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The Complete Guide to Understanding LLCs vs. Corporations
Formalizing your business structure is an exciting step forward. But, it’s not apparent which business structure is better between an LLC and a corporation. I have put together this guide to help settle the issue once and for all and to help you make the best decision for your business.
Why Differentiating LLCs vs. Corporations Is So Important
If you’re deciding between registering a Limited Liability Company (LLC) or corporation, you’re already on the right track. Both options offer personal liability protection. This protection means your personal assets cannot be claimed to pay off business debts, losses, or lawsuits.
The differences between LLCs and corporations become evident the moment you try to form either business structure. The filing process and requirements vary for both entities. So, the ease of formation can play a part in deciding between the two. But, this should be the last deciding factor given the other more serious implications of choosing either entity.
For example, LLCs and corporations are taxed differently. So, it’s hard to say which option is better from a tax perspective–it depends on your situation. But understanding how taxes work in both instances can help you make the right decision for your business.
Additionally, the entity you choose can make the difference between going public and remaining as a private business. Similarly, investors overwhelmingly prefer backing certain types of business structures. Thinking about the investment potential of your business will help you choose between starting an LLC vs. a corporation.
Lastly, LLCs and corporations have different ownership structures. For instance, some business owners prefer to maintain maximum control of their business. For others, it is more important to bring in internal or external experts to manage its day-to-day operations. Either way, the business structure you choose has a significant impact on how your business is run and managed
Quick Tips to Improve Your Understanding of LLCs vs. Corporations
Understanding the differences between LLC and corporations can get technical. But it is still necessary to learn the differences for the reasons we outlined in the previous section. Fortunately, there are some quick tips you can apply to help you choose between an LLC vs. a corporation.
Understand the Formation Process
The LLC and corporation formation processes vary slightly. With an LLC, you’ll need to file Articles of Organization. This document is pretty basic and contains details like the LLC name, registered agent’s details, the LLC members, and how the LLC is managed.
On the other hand, you’ll need to file an Articles of Incorporation for a corporation. This document is far more detailed. For example, you’ll need to include the corporation’s name, registered agent details, board of director’s details, and number and type of authorized shares.
Filing either document makes it public information. The Articles of Organization doesn’t include as much detail about the organization’s internal affairs. So, if you’re looking to keep your company’s running private, an LLC is the way to go. Lastly, an LLC is generally easier to form than a corporation.
Consider Using a Business Formation Service
It is worth keeping a business formation service at the back of your mind as you decide between an LLC and Corporation. These services take charge of the formation process. You only need to provide your details, and the formation service will file the appropriate paperwork with the secretary of state. For this step, we highly recommend Incfile. It is an affordable service with an excellent reputation for making the formation process simple and easy.
Incfile pricing depends on the entity you’d like to create and the state of formation. But, the service has three pricing tiers including:
Silver – you’ll only pay the state filing fee. Incfile will prepare and file the relevant documentation on your behalf. This free package also comes with unlimited name searches, just to make sure that your business name isn’t already taken.
Gold – You get the services included in the silver package and extras like requesting an EIN, banking resolution, operating agreement, business tax consultation, and business banking account.
Platinum – Comes with additional services not included in any of the other plans, such as expedited filing, lifetime company alerts, business contract templates, and domain name and business name.
Learn the Different Types of LLCs
There are actually multiple types of LLCs. So, understanding the different options under this designation can help when choosing your business structure.
Single Member LLC – As the name implies, a single-member LLC (SLLC) is owned by one person. For this reason, the IRS treats this entity just like a sole proprietorship. This is because the business income isn’t divided among members. So, SLLC does not have to file separate taxes, such as federal tax returns.
Multi-Member LLC – This LLC has multiple members. A single owner can also register a multi-member LLC. In this case, the owner may choose to include their spouse or children as LLC members. However, taxes can be a little more complicated for multi-member LLCs. For example, members need to complete K-1 forms to file with their taxes.
Member-Managed LLC – In this case, all the LLC members participate in running the business. Additionally, the company needs majority members’ approval for important decisions such as securing loans, entering contracts, and making crucial decisions. Therefore, by default, LLCs are considered member-managed unless the formation documents state otherwise.
Manager-Managed LLC – This LLC is run by a manager appointed by its members. The manager may be one of the LLC members or an external party. The manager is responsible for the day-to-day running of the company. Still, members who aren’t managers may still make strategic or high-level decisions. Alternatively, these members may be passive owners with a financial interest in the company.
Learn the Different Types of Corporations
There are two main types of corporations, C-Corp and S-Corp. By default, your business is a C-Corp at the time of incorporation. But you can elect to make it an S-Corp for tax purposes. We’ll get into more details about this subject in the coming sections.
Understand LLC vs. Corporation Taxation
The IRS treats LLCs and corporations differently come tax time. By default, LLCs do not have to pay federal income tax. Instead, this entity enjoys what is known as “pass-through” taxation. Here, the LLC members file taxes in their personal income tax returns. As a result, the business income is treated as personal income by the IRS. This setup means that the company’s profits are only taxed once at the individual level.
Things are different for corporations. By default, incorporating your business creates a C-Corporation. In this case, C-Corps do not enjoy pass-through taxation. Instead, the company pays a corporate tax. Then, shareholders also pay personal income tax on dividends when the corporation distributes its profits. This situation is known as “double taxation.”
