Selecting a business entity for your new business is often a very simple decision. Once you understand your options and their implications, the right path for you will become clear.
Here are some tips and guidelines to help you choose.
Difference Between LLC and Corporation
“LLC” stands for “limited liability company.” It is similar to a corporation, but offers more flexibility in management and taxation and generally has fewer recordkeeping requirements.
Corporations have been around for a long time, and they offer a predictable structure, perpetual life and easy transferability of shares—important features if you plan to seek outside investors.
LLCs and corporations are both business entities that are created by filing formation documents with the state. Both provide their owners with the same type of liability protection: owners are generally not personally responsible for business obligations of either LLCs or corporations.
Corporation vs. LLC Ownership
The owners of a corporation are called shareholders. The corporation issues shares and each shareholder owns the number of shares that corresponds to his or her percentage of ownership. So if the corporation issues 1,000 shares and you own half the company, you’ll have 500 shares.
Corporate shares are relatively easy to transfer from one person to another, and corporations have a perpetual life—meaning a shareholder can leave, die or sell shares without threatening the corporation’s existence.
LLC owners are called members, and each member owns a percentage of the business, which is sometimes called a “membership interest.” There are almost always restrictions on transferring LLC membership interests. You may be required to get the other members’ approval, and in some states, an LLC must be dissolved if a member leaves, dies, or files bankruptcy.
If your business is small and you want to be able to choose your business partners, you may appreciate these LLC restrictions. If, however, you plan to seek outside investors or provide company shares to employees, then you’ll need a corporation’s easy share transferability and eternal life. In fact, venture capitalists and other professional investors will typically only invest in a corporation.
LLC vs. Inc. Management and Recordkeeping
Corporations have a fairly rigid management structure. They must have a board of directors that oversees the “big picture” issues and officers who run the company’s day-to-day affairs. They are required to hold annual shareholder meetings, must make annual reports, and generally have more onerous recordkeeping requirements than LLCs.
Most LLCs are managed by their members. These LLCs function much more like a traditional business partnership, and the members may not even have formal business titles. An LLC can also be managed by a group of managers. An LLC might choose to be manager-managed if it has members who own part of the business but aren’t involved in running it. LLCs have more minimal recordkeeping rules. In a handful of states, LLCs don’t have to make annual reports.
If your business only has one or a few owners and you are all active participants in the business, you may prefer to avoid the formality of a corporation and form an LLC. If, however, you expect to have many owners who are simply financial investors, the predictable structure of a corporation may be better for you.
S Corp. vs. LLC: Taxes for LLCs and Corporations
Corporations are taxed as either C corporations or S corporations. LLCs don’t have their own tax classification but have the flexibility to choose how they will be taxed. LLC's can be taxed as a sole proprietorship, partnership, S corporation, or C corporation.
Following is a basic explanation of how each of the structures listed above is taxed.
- C corporations pay corporate income tax on profits. Their shareholders pay personal income taxes on the profits that are paid to them as dividends. This is frequently criticized as “double taxation.”
- S corporations avoid double taxation. S corporation profits pass through to shareholders’ personal tax returns, and shareholders are taxed on those profits.
- Not all corporations and LLCs can be taxed as S corporations. There must be 100 or fewer shareholders; the shareholders can’t be corporations, partnerships, or nonresident aliens; and there can only be one class of stock. A corporation that is ineligible for S corporation taxation must be taxed as a C corporation, while an LLC can also choose to be taxed as a sole proprietorship or partnership.
- Sole proprietorships and partnerships report business income on their owners’ personal tax returns. This simple structure can work well for a small business that doesn’t have large profits. However, it can be expensive for a business that makes a lot of money: unlike corporate shareholders, sole proprietors and partners are considered self-employed and will be expected to pay Social Security taxes up to the maximum and Medicare taxes on all their profits.
For some businesses, taxation won’t be the deciding factor in the LLC vs. Corp. debate. However, before forming your business entity, it’s a good idea to consult a tax professional to make sure you understand how your business will be taxed.
Forming an LLC or a corporation will allow you to take advantage of limited personal liability for business obligations. LLCs are favored by small, owner-managed businesses that want flexibility without a lot of corporate formality. Corporations are a good choice for a business that plans to seek outside investment.