LLC vs. Corporation: Everything you need to know.

Compare the two most common entity types small businesses choose.

One of the first decisions you'll make when starting a new business is choosing an entity type. Generally, most entrepreneurs choose to form a Corporation or a Limited Liability Company (LLC). The differences between an LLC and a corporation can seem complicated at first, but usually the choice is clear based on your business' goals.

No matter which entity you choose, both entities offer big benefits to your business. Incorporating a business allows you to establish credibility and professionalism. It also provides limited liability protection.

What Is Limited Liability?

Limited liability is a type of protection for your personal assets. It ensures that your personal liability for the business' debts and obligations is no more than the amount of money you invested in the business. This protects your home, automobiles, and other personal assets from being used to pay off any debts accrued by your business.

Without limited liability protection, your home could be used as collateral to repay the businesses debt after a lawsuit or bankruptcy. This is, by far, one of the greatest advantages gained by forming a business entity.

Now that we have explored what both entity types have in common, let's dive deeper into what makes them different.

LLC vs. Corporation: Taxes

One of the biggest differences between corporations and LLCs is the way they are taxed. Let's examine how taxation for each entity type works.

LLC Taxes

An LLC is taxed as a pass-through entity by default. This means that the profits of the business are "passed through" to the owners (called members). Profits and losses are reported on the individual tax returns for the owners, and not at the business level. As a result, filing taxes is often simpler for owners of an LLC. Any losses or operating costs of the business can be deducted on personal tax returns, which can help offset other income.

The rate at which an LLC is taxed depends on the total income of the owner, as it does when you file as a sole proprietor. Owners of an LLC may also be required to pay self-employment taxes. Some states require LLCs to pay a franchise tax. This is a tax issued by the state for the privilege of doing business in that state. Franchise taxes are usually paid annually and vary from state to state.

What happens if you do not pay your taxes? Failing to pay on time or at all could result in penalties and even the involuntary dissolution of your business.

Luckily, incorporating as an LLC provides entrepreneurs with flexibility. An LLC may elect to be taxed as Corporation or an C Corporation. While it is an uncommon choice, filing an LLC as a C Corp tax designation does make financial sense for some businesses.

Corporation Taxes

Corporations are taxed as a separate legal entity, which can earn its own income. Corporations are responsible for paying tax on their profits, (corporate tax), and tax on dividends the entity distributes to its shareholders. Since dividends are not tax deductible (like salaries and bonuses), dividends are taxed twice. This is referred to as double taxation. This is not an issue for smaller corporations where only the owners work for the corporation. Instead, owners receive tax deductible salaries and bonuses.

While double taxation is seen as a disadvantage for businesses choosing to file as a corporation, this additional tax responsibility can often be offset by federal deductions that are only available to corporations.

For example, a corporation may deduct all its business expenses. These can include advertising costs and operating expenses as well as certain employee fringe benefits such as medical and retirement plans. These deductions all add up to substantial savings over time for the business.

As of 2018, corporations pay a flat tax of 21% on their profits, which is lower than the top five individual tax rates. While this is largely offset by double taxation, any income the corporation chooses to retain at the end of the year will be taxed only once at the new 21% rate. This allows the owners of the corporation to save on taxes by investing some profits back into the business.

Keep in mind if a corporation has fewer than 100 shareholders, it can file an S Corporation election. This is a tax status that allows a business to be treated as a pass-through entity much like an LLC. This may be a good option for businesses who want to be taxed like an LLC, but also want some of the additional formalities a corporation provides. 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.

S Corporation Taxes

If a business qualifies as an S Corporation, the tax difference between an LLC and S Corp is a bit more nuanced. Both an LLC and an S Corp has flow-through taxation (no double taxation). Keep in mind that an LLC's distribution of profits are 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. However, there can be drawbacks of an S Corp that may deter a small business from taking this advantage. Always consult a professional before deciding on whether to be taxed as an LLC or S Corporation.

You can learn more about the differences between corporation and LLC taxes here in our learning center.

LLC vs. Corporation: Business Ownership

Ownership is another important aspect to keep in consideration when deciding between whether to form an LLC and a corporation. The structure of ownership in each entity is very different, and each has a clear purpose which makes choosing the right entity for your business a bit easier.

A corporation can issue shares of stock and sell percentages of the business to its owners, which are called shareholders. These shareholders can transfer shares, purchasing more stock to own a larger percentage of the company, or selling off stock to own less. If your business is one that wants to attract outside investors, a corporation may be the best entity for it. A corporation also exists in perpetuity separate from the owners, meaning that a corporation remains in existence even when an owner leaves or divests from the company.

A Limited Liability Company (LLC) has the freedom to distribute its ownership stake to its members without regard to a member's financial contribution to the LLC. Let's use the example where a member of the LLC may not have invested as much capital as another member. An LLC's operating agreement could specify that all members receive an equal share of the profits anyway. This creates additional flexibility when establishing the ownership of the business.

