation. This process involves submitting legal documentation and filing the necessary forms with the relevant federal and state agencies.
Ultimately, the incorporation process ensures that the entity is protected from personal liability in case of a legal claim or lawsuit.
- Personal liability protection: When compared to any other entity type, a corporation offers more personal asset or liability protection. If a corporation is sued, the owners cannot be held personally responsible for the company’s debts and obligations.
- Access to capital: Corporations may easily raise funds by selling stock since they sell ownership through publicly traded stock. Corporations have easy access to funding, which comes in handy for growing the company and saving the business from going bankrupt in times of need.
- Perpetual existence: The ownership of a corporation depends on the percentage of stock ownership, thereby granting owners more flexibility than any other business structure in terms of perpetuating the business over the long term and transferring ownership.
- Tax benefits: While the default corporation structure, known as the C Corporation structure, is liable for double taxation, corporations are allowed to elect the S corporation status, meaning that they can determine how their income will be distributed and consequently taxed.
- Strict formal requirements: The overall process of incorporating can be quite lengthy. You have to go through extensive paperwork and filing to properly document the details of your company as well as its ownership. You’ll need to create bylaws and a shareholders’ ownership change agreement, appoint a board of directors, take minutes during meetings, issue stock certificates, etc.
- Double taxation: Double taxation comes with the default corporation structure, the C corp. Double taxation means that the business is taxed at the corporate tax rate as well as the individual level since the shareholders will also have to pay taxes on their personal income tax returns. The only way to avoid double taxation is to elect the S corporation status.
- Rigid structure: Aside from the strict requirements during the application process, many formal and legal requirements are involved in maintaining a corporation. Some of those stringent requirements include maintaining a board of directors, following your company’s bylaws, holding annual meetings on time, submitting annual reports, and paying the necessary annual fees to remain in good standing.
- High cost: Corporations are not the cheapest entity type to form and operate, not to forget the payment of ongoing fees, filing charges, and taxes.
How is an LLC different from a corporation?
Both LLCs and corporations are different in a few ways. Let’s take a look at the differences below:
- Both business structures require you to file business formation documents with the state, but corporations have stricter formation requirements than LLCs.
- There is a lot more ongoing compliance paperwork, filing, and reporting requirements for corporations vs. LLCs
- However, corporations tend to have a more standardized and robust operating structure, but it also comes with more record-keeping and reporting requirements than LLCs.
- Ultimately, there is more flexibility in running a limited liability company than there is in running a corporation.
LLC vs. corporation taxes
Regarding taxes, LLCs have quite a few options compared to corporations. This is because limited liability companies are not restricted to one tax classification by the IRS and may choose to be taxed as partnerships, sole proprietorships, S corporations, or C corporations.
- LLCs do not pay corporate income tax; instead, the profits and losses of the business are passed through to the members, who will report this on their personal tax returns.
- LLCs may elect to be taxed as an S corporation.
- LLC members are not subject to Social Security or Medicare taxes since they are not considered employees. The only exception to this rule is when a member actively works in the business, and if so, they are not liable for self-employment taxes, including taxes on their salary and share of any profits.
- LLC members working for the business may deduct the company’s operating losses on their individual tax returns to offset other income.
- Corporations must submit tax returns and pay income taxes on their income or profits. This often leads to double taxation, where the corporation is taxed on profits, and owners are taxed on their share of the profits.
- To avoid double taxation, corporations may elect the S corporation status, where they’ll be taxed as pass-through entities.
- However, shares in a corporation are much easier to transfer than an ownership or membership interest in a limited liability company. So if you’re looking for outside investors, the corporation would be your best business structure.
Should I start an LLC or a corporation?
When deciding which business entity type is better for your company, you must consider several factors, including tax benefits, liability protection, and the various benefits of each business structure.
To select an entity that best meets your business goals, you’ll need to consider the differences between these two business structures, such as management, maintenance requirements, taxation, etc.
LLC vs. corporation: Formal requirements
Whether you’re forming an LLC or a corporation, you will be required by the state that you’re forming in to fulfill certain reporting and maintenance requirements. This allows the business to remain in good standing and manages the limited liability protection acquired by incorporation.
