Choosing Between an LLC and Corporation
A limited liability company (LLC) is usually the best business entity type for small businesses because it offers limited liability protection but is easy to run and has tax options that fit well with how small businesses operate and grow.
Limited Liability Protection provides legal separation between you and your business and can protect your personal assets if your business is sued.
A corporation offers limited liability protection but has complex operational procedures and tax options that often don’t provide tax advantages to small businesses.
Only small businesses that need to attract outside investors should form a corporation.
When To Form An LLC
An LLC is most likely the best structure for your business if:
- you don't need to attract investors
- you plan to invest most of your profit back into the business each year
- you would benefit most from an easy to maintain business structure
Reinvesting LLC Profit and Pass-Through Taxation
If you expect to reinvest most of the profit back into your small business, an LLC is the right choice.
Small businesses usually carry very little profit from one tax year to the next. This is because small businesses often spend most of their income on expenses to help the business grow.
Pass-through taxation means the net income (profit minus expenses) of the business passes through to the LLC member(s) individual tax returns. This means the business itself will not be taxed and you will only be subject to income tax on the business's net income. Distributions are subject to both income tax and FICA taxes.
A corporation's net income is taxed once on the corporate level at 21%. If any of that profit is paid as dividends to shareholders, they pay income tax and FICA taxes on the dividend as well.
To learn more, read our LLC vs. Corporation Taxes guide.
Only small businesses that need to carry large amounts of profit from one year to the next will see a tax advantage from starting a corporation.
LLCs are Easy to Start and Maintain
Limited liability companies (LLC) are a simple business structure: they require less paperwork, less administrative overhead, and are much easier to start and maintain than a corporation.
LLCs are also adaptable and can elect to become corporations at a later date. This makes LLCs a great starting point for your business to grow.
When to Form an LLC Taxed as an S Corporation
An LLC taxed as an S corporation (S corp) is the best choice for your business if:
- the business generates enough profit to pay you a "reasonable salary"
- you expect significant distributions year over year
- you can reach the break-even point between payroll costs and tax savings
- you don't need to attract investors (investors=corporation)
S Corp Savings Calculator
Calculate how much you can save by choosing an S Corp tax classification
As a Sole Proprietorship or Single-Member LLC
Self Employment Tax:
Salary Employer Tax
(S Corp pays)
Savings on Self Employment Taxes
Against this savings, you have to balance the time and costs of running payroll and tax withholding. To learn more about what this will cost, get a free tax consultation.
When to Form a Corporation
Most small businesses start as limited liability companies (LLCs) but there are some instances when starting as a corporation makes sense.
Your small business would benefit from a corporate structure if:
- you need to attract venture capitalists and investors
- you need to carry significant profit over from tax year to tax year
- there is benefit in managing a complex business structure
Venture Capital and Investors
If you need to attract investors, starting a corporation would be the best choice (and usually the only choice) for your small business.
An investor in a corporation pays taxes on dividends only when they receive them whereas an investor in an LLC would have to pay taxes regardless of whether they received a distribution or not. The LLC investor might never see a return on their investment but might have to pay taxes every year regardless. This is why investors prefer C corps.
Profit Carryover from Year to Year
If a small business is unable to spend a significant amount of its profit during a tax year on expenses to grow the business, it could make sense to structure the business as a corporation rather than an LLC. This is because of the difference in the way the two business entities are taxed.
A corporation is taxed at about 15% for all profits that carry over to the next tax year. In this same scenario, an LLC member's tax burden would be greater because they pay FICA taxes and federal and state income taxes, which are higher than the 15% corporate rate.
That said, a business owner who anticipates needing to carry profit into the next tax year should look closely at the financial benefits of forming a corporation.
Managing a Complex Business Structure
If the benefits of managing a complex business structure outweigh the costs, starting a corporation could make sense for your small business.
Corporations are more complex organizations compared to LLCs, with increased administrative overhead, more paperwork, and complex compliance requirements. Managing a corporation may require help from an attorney or accountant which can increase overall business costs.
To learn more about the complexities of running a corporation, visit our How to Start a Corporation guide.