One of the most important decisions you’ll make when starting a business is how to structure it. Two popular options are the Limited Liability Company (LLC) and the corporation. Both provide legal protections and have advantages and disadvantages, but one of them is better for your business.
Now, let’s break down the key differences between LLCs and corporations in simple terms, so you can choose the right structure for your business.
What is an LLC?
LLC stands for Limited Liability Company. It’s a flexible business structure that combines some advantages of a corporation with those of a sole proprietorship or partnership. It’s one of the most popular choices among small business owners, very simple to set up and also offers liability protection.
Benefits of an LLC
Personal Liability Protection
One of the most significant benefits of an LLC is liability protection. As the owner (or “member”) of an LLC, your personal assets—such as your home or car—are generally protected from business debts and lawsuits. In simple terms, your personal assets won’t pay your business’s liabilities if your business runs into financial trouble for any reason.
Tax Flexibility
One of the best reasons many business owners choose an LLC is its tax flexibility. By default, the IRS treats an LLC as a sole proprietorship for a single member or a partnership for multiple members. So, all your business profit and loss pass through your individual income tax return, and you pay taxes at your personal income tax rate.
But LLCs are also flexible in how they’re taxed. If you prefer, you can choose to be taxed as an S corporation or C corporation, which can potentially lower your tax burden depending on how you plan to pay yourself and reinvest in the business.
Fewer Formalities
LLCs are much easier to manage compared to corporations because they have fewer formalities. For example, you’re not required to hold regular board meetings, keep extensive records, or follow as many strict guidelines. This is why the LLC is a good option for those who want to focus on running their business and don’t want to deal with too much paperwork.
What is a Corporation?
A corporation is a more formal business structure that’s designed for businesses looking to grow, issue shares, and attract investors. Corporations are separate legal entities, meaning they exist independently from their owners, who are known as shareholders.
Benefits of Corporation
Personal Liability Protection
Like an LLC, a corporation extends personal liability protection. Business is considered legal incorporation in and of itself, and generally speaking, if the company gets sued or is in debt, your personal assets will be protected. The corporation assumes the responsibility that comes from debts and legal claims.
Taxation
Here is where it gets a little bit more complicated. A C corporation is taxed separately from its owners. It means that in addition to the corporation paying taxes on its profits, when those profits are distributed to shareholders in the form of dividends, the owners pay tax on that money, too. It’s sometimes called “double taxation.”.
An S corporation avoids double taxation. Like an LLC, the S corporation’s profits and losses pass through to the owners’ personal returns. However, there are some limitations on who can own an S corporation-for example, it’s limited to 100 shareholders, who must all be U.S. citizens or residents.
More Formalities and Paperwork
Running a corporation requires much more paperwork and formality compared to an LLC. You need to hold annual meetings, create detailed records, and follow specific corporate governance rules. This formal structure can be helpful for attracting investors or providing transparency, but it’s also more time-consuming and expensive to maintain.
LLC vs. Corporation: Main Differences
Now that we know what LLCs and corporations are, let’s compare LLCs and corporations in a few key areas:
01. Management
LLCs and corporations also differ in the way they are managed.
- LLC: An LLC can be managed either by the members themselves or by managers. This gives you flexibility in deciding how involved you want to be in the day-to-day operations, but this type of ownership often leads to chaos. However, there is no requirement for a board of directors or officers.
- Corporation: A corporation has a more rigid management setup involving shareholders or owners, a board of directors, and officers, like a CEO and CFO. The board usually makes the big decisions, and the officers manage the day-to-day operations. This structure is often required if you’re planning to find outside investors.
02. Taxation
Taxation is one significant area where LLCs differ from corporations, and things have gotten a little complicated.
- LLC: An LLC by default is a pass-through entity, which means its profit and loss will be reported on your individual tax return at your personal tax rate. You can, however, be taxed as a corporation if that is advantageous.
- Corporation: The C corporation has double taxation, while an S corporation has pass-through taxation but with more restrictions.
