If I had to choose one question I get asked by new clients more than anything else, it would have to be, “Should I form an LLC or a corporation?” Finding the right entity to help bring your business idea to life can be challenging. The LLC vs. Corporation question depends a lot on your plans for the business.
I hate articles that drone on and on without answering the questions, so I will give you a very brief summary to start with: for many small businesses, an LLC is all they need, but a corporation may be better in certain circumstances.
Still here? Great! Let’s dig into why an LLC works better for many new entrepreneurs and what circumstances may necessitate using a corporation instead.
Limited Liability
The biggest thing that LLCs and corporations have in common is that they limit their owners’ personal liability. In a sole proprietorship, which is essentially a fancy way of saying doing business under your name or an assumed name, the owner is liable for the debts and liabilities of their business. If the business defaults on a loan or gets sued, the owner’s personal assets are at risk.
With an LLC or a corporation, this is not the case. Limited liability means that the LLC or corporation is separate from its owners for liability purposes. So instead of being able to go after the owner’s personal assets, the debts and liabilities of the LLC or corporation are limited to its own assets.
Exceptions
While the limitation on liability is the general rule, there are exceptions. Depending on what state the LLC or corporation is located in, the limitation on liability may not apply in some of these situations:
- Alter Ego. An LLC or corporation is separate from its owners and should be operated accordingly. Some owners treat their entity as being nothing more than an extension of themself. Perhaps they buy their groceries and other personal items through the company or even hold the deed to their home through the company. In such extreme cases, a court may “pierce the veil” of the entity and hold the owner personally liable for its debts and liabilities.
- Fraud, criminal activity, or other misconduct. For normal everyday actions that are typical of a business, limited liability will protect the owners of a company. When the owners use the company to commit fraud or engage in criminal activity, however, the limitation might not be able to protect them. It’s important to note that only the owner who engages in fraud or misconduct would generally be liable. If another owner was unaware of the fraud or misconduct, they would likely still be protected unless they knew or should have known what the other owner was doing.
- Wrongful Distribution. Another scenario where liability may not apply is when the business makes a wrongful distribution to its owners. I usually see this come up when a company is going out of business and winding up its affairs. Normally, a company going out of business is supposed to pay off its debts before distributing the remaining assets to its owners. Sometimes, however, the company will pay the owners and leave its creditors high and dry. In this case, the creditors may be able to hold the owners liable for the amounts owed. That said, the owner’s liability is usually limited to the actual amount paid to the owner (depending on what the state’s rules and regulations are).
- Torts Committed by an Owner. Certain torts (acts or omissions that cause harm to another) may still make an owner personally liable to a third party. For example, if an owner hits a pedestrian with a work vehicle, the pedestrian may be able to sue both the company and the owner for their injuries.
Keep in mind; this is not an exhaustive list. I tried to focus on a few of the most common exceptions to limited liability.
LLC vs. Corporation
So, if LLCs and corporations offer the same limitation on liability, what is the difference between the two? While they serve similar functions, LLCs and corporations differ in several key areas, including taxation, structure, and maintenance. Let’s dig into each of these areas a little deeper.
Taxation
The most significant difference between an LLC and a corporation is taxation. An LLC is considered a pass-through entity for tax purposes. This means that, by default, an LLC is not taxed directly by the IRS. Instead, the owners (called members for an LLC) report the profits and losses of the LLC on their tax return. This also means that profits and losses are taxed at the same rate as the owner’s other income.
On the other hand, the default treatment of a corporation by the IRS is to treat it as a separate entity for tax purposes. This is called a C Corporation (we’ll talk more about this in a moment). A Corporation is responsible for reporting its profits and losses and is taxed at a corporate tax rate set by the IRS.
If the corporation issues a dividend, the owners (shareholders) will be responsible for reporting the dividend on their income tax return. This means that the corporation’s profits could be subject to double taxation. The profits are taxed once when reported as income by the corporation and then again when reported as a dividend by shareholders.
Flipping the Script
So by now, you know that, by default, an LLC’s profits and losses are passed-through to its members, and a corporation’s profits and losses are taxed separately. In reality, an LLC can elect to be taxed as a corporation, and a corporation can, in some circumstances, be taxed like an LLC. How so? Let me explain.
