Before deciding on your business setup, it is important to consider which type of business entity will best suit the needs of your organization. Your chosen business structure will determine the legal formalities you must comply with. A business cannot be both an LLC and a corporation. However, it is possible to change the designation of your business by completing the appropriate government paperwork. You might choose to do this if your business is undergoing growth or significant change. In this article, you can find out about the key differences between LLCs and corporations. Armed with this knowledge, you can make an informed decision about which business setup option will work best for your company.
What Is an LLC?
An LLC is a privately held company, owned by its members. It combines the features of a partnership firm and corporation, including flow-through income taxation and limited liability. Compared to a corporation, running a business as an LLC tends to offer more flexibility.
Setup
LLCs are set up under the jurisdiction of state law. The process for setting up an LLC slightly differs depending on which state you are filing the application in. You will usually be expected to file articles of organization with the Secretary of State, although some states will allow you to complete the registration documents online. In some states, you will be expected to file a public notice; this is usually published in local state newspapers. Working under the jurisdiction of state law can be complex, particularly for LLCs running operations in more than one state. Differences in rules and regulations between states can generate extra paperwork and lead to inconsistent decisions or processes across the different sites.
Membership
An LLC can have an unlimited number of members or owners. The members of an LLC do not own shares. Instead, they own a percentage of the company, which is often referred to as ‘membership interest’. Trading is private, which means that shares of an LLC cannot be sold to the public. As such, an LLC cannot raise funds from the market through shares. Transferring membership within an LLC can be more complex than transferring shares within a corporation.
Operating Agreement
It is important for LLCs to set up an operating agreement to outline:
The roles, rights and responsibilities of each member How membership interest can be transferred between members. In some states, the LLC will be dissolved if an LLC member leaves and the operating agreement does not set out an acceptable process for the transfer of membership interest. It is important to establish a process to follow in the event of a member buyout or the death of a member. Arrangements for the allocation of profits and losses
While setting up an operating agreement is not compulsory, if an LLC does not have one, it will be governed according to the default rules set out within state statutes.
Management
An LLC can either be managed by the members or a team of managers. Within a member-managed LLC, the owners are usually involved in the day-to-day running of the business. In a manager-managed LLC, the members do not tend to have an active role in business operations.
Tax
LLCs are not considered to be separate vehicles for tax purposes by the Internal Revenue Service (IRS). This means that they offer better flexibility in terms of taxation. Members can decide whether they want the business to be considered as a sole proprietor, partnership or corporation for tax purposes. LLC profits and losses must be reported by the owners of the business via their annual tax return. The owners’ personal property is protected from business obligations and debts. A single-member LLC will be taxed as a sole proprietorship, whilst a multi-member LLC will be taxed as a partnership. This means that LLC members must report and pay tax on business income via their personal tax returns. Unlike corporate shareholders, LLC members may also be required to pay self-employment taxes to cover Social Security and Medicare.
Legal Requirements
The legal requirements for an LLC are minimal. It is not necessary to hold meetings, keep minutes or log resolutions put in place by the company. Annual General Meetings (AGMs) are optional and an annual report is not required by law. Many different organizations choose to run as a corporation, including for-profit, not-for-profit, public and private companies.
Setup
To form a corporation, you must submit a certificate or articles of incorporation. This will include information such as:
Company objective Location Stock information
The corporation name is divided into three sections:
Distinctive element Descriptive element Legal ending
Shares
The owners of a corporation are referred to as ‘shareholders’. Shares can be easily transferred between owners, so a corporation is a good option if you want to encourage external investment or sell public stocks. The corporation refers to an artificial individual, or a separate legal entity that is independent of its members. A corporation has its own rights and obligations, holds property in its own name and has limited liability. When considering excess profits, corporations can offer better flexibility than LLCs. In an LLC, all income passes to its members, whereas an S Corp can pass income and losses on to its shareholders.
