When starting a new business venture, it is important to establish the type of entity that your business will be. In identifying the business entity, you are establishing the business ownership structure, which will determine the liability, taxation, and maintenance of that entity.Two of the most popular business organization types are the limited liability company (LLC) and the corporation. The biggest difference between an LLC and a corporation is around the ownership; an LLC is typically owned by one or more individuals, whereas a corporation is owned by its shareholders. There are advantages and disadvantages to both. Let’s break down both an LLC and a corporation to better understand the differences between the two and why you would want to go with one business entity over another.
What is an LLC?
An LLC stands for a limited liability company and it protects the owner or ownership by limiting the amount of personal liability that the owners have in their stake of the company. An LLC combines elements of a sole proprietorship and a partnership but it also protects the owners and the investors so that they are not personally liable for any liabilities or debts that the company incurs. By registering as an LLC, the company is put into a protected legal and tax bracket to encourage owners and companies to accept outside funding or investing without risking the personal assets of those who are considered investors or owners. LLC ownership is not restricted in the same way a sole proprietorship is. An LLC can be owned by an individual, a corporation, a foreigner, a foreign entity, and other LLCs. What is important is that an LLC limits the liability of those who have ownership in the company and is not required to be a separate legal entity. LLCs have the choice between being taxed as a partnership or a corporation.
What is a Corporation?
A corporation, or C Corp, is a legal entity that for liability and tax purposes is considered separate from its owners. A corporation has its own rights and responsibilities similar to the ones that individuals have, including the ability to enter into a contract, borrow or loan out money, file legal action, hire employees, pay taxes, and own assets. In this regard, a corporation is sometimes referred to as a legal person.The legal status of a corporation will vary depending on the jurisdiction, but what matters is that the corporation has limited liability. Investors in the corporation are considered to be shareholders (as opposed to owners or members) and they can receive the company’s profits with dividends and stock appreciation. Corporations are created when a group of shareholders, who own a percentage of the corporation, “incorporate” the group by holding common stock. Companies are considered to be for-profit or not-for-profit depending on whether the shareholders want to reap a profit or not. Publicly-traded corporations might have thousands of shareholders, but a company can also have one shareholder. Shareholders are only responsible for the payment of their shares and not for any debts that the company incurs.
Major Differences Between an LLC and a Corporation
LLCs are not a type of corporation, but instead, they are a unique entity that contains organization and tax benefits comparable to both sole proprietorships and the limited liability protections in place for corporations. With this in mind, there are major differences between LLCs and corporations when it comes to business ownership and management, taxation, and liability.
Business Ownership and Management
Business ownership and structure of LLCs and corporations differ greatly. Corporations can issue stock shares, allowing shareholders to own percentages of a company. A corporation’s stock acts as its capital; so if the corporation needs to gain capital, it can sell off stock to do so. Shareholders can transfer stock, purchase more (to own more of the company), or sell their stock. This type of business entity will be able to attract outside investors as it exists in perpetuity separate from its owners. In contrast, LLCs are able to distribute ownership to its members depending on the member’s financial contribution to the company. The LLC’s operating agreement would then specify the percentage of profits that each member gets, which might depend on how much that member has contributed to the company or it might not. LLCs can be owned by foreign entities, trusts, and other corporations. If a member of an LLC leaves the company or dies, the operating agreement would denote how the company ownership structure will adjust. Comparatively, a corporation exists in perpetuity from its owners so it would continue based on the shareholder’s decisions rather than any decisions from an owner. Additionally, an LLC is managed differently than an organization. An LLC will have a lot of flexibility in management styles, but a corporation must maintain a strict management structure, with a formal Board of Directors, regular meetings, corporate officers for maintaining daily operations, and regular elections held by the shareholders to elect directors.
Taxation between an LLC and a corporation varies greatly. An LLC is considered a pass-through taxable entity, which means that the business’s profits pass through the members (i.e., owners), and the profits and losses are reported on the member’s individual tax returns. Losses and operating costs can be deducted on personal tax returns. The tax rate depends on the income of the owner, similar to when you file as a sole proprietor or individual. There are some other variations depending on how the state has filed; some LLCs may need to pay self-employment taxes and franchise taxes. Corporations are taxed as separate entities so they earn their own income and file their own taxes. Corporations will pay a corporate tax as well as taxes on the number of dividends that are distributed to shareholders. Dividends are taxed twice (referred to as double taxation) because they are not tax-deductible, which is why they are not issued for smaller corporations. While corporations might be double taxed, they might also be able to reap some federal benefits. Corporations can usually deduct all of their business expenses (i.e., advertising costs and operating expenses), in addition to fringe benefits, like medical and retirement. Corporations generally pay a flat tax rate of 21% on their profits, which is a lower rate compared to the top five individual tax rates; in addition to that, there are other benefits that owners can take advantage of to avoid double or excessive taxation.
Both an LLC and a corporation have limited liability so that those who have invested in the company are not financially liable or responsible for the debts or liabilities. Liability protection might differ based on the company structure. For example, an LLC is considered a pass-through tax structure (i.e., the members will file their own taxes; the corporation does not file as an entity) that has limited liability protection. A corporation is not a pass-through tax structure, but instead, owners and shareholders’ personal assets are protected from the business-related debts by limited liability legalities.
Advantages and Disadvantages to an LLC and a Corporation
As you may be able to see, there are advantages and disadvantages to creating an LLC as well as incorporating it as a corporation. Companies who might have more than 10 members/owners might look to incorporating to make tax season a lot easier. A corporation with less than 100 shareholders can file taxes as an S Corporation, which maintains the flow-through tax style but the S Corporations’ dividends are not subject to employment taxes. S Corporations can also avoid employment taxes and are a major benefit to small businesses.There are also advantages and disadvantages when it comes to maintaining the company’s status. When you have a corporation, you’ll need to meet annually with your shareholders, in addition to filing an annual report. LLCs will have fewer recordkeeping requirements; they don’t need to hold annual meetings or file annual reports. In general, a business will decide to incorporate when they believe that their business needs to be considered a separate legal entity (i.e., an entity that has a choice with how they want to identify) rather than a separate tax entity (i.e., how the IRS views your business).