Although an LLC doesn’t have the problem of double taxation, it’s not the obvious choice. For example, LLC owners may need to pay a self-employment tax which isn’t the case for corporations. But, again, a tax attorney can help you figure out which option is better, given your type of business.
Long-Term Strategies for Understanding LLCs vs. Corporations
Many of the differences between LLCs and corporations become obvious early in the formation process. But, other differences take a longer time to manifest. Therefore, taking a longer-term view of your business can help you to settle on the appropriate structure.
Note the Difference Between Legal Entity and Tax Status
There is a subtle difference to note when choosing LLC vs. corporation. This difference lies in the legal entity vs. tax status. Just because the legal entity is an LLC doesn’t mean that it will be taxed as such. A business may have different legal and tax elections.
LLCs offer a lot of flexibility in this area. By default, an LLC is taxed as a partnership. But you can file with the IRS to have the LLC taxed as a C-Corp or an S-Corp. The latter is the more common option.
By electing to be taxed as an S-Corp, the LLC still enjoys the benefit of pass-through taxation. But, the members don’t have to pay employment tax. Instead, they only have to pay income tax on their dividends.
Additionally, an LLC with an S-Corp election may choose to pay its active business owners a salary. These members are legally considered employees of the company, and the business takes on the burden of paying payroll tax.
Similarly, a C-Corp may elect to be taxed as an S-Corp for tax benefits. In this case, the C-Corp will enjoy pass-through taxation and avoid paying federal income tax. In addition, the shareholders will only pay tax on the dividends at the individual level, thus avoiding double taxation.
However, an S-Corp has its limitations. For example, this structure is limited to 100 shareholders. On the other hand, both LLCs and C-Corps can have unlimited members. Additionally, S-Cops can only issue one type of stock, while C-Corps can issue multiple classes of stock.
Finally, S-Corp members have to be individuals. Thus, corporations and LLCs cannot own stock in an S-Corp. Similarly, only United States citizens or residents can be shareholders in an S-Corp, ruling out the possibility of foreign investment.
Consider Ownership Interests
An LLC is almost always the best option for small business owners who want to retain complete control of their business. This is because corporations must have a clear management structure, including a board of directors, officers, employees, and shareholders.
Distributing ownership interests is also easier with an LLC. In this case, an operating agreement dictates who is responsible for what in the business. For example, the operating agreement may mandate that all members share profits and losses equally, regardless of their financial investment.
The LLC setup is more favorable to business owners who bring different things to the table. For example, one owner may fund the business 100% while another brings business contacts and a client pipeline.
Things a far more rigid in a corporation setup. Shareholders own a percentage of the business based on their shares. Therefore, profits can only be shared based on each members’ shares, regardless of their other contributions.
Conversely, this rigid structure makes corporations more attractive to investors. Investors tend to prefer transparent management and ownership structures.
Think About Attracting Investors
It is possible to bring in investors for your LLC. Investor options may include individuals, partnerships, and corporations. But it will not be easy to attract investors for several reasons.
For one, investors have to become members of the LLC to invest. In turn, they’ll need to pay tax on their share of the profits, regardless of whether they received a distribution. This can unnecessarily complicate their personal tax situation, making it an unattractive investment.
Similarly, out-of-state investors may be required to pay a state income tax in your home state. This situation is even more problematic since not all states have an income tax. For example, investors in Washington don’t have to pay income tax in their home state. Therefore, if you are based in California, which has an income tax, it’s hard to see why your LLC would be an attractive investment.
Additionally, there are legal limitations when investing in LLCs. For example, stockholder rules dictate that venture capital funds cannot invest in LLCs or any other type of pass-through entity. So, you can rule out venture capital when thinking about investors.
For these reasons and more, investors almost always prefer investing in corporations. However, it is also worth noting that only U.S. citizens and residents can legally invest in S-Corps. Additionally, S-Corps are limited to offering only one kind of stock. So, investors may shy away from this structure. Nevertheless, it’s hard to beat a C-Corp if you’re looking for investors, whether domestic or foreign.
LLC vs. Corporation Post-Formation Compliance
You’ll need to meet specific requirements to keep your LLC or corporation in good standing with the secretary of state. Usually, this involves filing an annual report. The report also comes with a filing fee. Many states don’t require LLCs to file an annual report. However, corporations must file the reports to remain in good standing.
Generally, corporations have more stringent post-formation requirements. For example, some states require corporations to publish a notice of incorporation in local newspapers. Additionally, corporations need to create bylaws, issue shares, and hold initial meetings of directors and shareholders.
In short, corporations tend to have more post-formation requirements. An LLC might be easier to stay compliant with after the formation process.
Whether you end up choosing an LLC or a corporation, there are specific post-formation requirements you’ll need to meet in both cases. For example, in most states, you’ll need to file an annual report with the secretary of state. This is especially true for corporations. But, you’ll need to find out if your state requires you to file an annual report for an LLC.
Additionally, you’ll need an Employer Identification Number. Besides hiring employees, you’ll use this number to pay the necessary taxes, including federal and state taxes. Most banks also require an Employer Identification Number to open a business bank account.
Generally, corporations have more post-formation requirements. For example, the directors will need to hold and document an initial meeting called an organizational meeting. Similarly, the corporation will need to have a meeting for its shareholders.
Below are two more Crazy Egg posts to help you gain a better understanding of this topic: