LLC or Corporation?
Founders must make important decisions about their business early on that can majorly impact its future. Among the first decisions that founders must make is deciding on the legal structure for their startup. Two of the most popular choices are LLC and corporation.
There are similarities and differences between the two, which are important to understand. Both also have benefits and drawbacks to their legal structure. Choosing a business entity offers huge benefits to your startup. So let’s discuss LLCs and corporations here to understand all the considerations when choosing the best legal structure for your business.
What is an LLC?
A Limited Liability Company (LLC) is a business structure that protects its owners from facing personal responsibility for their liabilities or debts. LLCs are based on state statutes. Consequently, each state may have different regulations.
The owners are called members of this business type. With some exceptions, any individual or entity can be a member of an LLC. The most noteworthy expectations are insurance companies and banks. States decide whether to restrict ownership to certain individuals or entities.
With an LLC structure, the profits and losses are passed through to its members. That allows members to report them on their tax returns.
Since an LLC is a formal business arrangement, you must file articles of organization with the state. Articles of the organization is a legal document that outlines the rights, powers, duties, and other obligations between members of an LLC and between the LLC and members.
What is a Corporation?
A corporation is a business structure that’s goal is to operate at a profit. This legal entity is made up of individuals and stockholders (shareholders). With this type of structure, corporations can enter into contracts, borrow money from financial institutions, file federal and state taxes, and can sue/be sued.
When creating a corporation, you complete a legal process called incorporation. This involves creating legal documents that include information like the main purpose of the business, its name and location, the number of shares, and the types of stock available.
Three major types of business incorporations are explained below.
The most common type of incorporation is the C Corporation. Often called C Corps, it is a legal entity that separates itself from its owners. With this structure, the corporation can profit, be held legally liable, and be taxed.
This type of structure offers the most protection to its owners from personal liability. The trade-off is that it costs more. The record-keeping, reporting, and operational processes are more extensive as well. Corporations will pay income taxes on their profits. Additionally, corporate profits are potentially taxed twice. When shareholders are paid dividends, that amount can be taxed on personal tax returns.
Created the same way as a C Corp, the difference is in the tax purposes and owner limitation. Up to 100 shareholders can be a part of an S Corp. The taxes are not separated in this business type. The profits and losses are reported on the shareholder’s income tax returns.
To file as an S Corp, you file with the IRS to obtain the S Corp status. There’s a different process for registering in a state. It is important to note that some states don’t recognize an S Corp election. Instead, they are treated as a C Corp in these states. Shareholders can leave the company or sell their shares without disrupting the business flow.
A benefit corporation, or B Corp for short, is a for-profit corporation recognized by most U.S. states. The purpose, accountability, and transparency are handled differently from a C corp. However, they are taxed the same.
Mission and profit are both driven by B Corps. The company is held accountable by stakeholders to produce both financial profits and some public benefits. Some states require annual benefit reports to validate that the B Corp contributes to the public good.
Advantages of LLCs vs Corporations
Each of these business structures has certain advantages over the others that are important to consider when determining which type to choose. Let’s look at some of these advantages now.
Advantages of an LLC Structure
Limited Personal Liability
With an LLC structure, it is accountable for its debts and obligations. You can also lose any money you’ve invested into the company. However, your personal assets can’t be collected to satisfy these debts. This protection applies if a business partner, employee, or business is sued.
Require Less Paperwork
The recordkeeping requirements for corporations tend to be more substantial than LLCs. LLCs don’t have to hold annual meetings, create annual reports (in many states), or pay annual fees to the state.
Flexibility with Ownership
LLCs can have any number of shareholders they wish. The business structure has no restrictions on the type of owners it can have.
When it comes to taxation, LLCs hold the most advantages. LLCs can adopt the tax status of sole proprietorships, partnerships, S Corps, or C Corps. This is because they don’t have their own federal tax classification.
LLCs are automatically classified as partnerships or sole proprietorships by the IRS. As a result, LLCs receive the benefit of “pass-through” taxation. This means that they don’t pay LLC or corporate taxes. The income and expenses are instead passed through to the owner’s personal tax returns.
LLCs don’t have a formal management structure, unlike corporations with a fixed structure with a board of directors and officers. This provides more choices to LLC owners on how to make decisions and run their businesses.
Advantages of a Corporation
Personal Liability Protection
The most protection from personal asset liability comes from having a corporate structure. So if a corporation is sued, its shareholders are not personally held responsible for its legal obligations or debts. It doesn’t matter if the corporation doesn’t have the funds to repay its obligations.
The majority of corporations will sell ownership through publicly traded stocks. This makes it easy to raise funds. Other types of business structures don’t have this ability, which is handy for many situations like growing the business.
The ownership in a corporation is based on the percentage of stock ownership. This provides flexibility in transferring ownership and enabling the perpetuity of the business. The transfer of ownership depends on the governing agreement in the bylaws and articles of incorporation. Overall, it’s relatively easy to buy and sell ownership. When an owner wants to leave a company, it’s typically a matter of selling off their shares.
A C Corp business structure must deal with double taxation. But other corporation structures like S Corps have tax benefits. These advantages are based on how their income is distributed.
