Limited liability companies (LLCs) and corporations (inc.) are two of the best business structures for protecting your personal assets in a business venture. You may have heard about the importance of limited liability protection for business owners, but which of these protective entities is the best choice for your business?
Before you decide how to register your business, consider the following benefits and requirements of LLCs and corporations.
Difference Between LLC and Inc.
The main differences between LLCs and corporations involve ownership, formation, taxation, and ease of fundraising or investment.
Incorporating a business involves more initial fees than forming an LLC, as well as more requirements for creating and maintaining their status. One of the biggest advantages of spending a bit more to incorporate is that corporations are considered more credible businesses from a bank or an investor standpoint. As a result, it’s easier to raise money or take out a business loan as a corporation rather than an LLC. Furthermore, corporations have the option of selling stock to raise capital while LLCs don’t.
LLCs are considered a hybrid legal entity, because they merge some of the qualities of a corporation with the advantages of a partnership, like flexible taxation, management, and operation.
Limited Liability Protection
Limited liability means a business is a separate legal entity from its owners, so owners aren’t personally responsible if the business is sued or incurs debt, and creditors can only go after business assets. Both LLCs and corporations offer limited liability protection, and it’s one of the main reasons entrepreneurs decide to form one of these two entities.
Separating personal and business assets is essential to minimizing risks in a business venture. When operating without a separate legal entity (like with a sole proprietorship or a partnership), creditors can go after the business owner’s personal savings or property to settle debts.
In rare cases, when a court can prove negligence or misconduct, LLC or corporation owners may still be held personally liable, so it’s essential to keep records proving the separation of personal and business assets.
Corporations have the strongest liability protection, partially because of their strict recordkeeping requirements.
Formation and Management
Both LLCs and corporations are formed at the state level. An LLC or corporation can be formed in all 50 states and DC, although filing fees and specific regulations will vary. Compared to LLCs, corporations have more requirements for how they’re created and maintained.
A corporation is formed by filing articles of incorporation with the Secretary of State’s office, issuing stock to founders, and writing corporate bylaws. Even though bylaws are only required by certain states, they’re always recommended because they’re the internal guidelines for how a corporation will operate.
The owners of a corporation are called shareholders, or sometimes stockholders. They own a portion of the company and have the right to vote on matters relating to the corporation. Shareholders elect a board of directors to oversee the corporation.
Once a corporation is operational, there are several requirements to maintain its status. Corporations must hold annual shareholder meetings, keep meeting minutes and documentation of all decisions made, and record all transactions through double-entry accounting.
These requirements ensure solid liability protection for shareholders in case of a dispute, because creditors cannot hold shareholders personally responsible. While unlikely, there are situations where creditors can prove misconduct, and pierce the corporate veil.
The process of forming an LLC is similar to that of a corporation in many ways, but there are fewer requirements. While there are some start-up fees involved, it’s generally less expensive to create an LLC than a corporation. An LLC is formed by filing articles of organization with the Secretary of State, and governed by an LLC operating agreement or single-member LLC operating agreement (the LLC equivalent of bylaws).
LLC owners are called “members”, and the LLC can either be member-managed or manager-managed depending on who will carry out the daily operations on behalf of the company. It’s up to LLC members to decide how the business will operate, and despite obvious benefits to detailed recordkeeping, there are no requirements as with corporations.
In some states licensed practitioners such as doctors and lawyers aren’t able to form an LLC. Instead, they must form a professional limited liability company (PLLC).
LLC vs Corporation Taxes
For tax purposes, corporations can be divided into two categories: s corporations and c corporations. C corporations (or c corps) are the standard type of corporation, but can later file form 2553 with the IRS to become an s corporation (s corp) if they meet certain requirements. To understand the tax distinctions, let’s first take a look at c corporations.
C Corp Taxes
C corporations are subject to a 21% federal income tax, while state level taxes range from 3% to 12%. In addition to the entity itself paying taxes on profits, shareholders must also pay taxes on dividends. This is referred to as corporate double taxation. In other words, the corporation pays taxes on profits, and when shareholders receive a portion of those profits, the distributions are taxed again.
C corp tax rates may seem daunting, but there are several notable corporate tax benefits like carrying over profits and losses, and access to certain deductions and write-offs.
S Corp Taxes
A corporation is eligible to file as an s corporation if it has 100 or fewer shareholders who are all U.S. citizens or permanent residents. S corps may only have one class of stock and cannot own 80% or more of another corporation’s stock.
If a corporation meets these requirements, it may be beneficial to go through this filing process in order to avoid double taxation. S corporation profits pass through to shareholders, and are accounted for on their personal tax returns, so the corporation itself is not taxed separately.
LLCs have a flexible tax structure that allows them to be taxed in a number of ways depending on which is most beneficial.
If the LLC members don’t take any steps to change their designation, they’ll be automatically taxed like a sole proprietorship (for a single-member LLC) or a partnership (for a multi-member LLC). This tax designation allows LLC members to report on their share of the company’s profits on their personal tax return (a member’s share is based on the division of ownership in the LLC operating agreement).
LLCs also have the option to elect s-corp or c-corp tax designation while maintaining the flexible management structure of the LLC. Tax matters can be complex, so it’s important to understand how LLCs are taxed so you can make the right decision for your business.
Keep in mind, LLC members are likely to owe self-employment taxes, which account for the medicare and social security taxes withheld from a typical paycheck.
LLC or Inc: Which is Better for Your Business?
Choosing the best business structure depends on the specific traits and needs of your business. In general, corporations require more resources to form and maintain, but have considerable long-term benefits. LLCs may be the better choice for a small business where it’s not feasible to meet all of the incorporation requirements.
So, which is better — LLC or Corporation? If your business could benefit from the corporate structure but you don’t have the resources to get started, consider forming an LLC. You can then transfer the business assets to a newly-formed corporation once the business becomes more profitable.
If you currently have the start-up funds to incorporate, consider taking advantage of the most credibility, the best shot at raising capital, and the best liability protection of any business structure.