The decision to form an LLC or a corporation is a common debate among business owners that deserves careful consideration. While both are excellent choices for personal liability protection, each entity offers its own set of distinct advantages.
Choosing the right one for your company depends on your particular business, operational needs and tax strategy.
Advantages of an LLC compared to a corporation
Fewer corporate formalities
Corporations must hold regular meetings of the board of directors and shareholders, keep written corporate minutes and file annual reports with the state. On the other hand, the members and managers of an LLC need not hold regular meetings, which reduces complications and paperwork.
No ownership restrictions
S corporations cannot have more than 100 shareholders, and each shareholder must be a U.S. resident or citizen. There are no such restrictions on LLCs.
Ability to use the cash method of accounting
Unlike C corporations, which often must use the accrual method of accounting, most limited liability companies can use the cash method of accounting. This means income is not earned until it is received.
Ability to place membership interests in a living trust
Members of an LLC are free to place their membership interests in a living trust. In the case of an S Corporation, placing shares in a trust can raise issues with the S Corporation status.
Ability to deduct losses
Members who are active participants in the LLC's business can deduct its operating losses against the member's regular income to the extent permitted by law. Shareholders of an S corporation are also able to deduct operating losses, but shareholders of a C corporation are not.
By default, an LLC is treated as a "pass-through" entity for tax purposes, much like a sole proprietorship or partnership. This means that LLCs avoid double taxation. Furthermore, an LLC owner is not required to pay unemployment insurance taxes on his or her own salary. However, an LLC can also elect to be treated like a corporation for tax purposes, whether as a C corporation or an S corporation.
Disadvantages of an LLC compared to a corporation
Profits are subject to Social Security and Medicare taxes
In some cases, LLC owners may end up paying more taxes than owners of a corporation. Salaries and profits of an LLC are subject to self-employment taxes, currently equal to a combined 15.3%. With a corporation, only salaries (and not profits) are subject to such taxes. This disadvantage is most significant for owners who take a salary of less than $102,000.
Owners must immediately recognize profits
A C corporation does not have to immediately distribute profits to its shareholders as a dividend. This means that shareholders in a C corporation are not always taxed on the corporation's profits. Unless an LLC elects to be taxed as a corporation, profits are automatically included in a member's income.
Unfavorable state tax rules and fees
In some states, including California and New York, an LLC must pay higher taxes and fees than would a corporation that generated the same revenues.
Fewer fringe benefits
Employees of an LLC who receive fringe benefits, such as group insurance, medical reimbursement plans, medical insurance and parking, must treat these benefits as taxable income. The same is true for employees who own more than 2% of an S corporation. However, C corporation employees who receive fringe benefits do not have to report these benefits as taxable income.