The decision to incorporate or form a limited liability company (LLC) often depends on your business strategy and objectives, anticipated size of the business, opportunities for growth and expansion, annual reporting requirements, preferred taxation structure, desire for limited personal liability, and other significant factors.
Understanding the similarities and differences between incorporating and forming an LLC will allow you to make a sound business decision that suits your needs and goals.
Structure and ownership features of corporations and LLCs
A corporation is generally classified as a number of individuals authorized by a particular state's laws to transact business as a single legal entity. Corporations may be comprised of a single individual or hundreds—even thousands—of people.
The owners of the corporation are known as the "shareholders." The management of the day-to-day operations and major decision-making functions of the corporation is left in the board of directors' hands.
While an LLC is not a corporation, it's nonetheless a very popular business entity type, particularly among small businesses. The owners of an LLC are referred to as "members," while the individual or entity responsible for overseeing and managing the LLC's daily operations is known as the "managing member."
An LLC that a single owner operates is known as a single-member LLC. An LLC that is comprised of multiple owners is known as a multi-member LLC and is organized and treated much like a partnership.
While corporations are replete with statutory requirements and other formalities, LLCs are less structured. Many business owners and operators gravitate toward LLCs as the entity of choice partly because of their flexibility, including the lack of traditional corporate formalities and requirements.
The startup process for corporations and LLCs is quite different
The first step toward incorporating your business involves preparing and filing the required formation documents. This is done with the secretary of state or comparable governmental agency in the state where the corporation's primary place of business will be situated or where the majority of business transactions will occur.
Although the incorporation forms and the process to be followed may be slightly different in each state, corporations must typically file articles of incorporation and pay certain incorporation fees at the time of filing.
After the incorporation documents have been filed and processed, the corporation will be required to nominate a board of directors and, normally, a CEO and other corporate officers. It will also establish and vote on bylaws that set forth how the corporation will be operated and managed—such as the procedure for issuing stocks, dividends, bonuses, and similar financial concerns.
Additionally, the corporation must apply for an employer identification number (EIN) through the IRS so that annual corporate taxes can be paid, set up corporate bank accounts, and select a registered agent to receive and process correspondence, notices, and lawsuits.
Once up and running, corporations may purchase or sell property, enter into contracts, and engage in a number of other business activities. If the corporation is formed as a stock corporation, it's permitted to issue and distribute "shares" of stock to its shareholders, officers, and directors.
LLCs, on the other hand, are not incorporated. They are "formed" or "organized." Although there may be different legal requirements in each state, forming an LLC normally begins by filing one or more documents with the secretary of state or similar governmental entity that regulates new and existing businesses.
These documents generally include the certificate of formation or articles of organization. Each document offers general information concerning the LLC, including the name, address, nature of the business, number of members, and similar topics.
And, instead of being guided by corporate bylaws, LLCs are normally governed by an operating agreement. The operating agreement provides the details regarding the company, including each member's initial financial contribution to the LLC, the voting rights afforded to each member, as well as the percentage of interest each member holds. Finally, unlike corporations, LLCs don't issue shares; instead, the members of the LLC hold a percentage of "interest" in the company.
So if the setup, rigid bylaws, and overall operation of a corporation seem too onerous, perhaps the simplicity and flexibility of an LLC is a better fit.
Corporations and LLCs each feature protection from personal liability
The primary benefit and most attractive feature shared by both corporations and LLCs is the fact that both entities remain separate and distinct from the owners. This is important because it allows the owners to avoid incurring personal liability for the corporation or LLC's business debts. For instance, in the event of a bankruptcy or a legal dispute with the business, the owner's personal assets like bank accounts, homes, and cars are not typically viewed as assets of the company.
In the case of a corporation, the shareholders, officers, board members, and employees are all shielded from the threat of taking on personal liability in the event a lawsuit is filed against the corporation, or if the corporation incurs a debt, expenses, or other liabilities or losses.
Similarly, the members of an LLC are protected against becoming personally liable for the LLC's losses, liabilities, or debts, just as they are immune from individual liability in the event a lawsuit is filed against the LLC, or if a collection action is pursued against the LLC.
Annual filing and other obligations
Corporations and LLCs have different requirements with respect to annual filing obligations.
All corporations must file an annual report and convene an annual shareholders' meeting. During the annual meeting, minutes are kept and records of any significant matters discussed or decided upon are maintained. Chief among the issues discussed at the annual meeting is the framework for issuing dividends, bonuses, and other forms of compensation.
On the other hand, LLCs are not obligated to convene annual meetings or to maintain minutes of any company meetings. Additionally, except in some states, annual reports are not required to be filed.
In many cases, it's the flexibility of the LLC which makes it such an appealing entity choice, especially among individuals who wish to operate a business and small businesses. Corporations can be less attractive if you are someone who is not interested in keeping up with the rather onerous corporate requirements.
When it comes to the differences between corporations and LLCs in terms of their tax structure, it's important to recognize that income that the corporation generates is subject to so-called "double taxation." The income is taxed twice—once at the corporate entity level and a second time when income is distributed to the shareholders.
Conversely, for LLCs, the benefit at tax time is the array of filing options available. In this regard, LLCs are not locked into one particular tax structure or classification.
Instead, they may choose how they wish to be taxed. For instance, the benefit of a single-member LLC is that the owner is subject to paying personal income tax on any profits generated by the LLC in a given tax year—just as would be the case if an individual operated a business as a sole proprietorship.
A sole proprietor is not required to pay tax at the corporate level. On the other hand, a multi-member LLC may choose to be taxed and treated as a partnership. In either case, any profits are taxed to the shareholders and not the entity itself.
It should be noted that, in general, it costs more to incorporate than it does to form an LLC.
Determining which entity type best suits your business' specific needs is never a simple process. It's normally best to consult with a tax expert, financial advisor, or attorney. If you seek to start a new business—whether you decide to incorporate your new business or form an LLC—an attorney is equipped to assist you with preparing and filing the required legal documents in your state to get you up and running.