An LLC can also be owned by foreign individuals, other corporations, or any kind of trust. This may make it the right choice for businesses in certain circumstances where these factors are important.

An LLC's operating agreement also outlines the details about how membership interest can be transferred between its members, if at all, and what happens when a member leaves the LLC. By default, if not defined in the operating agreement, when a member leaves the LLC it must be dissolved.

LLC vs. Corporation: Management

An LLC has a flexible management structure. The entity can be managed by its members or a group of managers, and any member may act as the LLC's manager. The LLC may also elect to have no distinction between an owner and a manager of the business. Due to its flexible nature, LLC management is less formal which may make it an ideal entity for some entrepreneurs.

What is the difference between "manager-managed" and "member-managed" LLCs? In a member-managed LLC, the owners themselves oversee running the day to day operations, while a manager-managed LLC generally has investors that sit on the side lines, and don't have any other active role in the business.

A corporation's management structure is much stricter. A corporation must have a formal structure with a Board of Directors handling the management responsibilities of generating profits for the shareholders. Corporate officers are assigned to handle the day-to-day operations of the business. The shareholders are considered owners of the corporation but remain separate from business decisions and daily operations of the corporation (except for approval of major corporate decisions).

However, shareholders retain the power to elect directors, and individual shareholders can be elected as a director or appointed as an officer. The individual rules of any corporation are dictated by its corporate bylaws, which is a detailed set of rules adopted by the Board of Directors after the corporation is formed.

LLC vs. Corporation: Formal Requirements

Both corporations and LLCs are required to fulfill maintenance and/or reporting requirements set by the state where their entity has been formed. This keeps the business in good standing and maintains the limited liability protection acquired by incorporation. While every state has its own rules and regulations that govern both corporations and LLCs, corporations generally have more annual requirements than LLCs.

Corporations are required to hold an annual shareholder meeting each year. These details are documented, along with any discussions, as notes called corporate minutes. A corporation is generally required to file an annual report, too. This helps keep the business' information current with the Secretary of State. Any actions or changes in the business will require a corporate resolution to be voted on at a meeting with the board of directors.

LLCs, on the other hand, have fewer record keeping requirements than their corporation counterparts. For example, an LLC is not required to keep minutes, hold annual meetings, or have a board of directors. While some states still require LLCs to file annual reports, others do not. Check in with your local Secretary of State to determine which requirements are applicable to your LLC entity.

Legal Entity vs. Tax Entity: What's The Difference?

Many new business owners get confused when it comes to understanding the difference between legal entities and tax entities. Let's take a moment to unpack their differences.

A tax entity is how the IRS sees your business. Subsequently, this reflects how your business will be taxed. Tax entity examples include C Corporations, S Corporations, and sole proprietorships. Legal entities have a choice about what tax entity they want to identify as. Both an LLC and a corporation can file an S Corp election and choose to be taxed as an S Corporation, even though they are still two different legal entities.

Overall, LLCs have more options when it comes to choosing a tax identity than corporations. However, both legal and tax entities offer benefits that are best consulted with a CPA or attorney that understands the ins and outs of your business.

LLC vs Corporation: Legal Discrepancies

Both LLCs and corporations provide benefits to its owners when it comes to legal protections, although there are differences between the two and how they are seen by the court system.

Corporations have been in existence since the start of U.S. history. Because of this, a corporation as an entity has matured and developed to the point where the laws have become uniform. United States courts have centuries of law history cases to help resolve disputes and issues related to corporations. This creates significant legal stability for corporations.

Limited Liability Companies are still considered to be relatively "new." Their entity was first recognized in the 1970s as the offspring of both the corporate and sole proprietorship/partnership form. Due to this dual nature, an LLC takes on the characteristics of both legal entities. However, as a result of being a "new" legal entity and having characteristics of both a corporation and partnership, states differ in their treatment of LLCs.

While most states have similar LLC laws, there are differences that may lead a business to choose to become an LLC in one state and a corporation in another. In time, LLC laws will become more uniform throughout the United States. For most businesses, these discrepancies between LLC laws should not be a factor, but the discrepancies may be the deciding factor for a few.

Wrapping Up

Both corporations and limited liability companies, with each entity offering its own benefits, separate the owners from the business and provide limited liability protection for their assets.

How will you know which entity to incorporate a business as? Ultimately, deciding which entity aligns the most with your goals is an important first step to take on the way to forming your business.

You can learn more about the differences between the entity types by viewing our entity comparison chart, or take our short business formation quiz to find out which entity best suits your business.

It is also recommended that you speak with a licensed CPA or attorney. They can help answer any questions you may have about which entity is right for your business and provide further insight into the process.