03. Liability Protection
Both LLCs and corporations offer limited liability protection, meaning that owners are not personally liable for debts or legal issues incurred by the business.
- LLC: LLCs provide liability protection for the members, so your personal assets are usually protected from business debts or lawsuits.
- Corporation: Corporations also provide strong liability protection, keeping personal assets separate from business liabilities.
04. Setup and Maintenance
An LLC is easier to set up and operate than a corporation.
- LLC: Forming an LLC is generally straightforward. You’ll need to file Articles of Organization with your state and draft an Operating Agreement that outlines how your LLC will be run. Following that, there aren’t many continuing obligations other than to file an annual report (in most states).
- Corporation: Setting up a corporation involves more steps. You’ll need to file Articles of Incorporation, draft corporate bylaws, issue stock, and appoint a board of directors. Annual meetings among shareholders, keeping minutes of those meetings, and filing annual reports are ongoing requirements. All of these formalities are necessary to keep your limited liability protection.
05. Ownership
Ownership in an LLC or corporation functions quite differently, particularly when it comes to raising capital.
- LLC: Ownership in an LLC is based on membership. Each member owns some portion of the business, known as a membership interest; however, that interest is not freely transferable as shares in a corporation. To include or exclude members, you will likely need approval from the other members.
- Corporation: Shareholders are the owners of the corporation who have purchased shares of the company. Share ownership is easily transferable, allowing corporations to raise funds by selling stock. Corporations can issue multiple types of stock, which gives them flexibility in attracting investors.
Which is Right for Your Business?
So how do you know if an LLC or a corporation is right for your business?
When to Choose an LLC?
An LLC might be the right choice if you’re looking for flexibility and simplicity. It’s a popular business structure among small businesses, freelancers, and startups who prefer to keep things simple while still providing liability protection.
You should consider an LLC if:
- You want a flexible management structure.
- Don’t want to deal with huge paperwork and formalities.
- Prefer pass-through taxation and don’t want double taxation.
- You have a smaller business, or you’re just starting out.
- You’re okay with limited options for raising funds from outside investors.
When to Choose a Corporation?
A corporation can be a good option if you want to grow quickly and raise a lot of business funds. The corporation’s business structure is designed to scale, and it’s often the best choice for businesses planning to raise venture capital or go public.
You should consider a corporation if:
- You plan to raise money by issuing stock.
- Want a more formal entity structure with distinct roles for shareholders, directors, and officers.
- Comfortable with extra paperwork and formalities.
- You assume to reinvest profits rather than distribute them to shareholders to mitigate the effects of double taxation.
- Seeking investors or are planning to go public one day.
S Corporations: A Middle Ground?
So, if you’re not sure whether to take advantage of an LLC or a corporation, S Corporation is probably your middle-ground solution. S corps are corporations in name only, but they have certain tax advantages like LLCs. With an S corp, you can avoid double taxation because the income passes through to the shareholder’s individual tax return. There are, however, some limitations on the number of shareholders (100 or less) and restrictions on who can become a shareholder (e.g., must be U.S. citizens or residents).
Converting an LLC to a Corporation (or Vice Versa)
If you start with an LLC but later realize a corporation would be a better fit, or vice versa, you do have options. The process can involve paperwork and fees, but some businesses find that a change makes sense as they grow.
An LLC, for example, might change to a corporation to attract outside investors, but a corporation might change to an LLC if it’s downsizing and prefers simpler operations.
Consulting a Professional
You don’t necessarily need a full-time legal team to protect your business, but it’s worth having a business lawyer behind you. From drafting contracts, negotiating customer disputes, or simply navigating the intricacies of employment law, a lawyer can save you from common mistakes that will protect you from legal complications in the long run.
Final Thoughts
Choosing the right business structure is a big decision, but it doesn’t have to be overwhelming. By understanding the differences between LLCs and corporations, you can make an informed choice that fits your business and sets you up for long-term success.