Tax
In the US, a corporation can be classified as either an S Corp or a C Corp for taxation purposes. By default, all corporations are taxed as C Corps. This means that they must pay federal income tax on any corporate profits, after which the shareholders must also pay tax on dividends. However, a corporation with 100 or fewer shareholders may be able to avoid double taxation by electing to be taxed as an S Corp. An S Corp is not required to pay corporate income tax; however the company profits must pass through the shareholders’ tax returns. Every shareholder will be required to pay tax on their share of the overall profits. In some cases, shareholders may be eligible to receive tax-free dividends.
Management
Management of a corporation tends to be rigid, with standard operating procedures in place. A board of directors will be elected to set out policies and oversee business operations. The day to day activities of the business are managed by officers. Within a small corporation, one person might be responsible for several different roles, including shareholder, officer and director. In a larger corporation, shareholders are unlikely to be involved in the day-to-day running of the business.
Legal Requirements
Corporations must set bylaws to outline the rights and responsibilities of all parties, from officers to directors. Corporations are legally required to hold an AGM, giving adequate written notice of the meeting date to all shareholders. Corporations must also compile an annual report. In many states, filing this report will incur a fee.
LLC vs Inc: How to Decide Which to Pursue?
The key differences between an LLC and a corporation relate to ownership, management, taxation, record-keeping and reporting. Whether you choose to set up an LLC or a corporation, you will need to file official documentation with the state. Both types of business entities will protect you from liability for business obligations.
Cost and ease of setup – Setting up an LLC tends to be more straightforward and cheaper when compared with incorporating. Legal formalities – In general, a corporation is expected to comply with more regulations and requirements than an LLC. Corporations have to work in line with clear legal formalities and record-keeping requirements. For LLCs, legal formalities and record-keeping are less structured. Tax – As an LLC, your business will benefit from pass-through taxation. This means that the LLC’s income is taxable through its owners after it has been distributed. Corporations are double taxed, first at corporate level, then at individual level after the profit has been distributed to shareholders as dividends. Corporate reporting – This is simpler for an LLC as no annual report is required; therefore, it is not necessary to create a balance sheet. Company dissolution — If you want to dissolve your LLC company for any reason, there are fewer obstacles to overcome if you want to make changes to the business model. Small businesses – If you have a small business or startup, an LLC may be the best option. This is especially true if you expect small profits or incur a loss. If the business does incur a loss, these can be recorded on the owner’s personal tax return to reduce their tax burden whilst they invest in the business. Medium businesses – Medium-sized businesses are best suited to running as an S Corp, whereas larger businesses are best suited to running as a C Corp. Large businesses – If you have a larger business and you want to benefit from movable shares, a corporation offers better prospects for profitability and growth. If you plan to grow your small business or you want to make shares available to the public, a corporation might also be the better choice. Investment in the business – If you are looking for investment into your business, running it as a C Corp is often the best choice. Number of members – There is no maximum number of members allowed in an LLC. However, an S Corp can only have up to 100 members.
In an LLC, owners are ‘members’ and they have a designated percentage of the business. They pay tax through personal tax accounts rather than through corporate taxation, and are adaptable and flexible in terms of management, with less formal requirements for record-keeping. A Corporation has owners which are shareholders. A C-Corp must pay corporate tax on profits, as well as the shareholders paying tax on dividends, whereas an S-Corp doesn’t need to pay corporate income tax. Corporations have to have a board of directors to make decisions and set policies, with bylaws and must provide annual reports as well as hold yearly shareholders’ meetings. They allow owners to be more ‘hands-on’ with the business, operating as managers within the company and directing operations without the oversight and control of a board of directors. The LLC is considered a more modern concept, which is perfect for a small business or an entrepreneur. LLCs are adaptable and flexible, which makes them easier to manage and maintain over a longer period – and they can become corporations later if that becomes more suitable for the business model. An LLC is flexible, and it can be treated by the IRS as a sole proprietorship or a partnership, as well as an S or C Corporation. It generally costs less to file a business as an LLC with the state, and they can have an unlimited number of owners (members). Although taxation is through the personal tax report of the members, and reporting is usually simpler than a corporation, members are still protected from