A limited liability company (LLC) is a registered business entity. LLCs are treated as separate entities from their owners for legal purposes, affording members personal liability protection against business debts and other legal actions.
The IRS, however, regards LLCs as indistinguishable from their owners for tax purposes. For this reason, they are considered pass-through tax entities. All business profits pass through the LLC to its members who then report them on their personal income tax return. LLC profits are taxed only once but are also subject to self-employment tax.
A corporation is a registered business treated as a separate legal entity from its owners, also known as shareholders, and guided by a board of directors. Like LLC members, corporate shareholders enjoy limited liability protection, with their assets shielded by the business in the event of legal action.
Unlike LLCs, corporations are also considered separate entities for tax purposes. This means that all corporate profits are subject to taxation at the corporate tax rate before being distributed to shareholders. Once divided and distributed as dividends, shareholders are then responsible for paying personal income tax on the amount they receive.
The greatest similarity between corporations and LLCs is that they are both registered business entities that enjoy the benefit of limited liability protection.
Beyond this important similarity, there are several significant differences when it comes to LLCs and corporations. To determine which business type is best for you, it is important to understand what distinguishes them from one another. Some of their major differences include:
The Formation Process
Forming an LLC is a fairly straightforward process. It begins by establishing or gathering all necessary information and filing articles of organization with your state. The articles of organization will need to include the name of the company, the principal place of business, your registered agent’s information, members and their contact information, and the purpose of business.
Once you have filed your paperwork with the state, the next step is to draft an operating agreement. Your operating agreement is essentially the blueprint of your LLC. It should detail members’ duties, responsibilities, and powers, as well as the core procedures and operations of the business. While typically not required by law, an operating agreement a critical component in ensuring your business runs smoothly.
Forming a corporation begins in a similar way, by filing articles of incorporation with the state. Once this paperwork is completed, however, corporations require a few additional steps to begin operations. Unlike LLC operating agreements, the majority of states require corporations to draft bylaws to outline important information about how the business is run. To get started, corporations must also elect a board of directors, hold a board meeting to approve the bylaws, conduct a shareholder meeting, and issue stock.
Ownership and Responsibilities
LLC owners are known as members and can be organized as single-member or multi-member businesses. An LLC can also be organized as member-managed or manager-managed. While the default setting is member-managed, with all members taking an active role in business operations, an LLC may also elect to be manager-managed. A manager may be selected from among an LLC’s members or brought in from outside the company. An LLC can also choose another business entity as a manager. Managers will handle the day-to-day operations of the business, while members retain control over major decision making.
Corporation owners are known as shareholders. Shareholders elect the board of directors, who make major business decisions for the company. The directors then appoint officers (i.e., CEOs, CFOs, CMOs) to run the day-to-day business operations. It is possible to have a one-person corporation, where a single owner is the sole shareholder, director, and officer.
One of the main differences between an LLC and a corporation is how the two entities are taxed. Since the IRS does not recognize LLCs as taxable entities, they can elect to be taxed as C corporations, S corporations, partnerships, or sole proprietorships. The default status for an LLC is to be taxed as either a partnership or sole proprietorship, depending on how many members the business has. These entities are considered pass-through entities, with all profits passing from the business to the members to be reported on their personal tax returns.
The default structure for corporations is a C corporation. A C corps is the only business entity treated as a separate entity for tax purposes. This means that all C corp profits are taxed at the corporate level first. When company profits are distributed to shareholders in the form of dividends, those profits are then taxed again at each shareholder’s personal tax rate. This is referred to as the double taxation of dividends.
An S corporation is not actually a business structure, but rather a tax designation. Businesses that elect S corp status are taxed as pass-through entities and are not subject to corporate taxation. Unlike LLCs, S corps are not subject to self-employment tax on profits that are not distributed to shareholders.
Maintenance and Paperwork
Both entities require ongoing maintenance to remain in good standing and compliance, but corporations are more strictly regulated and require more paperwork. LLCs should draft and maintain an operating agreement, but need not file it with their state of formation. LLCs will also typically need to file annual or biennial reports along with a fee to maintain compliance. While it is a good idea to document major decisions, it is not required.
Corporations, on the other hand, must abide by additional corporate formalities. In addition to drafting bylaws and issuing stock, corporations must maintain tight records of meetings and stock transfers and prepare reports for shareholders. They must also have an annual meeting. Failure to follow these formalities can be used against a corporation in the face of legal action looking to override their limited liability protections.
The main advantages of LLCs are the flexibility they allow for in management, taxation, and governance.
Management and Business Formality Flexibility
LLCs offer great flexibility in the structure and management of a business. The amount of power, responsibility, and voting rights each member has can be determined by the members themselves. It need not be determined by how much start-up capital each contributes.
Members can directly manage the business, or they can appoint one or more people to manage the day to day business operations. How you structure the LLC and manage it should be thoroughly laid out in your operating agreement to avoid any confusion and help settle disputes.
The default tax structure of an LLC is pass-through taxation. This is a simple structure that avoids double taxation. However, if you find your business can benefit more from being taxed in a different way, you have the flexibility to choose exactly which tax structure works best for you.
Inexpensive Registration and Filing Fees
The fees to register and maintain an LLC are typically lower than those of a corporation.
Corporations also come with several advantages, from the ease of raising capital to the ability to transfer ownership.
Unlimited Capital-Raising Potential
A corporation’s stock structure can make it easier to raise capital for the business. Unlike LLCs, corporations have the ability to sell shares of the company to easily raise funds.
While corporations are disadvantaged by double taxation, they also enjoy several tax benefits. For one, corporations can deduct employee salaries, fringe benefits, and company losses from their taxable income and are not subject to self-employment taxes. Corporations also have the option to retain and reinvest profits in the company to cover expenses and increase stock valuation. Up to a limit, these retained earnings are not subject to double taxation.
Transfer of Ownership
The ability to easily transfer the ownership of a corporation is an extremely attractive feature. This ensures the continuity of your business long after you are no longer able to run it. The transfer of ownership is simply a matter of selling corporate shares. These transfers will not affect the business structure or hinder business operations.
C-corporations are the default corporate structure. Both C corps and LLCs can elect to be taxed as an S corporation. There are some notable differences to keep in mind as you decide which structure is better for your business.
- Taxes. The main difference between a C corporation and an S corporation is how they are taxed. C corp profits are taxed first at the corporate level and then at shareholders’ personal tax rate once distributed as dividends. S corps, on the other hand, are pass-through tax entities, where the profits and losses pass through to the shareholders to be reported on their personal tax returns.
- Shareholders. C corps can have an unlimited number of shareholders with no restrictions on citizenship or residency. S corps have a limit of 100 shareholders and are limited to U.S. citizens or residents only. Unlike C corps, S corp shareholders cannot be other business entities.
- Raising capital. Since S corps are limited to 100 shareholders, this can be a deterrent for some investors. C corps can have an easier time raising capital since there is more growth opportunity.
- Fringe benefits. C corps benefit from being able to deduct certain expenses such as employee health, life, and disability insurance. These deductions are not taxable to shareholders. S corps do not enjoy these same deductions and these benefits become taxable to shareholders who own more than 2% of the company.
Selecting the best structure for your business can be a difficult decision. It will have a huge effect on how you raise capital, how fast your business can grow, and how your business is managed and taxed. While businesses can benefit from any one of the structures discussed here, it is critical to understand how each one will work for your specific business. To help you make an even more informed decision, a business attorney or tax professional can help you understand which structure is best based on your goals, concerns, and priorities.