Many business owners often struggle to start because they don't understand what types of structures are available and which offers the most advantages for their unique situation.
The business entity (or structure) you choose affects the paperwork you need to file, your daily operations, how much you pay in taxes, and your personal liability. Therefore, it's crucial to choose a structure that gives your business a balance of benefits and legal protection.
Which is better, a corporation or an LLC? Keep reading to find out!
What is a Corporation?
A corporation is a legal business structure that's separate and distinct from its owners. Corporations offer business owners the best protection from personal liability. However, many benefits depend on the type of corporation you form.
There are three types of corporations to know about:
C Corporations – Businesses form C Corps when they regularly sell products, have employees, and a storefront. Shareholders elect directors who manage business activities, and they must have annual meetings and more. Additionally, shareholders are not typically held liable for personal liability.
S Corp – Businesses with high start-up costs often choose to form this type of corporation because of the flow-through taxation. There's no tax at this entity level, and income is passed through to the shareholders. S Corps offers both the structure and protection of a corporation but is flexible for shareholders.
Nonprofit – Nonprofits are similar in structure to a traditional corporation but generates no profits. Nonprofit corporations can receive funding through various sources such as private donors and grants. Plus, these corporations are tax-exempt!
Benefits of Starting a Corporation
Limited liability – Business and personal assets are separate when a corporation is properly formed, and shareholders are only liable up to the amount of their investment.
Separate legal entity - If a corporation is sued, shareholders are not held personally responsible for the debts. A corporation provides more liability than any other business entity.
Tax benefits – As an S Corp, salary is subject to self-employment tax, but shareholder distributions are not subject to employment tax.
Source of capital – Corporations can raise capital quickly by selling stocks. Something LLCs cannot do. This funding helps the business operate, increase performance, and scale.
Term – Both C Corps and S Corps are perpetual, which means they can extend past the death or withdrawal of shareholders.
Transfer of ownership – If you're a shareholder and want to sell your shares, it's not difficult to transfer ownership through a corporation.
Disadvantages of a Corporation
It costs more – Forming a corporation of any kind is more costly and time-consuming than any other business entity.
Taxation – As a C Corp, you pay income tax on profits, and you're subject to double taxation. Double taxation means you're taxed once when the company makes a profit, and you're taxed on dividends claimed on your personal tax return. It would be in your best interest to speak with a lawyer to avoid double taxation.
Reporting – Corporations require more extensive record-keeping and reporting. They must keep (and file) accurate records of income, shares, and other tax documents.
Management – Depending on how you set your corporation up, there may be a management team operating without any real direction from an owner.
What is an LLC?
A limited liability company (LLC) is a hybrid entity because it combines a corporation and sole proprietorship. The perk to this business structure is that owners are not personally liable for the company's debts or liabilities.
As a separate entity, forming an LLC means you separate your business assets from your assets. Therefore, if something bad happens, only the LLC's assets are at risk. However, there are requirements to treat the LLC as a separate legal entity rather than a personal account. For example, you must fund the LLC properly and have business insurance, or you risk being personally liable for the LLC's debts.
Advantages of Forming an LLC
Now that you know what an LLC is, how it's different from a corporation, and why you may want to choose to form an LLC. Let's look at the advantages of making your business structure an LLC.
Limited Personal Liability – When properly formed, an LLC protects you from creditors and other liabilities.
Tax Advantages – You can write off (or deduct) your business expenses from your LLC's income – as long as they're legitimate. This is a long-term advantage and can significantly lower the profits reported to the IRS.
Less Paperwork – LLCs can save you a lot of time and money compared to owning and operating a corporation.
More flexible – LLCs can elect management flexibility in many states and choose tax flexibility since the LLC itself doesn't pay federal income taxes.
Privacy Protection – If you're interested in being anonymous as a business owner, there are a few states that allow businesses to form an Anonymous LLC.
Perpetual Existence – LLCs can survive and thrive in the event of death or other major life events as long as the paperwork is filed correctly.
Disadvantages of an LLC
Less certainty – Statutory and case law is less developed than that of a Corporations, giving LLC owners less assurance in the courtroom.
Need a professional for paperwork – An LLC has more administrative requirements than other business entities. Depending on how you choose to file the paperwork and the purpose of your business, more details may need to be added.
Formation Costs – Although forming a corporation is more expensive, as a small business or freelancer, forming an LLC can get pricey in the beginning.
No capital – If you plan to raise venture capital, then investors will not be interested in LLCs.
What is the Difference Between a Corporation and an LLC?
The difference most business owners see between an LLC and a corporation is in ownership. An LLC is owned by one or more individuals, while a corporation is owned by its shareholders. No matter which entity you choose, both entities can benefit your business.
How your business is taxed is a huge factor in how you choose to operate it. An LLC is taxed as a pass-through entity – this means the business is not subject to corporate income tax or any other entity-level tax - whereas corporations are taxed as a separate legal entity.
As a pass-through entity, the taxes of an LLC depend on the total income of the owner. While corporations are responsible for paying taxes on profits and dividends paid to shareholders – a process known as double taxation. This can often be avoided as an S Corp that has less than 100 shareholders.
An LLC offers a flexible management structure, while corporations are more formal and stricter. For example, LLCs can elect to be manager-managed (investors don't play active roles in the business) and member-managed (the owners run all operations.)
A corporation elects a board of directors who manages the profits, handles the daily operations, and shareholders. To maintain structure and balance, corporate bylaws ( or rules) of any corporation are made by the directors after the business entity is formed.
Both LLCs and corporations have owners, but the definitions and concepts are different. There are no limitations for LLCs when it comes to members. Plus, members have interest in the assets of the business.
As a corporation, owners are known as shareholders and have stock in the business. If you want to form an S Corp, you're limited to 100 or less shareholders.
Unless an LLC operating agreement denies members the right to distributions (or dividends), they will be allocated equally. The amount can be based on what the members choose, but it's often based on the members' capital contributions.
As a corporation, the board of directors decides the number of dividends and when it will occur. Shareholders do not have a voice in determining dividends, but when distributed, they are paid equally.
Can an LLC Elect to be Taxed Like a Corporation?
When it comes to federal income tax, there's no option for being taxed as an LLC. An LLC can choose to be taxed like a sole proprietorship, a partnership, a C Corp, or an S Corp if you qualify.
By default, an LLC with one member is taxed as a sole proprietorship. An LLC with more than one member is taxed as a partnership. However, the option that provides the most savings for business owners that have a higher payroll tax is an S Corp.
Sole proprietorships, partnerships, and S Corps are all pass-through entities, but they're not taxed the same. If you choose to form an LLC, you can also choose to be treated as an S corporation by filing an Entity Classification Election form.
Corporation vs LLC: Which is Best for You?
We've covered all the basics when it comes to corporations and LLCs. Now, let's answer the biggest question we hear from business owners: Which is best, a corporation or an LLC?
A corporation is a good option for businesses with a medium-to-high risk, those that need to raise capital, and those that plan to sell eventually. In addition, corporations are best for those who want a more structured business formation with a board of directors and shareholders.
An LLC is the right entity for you if you want limited liability protection, don't plan to raise capital, and desire fewer formalities and paperwork than a corporation.
It's important to note that some states don't allow certain professionals, such as attorneys, doctors, or dentists, to form LLCs because of the liability of their profession. However, they will allow other entities to be formed.