The difference between an LLC and a corporation can be complicated when looking at the fine details of both legal entities. These fine details can sometimes be the deciding factor in choosing to become an LLC or a corporation. You may want to seek the advice of a lawyer or accountant (be warned, not all lawyers and accountants will be up to date with all LLC laws) to help you decide what business entity would best suit your needs. However, for many businesses, these fine details will not be a factor in deciding to become an LLC or a corporation, and so let's look at the general differences between an LLC and a corporation.
Legal entity vs tax entity
Before going any further, a distinction between a legal entity (LLC v. corporation) and a tax entity (sole proprietor / partnership vs. C-corporation v. S-corporation) must be made. Often, new entrepreneurs get these two concepts mixed up and will end up unnecessarily confused. A tax entity classification is simply the way the IRS (and the state taxing board) sees the business. The legal entity classification is how everybody else (i.e. courts, state, contractual partners) sees the business. A corporation (legal entity) will be given a corporation (C-corp or S-corp) designation as a tax entity. However, an LLC (legal entity) has a choice on what tax identity it wants to have. An LLC can be seen as a sole proprietor / partnership, or as a C-corp, or as an S-corp (there is no true LLC tax entity and so an LLC is seen as one of the traditional business designations instead). In this sense, an LLC has greater flexibility and can choose the tax identity that most benefits its members. With this in mind, here are the major differences:
As mentioned above, an LLC has complete flexibility on how it wants to be taxed whereas a corporation may not. A major disadvantage to the corporate designation is its double taxation implications. A corporation's profit is taxed once (corporate tax), and the dividends its shareholders receive is then taxed again (individual tax). The S-corporation designation does allow flow through taxation (no corporate tax), but there are certain requirements to qualify as an S-corp that may limit its utility to a business. Depending upon the circumstances of a corporation, it may have no choice but to be a C-corp and face double taxation.
An LLC, on the other hand, no matter its structure or organization, can choose how it wants to be taxed. By default, an LLC is treated as a "pass-through" entity (single taxation), but can elect to be taxed as a C-corp or an S-corp (if it qualifies). Although it may seem counter-intuitive to potential entrepreneurs to choose to be doubly taxed, for certain specific situations, filing the LLC as a C-corp tax designation will make financial sense. But for most, this will make no sense.
If a business qualifies as an S-corp, the tax difference between an LLC and S-corp are a bit more nuanced. Both an LLC and an S-corp has flow through taxation (no double taxation). However, an LLC's distribution of profits is subject to an employment tax, whereas an S-corp's dividends are not. With careful planning, a small business can avoid significant employment taxes by electing to become an S-corp. Beyond the drawbacks of an S-corp mentioned below, there are other reasons (i.e. a lot more paperwork) that may deter a small business from taking this advantage. Consult a professional before making a decision on whether to be taxed as an LLC or S-corp.
The owners of a corporation are the shareholders. The owners of an LLC are its members. Beyond the name differences, there are other substantial differences between the two. An LLC has complete freedom to distribute its ownership stake to its members without any regard to a member's capital contribution to an LLC. This becomes important when profits are distributed to each member. Although a certain member may not have invested as much as another member, an LLC's operating agreement may specify that all members receive an equal share of the profits.
A corporation can theoretically do the same by creating a unique stock class structure, but this is limited to C-corps. Unfortunately, a business that wants to be identified as an S-corp to avoid the double taxation cannot create a unique stock class structure. As a pre-requisite, an S-corp must have a single class of stocks with its dividends distributed in proportion to a shareholders capital investment. Thus, in order for a corporation to create a unique stock class structure, it must be subject to the double taxation.
An LLC has a more centralized management structure. Any member may act as the LLC's manager(s) and the LLC can elect to have no distinction between an owner and manager of the LLC.
A corporation must have a corporate structure with a Board of Directors handling the management responsibilities and the corporate officers handling the day-to-day operations. The shareholders as a class are considered the owners of the corporation, but remain separated from the business decisions of the corporation (except for approval of major corporate decisions) and only retain the power to elect directors. However, individual shareholders can be elected as a director or appointed as an officer.
There are also certain legal concerns to consider when choosing between an LLC and a corporation. To help illustrate the difference between an LLC and a corporation, an LLC can be seen as the new kid on the block with the corporation as the old predictable senior citizen. The corporation classification has been around for centuries, but more importantly to our discussion, the corporate form has been a part of U.S. history from beyond its inception. This is important because this has allowed the corporate form to mature and develop to the point where the laws for corporations have, for the most part, become uniform. Courts have centuries of case law to look to see how to resolve a dispute involving corporations. Financial planners can be comfortable guiding a corporation into the future knowing how the law will react.
Unfortunately, the same cannot be said about LLCs. LLCs were first recognized in the 1970s. As the offspring of both the corporate and sole-proprietorship / partnership form, the LLC takes on the characteristics of both legal entities. As a consequence of being a "new" legal entity and having characteristics of both a corporation and partnership, states differ in their treatment of LLCs. Generally, states have similar LLC laws, but there are differences that may lead a particular business to choose to be an LLC in one state, but a corporation in another. In time, LLC laws will become more uniform throughout the United States and this point will become irrelevant. For most businesses, these discrepancies between LLC laws should not be a factor, but for the few, the discrepancies may be the deciding factor.
Although most people should be able to figure out what business form will best suit their needs, if one is not 100 percent sure, he or she should consult a professional to decide what may be the best choice.