Formal requirements for LLCs
- Limited liability companies have far fewer record-keeping requirements than corporations.
- LLCs are not required to hold annual meetings, keep minutes or have a Board of Directors. They do still need to nominate a registered agent or registered agent service.
- They may need to create Articles of Incorporation, Articles of Organization, or operating agreements. Some states may require annual reports. However, many of them do not.
Formal requirements for corporations
- Corporations tend to have more annual requirements than limited liability companies, even though state law varies from one state to the next.
- Corporations must hold an annual shareholders meeting once a year, and these details must be documented, including discussions as notes referred to as corporate minutes.
- Additionally, corporations must have bylaws and submit annual reports which keep the business information up to date with the Secretary of State.
For LLCs and corporations to remain in good standing, they will need to keep tax payments current and file income taxes with the IRS on time.
Additionally, ongoing compliance requirements dictate that both LLCs and corporations file annual reports, keep their business information up to date, maintain a statutory agent, and renew licenses and permits.
Failure to adhere to the ongoing compliance requirements in the state of formation could mean that your company is no longer in good standing.
LLC vs. corporation: Management
In terms of management structure, a corporation’s management structure is far stricter than an LLC. This is because corporations have a formal structure and, therefore, must have a Board of Directors that maintain and manage the responsibilities of generating profits for the shareholders.
With corporations, the business’s day-to-day operations are assigned to corporate officers, and the shareholders are also considered owners of the company but remain separate and uninvolved in the business’s decision-making process.
- LLCs have a much more workable management structure, and this business type may be managed by its members or a group of managers.
- Any limited liability company member may fulfill the role of an LLC manager.
- Additionally, an LLC may choose to elect to have no differentiation between a manager and a business owner. So this business type is very flexible.
- LLC management is more informal, making it ideal and appealing for many entrepreneurs.
LLC vs. corporation: Ownership structure
Before starting an LLC or corporation, business ownership is yet another crucial aspect you must bear in mind. This is because the ownership structure in each business type differs, and each has transparent grounds, making your choice easier.
LLC ownership structure
- A limited liability company can dispense its ownership stake to the owners without speculating on a member’s monetary allowance to the company itself.
- Individuals, trusts, and other types of corporations may also own LLCs. Therefore, it’s the ideal option for businesses when these factors are significant.
Corporation ownership structure
Corporations sell percentages and issue shares of stock to owners or shareholders. Shareholders, in turn, may transfer the shares, purchasing additional stock to possess a larger percentage of the business or selling stock off to own a smaller percentage.
LLCs and corporations have benefits, such as providing limited liability protection for owners’ assets and separating the owners from the business. The first step is deciding which business structure or type most aligns with your business goals.
In a nutshell, LLCs offer a simple management structure, less paperwork, no double taxation, and the option to distribute ownership freely.
On the other hand, corporations offer a formal management structure, the ability to raise capital by issuing stock, tax-deductible fringe benefits, and ownership represented by the stock.
C corporations are classified as separate legal entities and are subject to double taxation unless they elect S corporation status. Double taxation means the business is taxed at the corporate level, and the owners are also liable for taxes on their personal income.
The owners of an LLC may share in issuing the business’s profits and losses. Additionally, they are entitled to the LLC’s asset distributions at the time of existence and when it liquidates or dissolves.
Single-member LLCs are LLCs with only one owner compared to multi-owner LLCs with several owners, also known as members. However, single-member LLCs and Multi-member LLCs share the same benefits, such as pass-through taxation, perpetual existence, and limited liability. Additionally, they share the same drawbacks, such as a lack of investor appeal and higher formation costs compared to a corporation.
Self-employment tax is a federal tax placed on a self-employed person’s income. However, it is not a federal income tax. Owners of LLCs, sole props, and general partners must pay self-employment tax (social security and medicare tax).
For an LLC to be treated or regarded as an S corp by the IRS, they’ll need to file Form 2553, and if approved, they will elect the S corp status and enjoy the tax benefits that come along with it.