LLC vs. Corporation: How They Differ
When you start a business, choosing a business entity is one of the first steps because it determines your personal liability and how you pay your taxes. A corporation and a limited liability company, or LLC, are among the types of business entities. Both structures are suitable for business owners who want to separate their personal assets from the company.
Although some aspects of the two entities are similar, there are some distinct differences. We’ll walk you through the details of each so that you can make an informed decision when choosing an LLC or a corporation designation for your small business.
What is an LLC?
An LLC structure protects your personal assets from liability. If the business faces bankruptcy or lawsuits, assets like your personal bank account, house or vehicle wouldn’t be at risk.
However, if you provide a personal guarantee to secure a loan or other type of financing, your assets would be on the line regardless of your business structure. Also, if you are negligent in your conduct as a business owner, you could lose the protection of the LLC.
Profits and losses from your business could be passed through to your personal income. You could pay personal income taxes rather than corporate taxes, which could be higher, though the top corporate tax rate is capped at 21%. As an owner of an LLC, you would be considered self-employed by the IRS and would need to pay self-employment taxes consisting of Medicare and Social Security contributions.
Most states do not regulate ownership, although you should check your state’s individual guidelines for LLCs. For example, California prohibits LLCs from providing professional services.
Membership and transferring ownership
One or more people can own an LLC, and owners are referred to as members. There’s no maximum number of members for an LLC. Members can be individual business owners, corporations, other LLCs or foreign entities that have ownership of the business.
When a member joins or leaves an LLC, some states require that the LLC be dissolved and re-formed with the new membership. You may need to put an agreement in place outlining the process for buying, selling and transferring ownership when you form an LLC.
What is a corporation?
A corporation as a business entity is also separate from its owners, protecting their assets from liability. Corporations are held to more extensive standards than other entities and require detailed record-keeping and financial reporting.
A corporation is formed when a group of owners, also called shareholders, incorporate a business. Corporations are legally treated as a person and can enter into contracts, get sued and possess most rights and liabilities that a person would.
Corporations must meet several requirements, such as electing a board of directors, filing an annual report, holding annual shareholder meetings and following company bylaws. These obligations can make a corporation an expensive type of business to run.
There are a variety of corporate structures from which to choose, but the common options are C corporations and S corporations.
A C-corp is a standard corporation that can sell stock to raise funds and become a public company. The IRS does not limit the number of shareholders a C-corp can have. C-corp employees can typically take advantage of stock option plans.
C-corps are subject to double taxation, as the business would have to pay corporate income taxes on profits and shareholders would pay taxes on dividends they receive on personal tax returns.
A C-corp operates independently from its shareholders, so if someone decides to sell their shares or leave the company, the business can continue to operate.
An S-corp is recognized as a pass-through entity, meaning all company profits and losses are passed through to owners and taxed at the individual income tax rate rather than the corporate tax rate. S-corps can avoid the double taxation that C-corps experience.
But some states tax S-corps on profits exceeding a certain limit. Other states treat S-corps the same as C-corps and subject them to the same taxes.
The IRS limits S-corps to 100 shareholders, and all shareholders must be U.S. citizens. These types of corporations can only offer common stock, which may give owners less control of the company’s stock value. C-corps, on the other hand, can issue preferred stock. Holders of common stock are entitled to a share of the company’s profits and can participate in the election of board members and vote on company policies. Holders of preferred stock are not afforded the same voting rights, but preferred stock is considered more senior than common stock. Holders of preferred stock are prioritized in dividend payments.
The difference between an LLC and a corporation
Although LLCs and corporations protect business owners from personal liability, the two entities vary. Here are a few differences to keep in mind when comparing an LLC and a corporate structure.
Ownership changes have greater impact on LLCs
When a member of an LLC joins or leaves the company, the LLC may need to be resolved and re-formed as a new entity. If shareholders part ways with a corporation, the company can continue operating.
Corporate entities can be expensive
Setting up an LLC or a corporation will cost you, but an LLC may be the cheaper way to go. State fees for forming an LLC are typically a few hundred dollars. The cost to incorporate a business can be thousands, depending on the state in which you incorporate. Maintaining a corporation can also be expensive, as you may need to hire a lawyer to draft bylaws and an accountant to create and submit annual financial reports.
LLCs can choose how to be taxed
LLCs can choose how the IRS taxes the business. LLCs can be taxed as a corporation, partnership or a pass-through entity with the profits flowing through to the business owner’s personal income. If you are the sole owner and choose to be classified as a pass-through entity, you would owe personal income tax and self-employment tax. If there are two or more owners, you would each owe personal taxes under a partnership classification. You would owe corporate taxes if you are classified as a corporation.
Here’s a quick look at how the entities compare:
|1 or more people referred to as members
|1 or more people, but no more than 100 shareholders
|1 or more people; unlimited number of shareholders
|Personal or corporate taxes
|Corporate taxes (company) and personal taxes (shareholders)
How to choose the right business entity
If you are concerned about being personally responsible for your business’s debts and obligations, you may want to consider an LLC or a corporation. Both structures would protect your personal assets and separate you from your company.
The entity you choose would also impact your ownership structure. If you plan to have multiple owners who are shareholders in the company, you’d need to be a corporation. You should choose a C-corp structure if you plan to take the company public at any point. But if you don’t plan to seek a public offering, you could consider an S-corp structure, which would allow you to avoid paying corporate taxes.
LLCs have more flexibility in their IRS classification. You could set up your business as an LLC, which is less expensive compared with a corporation, but you’d be taxed as an S-corp or C-corp would. You could choose the tax status that works best for your company.
You’re not locked in to the entity you first choose when you start a business. You could change your entity at a later time, though you may face restrictions based on your state regulations. To make sure you take the right step for your business, consider consulting an advisor, attorney or accountant to help you make your decision.