liability in debts and legal issues associated with the business. LLC members can receive revenues that are bigger than their percentage of the business. A member of an LLC cannot be paid a salary – they receive drawings instead which are taxed as part of a personal tax return. The ongoing costs of managing an LLC, such as renewal and franchise fees, can be high (depending on the state), and the capital values tax could be crippling. For businesses looking for growth through getting capital, investors might be put off or prefer to invest in a corporation for ownership of shares. The state filing fee can be anywhere from $40 to $500, depending on your state. You might want to use a professional LLC forming service, which makes the filing process simpler – but there is usually an additional fee for this. The easiest is a Statutory Conversion, which just needs some details to be filed with the secretary of state, the company name, EIN, and registered agent’s information. A Statutory Merger needs a new corporation to be created, and then the members need to vote to change their ownership to shareholders. Then a certificate of merger just needs to be filed with the secretary of state. The most expensive and difficult way is the Nonstatutory Conversion, which involves completely dissolving the existing LLC, liquidizing all the assets, and then creating the new Corporation. The Corporation can then absorb all the liabilities and the assets. If you are a single-member LLC, you can be your own registered agent – or you can use a Registered Agent Service to receive all the legal documents, like tax forms or summons. California, on the other hand, is the most expensive, with fees of $800 and individual income tax reaching up to 13.3%. This means that you need to file articles of amendment with the secretary of state and notify the IRS and the state tax agency. You will also have to inform your vendors, suppliers, and other agencies that you work with, as well as customers. Before you amend the articles of organization and file the changes with the secretary of state, you need to make sure that the name you want to use is available in your state – there are search engines available for this. Once you have submitted the changes to the state, you can then change the details on all your paperwork, and with vendors, suppliers and customers. If you don’t file an 8832, then your business will be given a default tax classification and you might end up paying more tax. If you want to file an 8832, you need to have an Employee Identification Number (EIN), which you can obtain through the IRS website at no cost. In a W9, the LLC needs to provide:
Legal name (and ‘doing business as’ name, if different) Current Address Employee Identification Number (EIN) or Taxpayer Identification Number (TIN) Business taxation classification
It is good practice for an LLC to keep a signed copy of the W9 on file so that it can be sent when requested, and it needs to be signed by the owner or an authorized representative. If the LLC is registered as a C Corporation, there is no requirement for a 1099, and if it is an S Corporation then a 1099 is needed for certain payments, like payments in lieu of dividends or for medical and health care. For most small businesses, being a disregarded entity is simpler. Whether a sole proprietor or a partnership, the income, expenses, and net profit all pass through the owner’s (known as members) personal tax returns. This is known as pass-through taxation. A C Corporation is subject to what is known as double taxation – which means that the profits are taxed, and the dividends that are paid to the shareholders are also subject to tax. However, the C Corporation can leave profits in the company and pay a lower tax rate on them. An S Corporation, with 100 or fewer employees, can be taxed using pass-through taxation (like the disregarded entity), which means no double taxation on corporate dividends. An LLC cannot keep profits in the business – they need to immediately recognize them and share them with the members according to their percentage. Both payments and profits are subject to self-employment taxes, whereas Corporations are only taxed on salaries. The annual filing fees can be expensive, and it might be too simple as the business develops. It is worth considering that investors might be less inclined to support an LLC in development – they might prefer to invest in a Corporation for shares. A multi-member LLC might allow members to get ‘guaranteed payouts,’ which ensures a draw even when there is not enough profit in the business, but this is something that needs to be decided through operating agreements. For a multi-member LLC, each member needs a Schedule K-1 to be completed, which allocates them a share of the profit or loss according to the percentage of the company that they own. This information is then transferred to their 1040 or 1040-SR on the Schedule E part. However, if your business has employees, you will need an Employer Identification Number, which is free to obtain from the IRS using form SS4. Your decision should be based on the purpose of your business and the associated tax consequences of running it. Regardless of whether you choose to set up as an LLC or corporation, your personal assets will be protected from creditors. For the majority of new business owners, it is best to set up as an LLC in the first instance. Fast-growing startups and companies seeking investment are better suited to incorporation as an S Corp or C Corp company.