Disadvantages of an LLC and Corporation
Each business structure has its drawbacks as well. Let’s look at the potential disadvantages that could end up costing you more time and money than it’s worth.
Disadvantages of an LLC
Limits to Limited Liability
Your personal assets could be at risk if a judge rules that your LLC structure doesn’t protect it. Called “piercing the corporate veil,” if you don’t take actions like clearly separating business transactions from personal transactions, it is possible that the LLC structure won’t protect your personal assets.
Member Turnover Risks
If a member of the company leaves, dies, or goes bankrupt, in certain states, the LLC must be dissolved. The remaining members can continue the business but must start a new LLC. They are responsible for all the remaining financial and legal obligations to terminate the existing business if they wish to leave.
Must Pay Self-Employment tax
LLCs are considered partnerships for tax purposes by the IRS. The exception is if members have opted to be taxed as a corporation. When an LLC is taxed as a partnership, each member is personally responsible for paying Social Security and Medicare taxes on their actual compensation. If members have opted to be taxed as a corporation, they must pay Social Security and Medicare taxes on their actual compensation.
Disadvantages of a Corporation
Corporations are taxed at the corporate and personal levels when shareholders receive dividends. If you’re an employee of the company, you’ll also pay self-employment taxes. Dividends can’t be deducted from taxable income. While some of these tax issues can be prevented by forming an S Corp, all corporations aren’t eligible.
A corporation is managed by a board of directors who makes the decisions. The board of directors can have you removed from the company. Owner oversight can also be ignored by the management team if there’s not a majority interest in the company.
Costs and Documentation
It’s more expensive and time intensive to form a corporation over other business types. Before filing, you must complete documentation like articles of incorporation and bylaws. There is additional government oversight on corporations which requires detailed records to be kept of its business activities. The majority of states also charge an annual franchise tax fee.
Who is an LLC vs a Corporation best for?
Depending on your specific business, one of these two business types could be a better match. Here are some examples of which structure might be better for your situation below.
LLCs are Best for
Founders that wish to have more flexibility in the way their business is run may choose an LLC structure. There are fewer requirements and this structure lacks traditional corporate formalities. An LLC can have a single owner operate the business or have multiple owners where it’s treated similarly to a partnership.
Medium or higher-risk businesses, owners with significant personal assets to protect, or owners who wish to pay a lower rate are all good candidates for an LLC.
Corporations are Best for
If you plan to raise funds for your business in the future, a corporate structure will enable you to access cash through investors. The business can “go public” or be sold eventually when it’s a corporation.
The strongest protection from personal liability is also found through this structure. Since the company is separate from the independent life of a shareholder, the company can continue doing business relatively undisturbed if a shareholder leaves or sells its stock.
Incorporating in Delaware
Many companies choose to incorporate in Delaware early on. This decision has lasting impacts on companies, especially when seeking outside capital. Here are four main reasons that companies choose to incorporate in this state below:
- Delaware has the most public companies incorporated in the state –93% of U.S.-based initial public offerings choose Delaware as their corporate home. There’s familiarity with Delaware laws among investors, attorneys, and companies.
- Offers more privacy – Records requests Delaware requires that disputes of the company books be made inside the state. That means a shareholder must obtain local counsel and pursue action in Delaware courts. Delaware also doesn’t require corporations to publicly identify their officers and directors in state filings.
- Delaware’s expertise in business – Business law developments are a focus of Delaware’s legislature. As a result, the state’s regulations and statutes are consistently updated.
- Investor preference – Many angel investors, startup accelerators, and venture capital firms require that the company be incorporated in Delaware before they invest. That is due to the reasons listed above.
How to Form an LLC vs Corporation
Once you’ve chosen the right business entity, you’ll need to complete the formation process. Whether you choose an LLC vs corporation, each state has specific guidelines on the process. Be sure to check your state’s information before starting the process.
Forming an LLC
- Determine a name – Your business name is what you’ll use to market it. Make sure to choose a name that can be used for branding and verify that your business name meets state requirements.
- Choose a registered agent – Regardless of the state you’re forming your LLC, you must have a registered agent. This individual will receive official or legal documents on behalf of the LLC. The registered agent is in charge of passing these documents to the person who’s in charge of the LLC.
- Obtain a copy of your State’s LLC Article of Organization form – This document is what needs to be filed to establish your LLC as a legal entity.
- Complete the LLC Article of Organization form – The requirements and procedures will vary depending on the state. Your business name, address of the principal place of business, the purpose of business, how your LLC will be managed, and the contact information of the registered agent is among the details you’ll need to provide.
- File the LLC Article of Organization form – Submit the document to the state along with the filing fee. Once approved, you’ll be issued a certificate by the state that will allow you to get a tax ID number and set up a business bank account.
Forming a Corporation
- Determine a name – Check the state to see the specific rules about your corporation’s name. Your name must be different from other existing businesses in the state.
- Appoint directors – Your initial board of directors must be appointed when you incorporate. You can replace this board with a personal one after forming the corporation.
- File Articles of Incorporation – Each state has its requirements. Typically you’ll need to provide the corporation’s name, principal place of business, its purpose, and the name/address of the registered agent.
- Create Corporate Bylaws – In some states, you’re required to have corporate bylaws to legally be recognized as a corporation.