When you choose to take the next step in your business and incorporate, you’ll face a big decision: Should you form a limited liability company (LLC) or a corporation?
Both the LLC and corporation business structures are legal entities that provide liability protection for their owners. While the corporation has been around longer, the LLC was created to offer the same level of protection. However, the LLC structure specifically caters to small business owners. It offers the same liability protection as a corporation but allows a much simpler structure than other business types.
LLC vs. Corporation: Overview
There are big differences between these two types of business entities, and your choice will have a big impact on your business.
As one of the most popular choices for small businesses, the LLC structure is basically a pass-through entity that also can be taxed as a corporation. Many business owners choose to form an LLC because this structure is very flexible. An LLC’s income will pass through to its individual members, who’ll pay their share on their tax returns. Alternatively, an LLC can opt to have the Internal Revenue Service tax its earnings as a C corporation )C corp) or an S corporation (S corp).
LLCs have no specific ownership or management structure requirements. While most people choose to manage their LLC with members — also known as the owners — they can instead choose to form an LLC with a board of managers. By forming an LLC, you gain limited liability protection that’ll protect your personal assets if your business faces a lawsuit or can’t pay its debts.
The corporation structure usually offers a better fit for a larger company because it comes with strict requirements. For example, a corporation must have a central management structure with a board of directors. In addition, a corporation also must have regular board and shareholder meetings, maintain and file documents, and maintain meeting minutes.
An LLC can choose how the IRS will tax it, but a corporation will face something called “double taxation.” This means that the business’s income is taxed at a corporate level and then taxed again when it’s distributed to the shareholders.
Choosing Between an LLC and a Corporation
While there’s no choice that’ll suit every business, the LLC structure typically works better for small businesses and startups. Why? Because LLCs have fewer requirements, cost less to form and maintain, and enjoy limited liability. The corporate structure usually makes a better fit for large businesses.
LLC vs. Corporation: Formation
An LLC most likely is the best structure for your business if you plan to invest most of your profits back into the company each year. An LLC also is an easy-to-maintain business structure, which suits most small businesses.
Your business would benefit from a corporate structure if you want to attract investors and need to carry significant profit over from one tax year to the next.
LLC vs. Corporation: Taxation
An LLC offers more tax choices than a corporation. Owners of an LLC can elect for the company’s profits to be taxed in one of three ways:
- As a pass-through structure (a single layer of taxation)
- As a C corp (double taxation)
- As an S corp (a single layer of taxation, but with many ongoing compliance and other requirements)
Corporations typically face about a 15 percent tax rate for all profits that carry over to the next tax year. Meanwhile, an LLC member’s tax burden would be greater because they must pay Federal Insurance Contributions Act (FICA) taxes as well as federal and state income taxes, which are higher than the 15 percent corporate rate.
A corporation only has the choice of C corp or S corp taxation status. Small business owners often prefer the LLC pass-through taxation status because it allows them to avoid the double taxation of their business profits. In many cases, it also enables them to take business losses to reduce taxes from other income without having to worry about meeting a list of S corp requirements.
While the S corp structure is available to both LLCs and corporations, it only allows a certain number of owners and all owners must be individuals (not entities) and U.S. citizens or permanent residents of the United States. Other requirements also apply so check with your accountant for the specific details.
With an S corp tax status, you must always stay on top of the latest S corp requirements as your business evolves. The failure to meet a requirement — even if accidental — can result in disastrous tax liabilities and penalties.
Yet, despite all of its requirements, S corp status can offer some tax benefits over the standard pass-through entity when it comes to self-employment. In these cases, you have the option of choosing S corp taxation with either the LLC or corporate business structure.
LLC vs. Corporation: Ownership Structure
An LLC structure gives your business much more flexibility when it comes to ownership structure. Specifically, LLC rules and regulations enable the company to tailor what each owner will get in terms of voting control and distributions.
In contrast, corporations have a set ownership structure. Ownership is defined by a share of stock, and each stock share provides a set right related to voting and sharing the profits. An LLC also can choose this standard structure, but has the flexibility to customize it, if needed, without having to create multiple classes of ownership.
Accordingly, an LLC is more attractive when it comes to attracting investment capital or service partners because it offers more options to address specific business situations.
LLC vs. Corporation: Management Structure
An LLC can have a very simple, single layer of management (member-managed) or a management structure with a central governing body (manager-managed).
When it comes to operations, an LLC isn’t required to meet the same level of formalities and paperwork as a corporation.
The laws governing corporations generally impose a set management structure that requires a board of directors as a central body of management. In addition, in most states, corporations must hold a set of required meetings and file certain governance documents each year.
While LLCs should, as a best practice, still have some simple governance paperwork to document major business decisions, it’s comforting to know the law doesn’t require it for the legal entity to qualify as an LLC and receive LLC benefits.
In deciding between forming an LLC or a corporation, remember that an LLC offers the same management structure required for a standard corporation while also allowing for a much simpler structure or a more complex one if needed to protect investors or the business.
As noted above, the decision to form an LLC or a corporation should depend on your specific situation. The best way to choose between these two business structures is with the help of a lawyer, accountant, or a corporate services company. Why? Because you should base this decision on many factors related to your business, including your risk level, business income, and long-term goals.
LLC vs. Corporation FAQ
Is it better to have an LLC or corporation?
Given the simplicity and flexibility of the limited liability company (LLC), this business structure offers all the benefits of a corporation without the disadvantages. As a result, the number of LLC formations each year greatly surpass incorporations when it comes to small businesses.
Do corporations pay more taxes than LLC?
Yes. Corporate distributions are taxed at both the corporate and the shareholder level. Therefore, corporations and their shareholders end up paying more in taxes than LLCs.
Can you switch from an LLC to a corporation?
Yes. LLC members can elect to transition the company into a C corp or an S corp by amending their LLC Operating Agreement.
Does an LLC converting to a corporation need a new EIN?
Yes. An LLC converting to a corporation must apply for a new employer identification number (EIN), using the new corporate entity’s name.