Checking the Box
An LLC can “check the box” to elect to be taxed as a corporation. While the company will remain an LLC with regard to structure and maintenance requirements, it will not need to file a separate tax return. This also means that the company could, in theory, be subject to double taxation like a C Corporation. So, why would an LLC prefer to be taxed as a corporation? There are a few situations where this can be advantageous:
- Profits are kept in the company. If an LLC would rather reinvest the company’s profits than distribute them to the members, being taxed as a corporation could be more efficient, especially if the corporate tax rate is lower than the members’ personal rate.
- The LLC employs the members. LLC members are typically subject to a self-employment tax on the income passed through from the LLC. If the members are employed by the LLC and paid a reasonable wage, the self-employment tax may not apply. However, the LLC would still need to follow appropriate withholding on the wages paid to members and other employees.
S Corporation
An LLC or a corporation may also be able to elect S corporation status with the IRS. An S Corporation is taxed similarly to an LLC. The income is passed to the shareholders (or members), who report it on their tax returns. This can prevent double taxation, as discussed above.
However, one key difference between S corporations and typical LLC taxation is that an S Corporation has the same treatment as a C corporation for self-employment taxes. This means that, in theory, an LLC could maintain pass-through taxation but still benefit from self-employment tax savings. That said, the income paid to members must be reasonable. Further, proper withholding must be made on the wages.
Not every entity can elect S corporation status. LLCs and corporations seeking to make an S corporation election must meet certain criteria. The entity must:
- Be an entity formed in the United States;
- Have no more than 100 shareholders (or members);
- Have only individuals or certain types of trusts or estates as shareholders (or members);
- Not have corporations, partnerships, or non-resident aliens as shareholders (or members); and
- Must only have one class of stock (we’ll discuss what this means later).
While an S corporation offers many benefits for certain LLCs and corporations, the intricacies and requirements should be carefully reviewed before the S corporation election is made.
Structural Differences
The next thing that sets LLCs and corporations apart is their structural differences. As mentioned above, an LLC is owned by members and shareholders own a corporation. While both members and shareholders share some similarities, there are some key differences.
One of the most important differences is that a corporation can have different classes of stock. In an LLC, control is typically distributed according to the amount of the company owned by the member (in membership interest units). So a member with 51% or more of the membership interest in the company would usually be in control (depending on the operating agreement and other governing documents).
With a corporation, this can be more complicated. A corporation can issue different classes of stock. Common stock, for example, typically gives the shareholder voting rights in electing a board or making certain major decisions. Preferred stock, on the other hand, may not give voting rights but could offer higher dividends. This is just the tip of the iceberg. We will revisit different stock classifications in another article.
LLCs and corporations are also managed differently. In a corporation, the shareholders will vote for a board of directors to oversee the corporation and appoint officers to run it. An LLC, on the other hand, has the option to be managed by its members. The members also can appoint managers who can serve in a role similar to a board of directors. In general, LLC members can be much more engaged in the entity’s running than shareholders.
Maintenance & Formalities
Corporations are subject to stricter maintenance and corporate formalities than LLCs. Corporations typically must have annual meetings of its shareholders. While LLCs are not generally required to have annual meetings of their members, many choose to do so anyway.
Bylaws serve as the governing rules of a corporation. LLCs have a similar governing document called an operating agreement (or company agreement, depending on the state). Both bylaws and operating agreements usually set rules about how the entity is managed, selling ownership interest, appointing officers, and other key governing policies.
Finally, states will often have somewhat different formation documents and procedures. Generally, LLCs typically have fewer formation requirements than a corporation. That said, the filing requirements vary from state to state.
Is an LLC Better than a Corporation?
Honestly, it just depends. LLCs are fairly easy to set up and maintain. This is why I often recommend LLCs to clients starting a small business. Still, corporations can be the better choice for certain businesses as well. If the owners need to be able to implement an intricate ownership system, then a corporation works very well in this regard. Corporations may also be a good choice for a foreign owner who wants to keep profits located in the US entity or does not want to file a US tax return.
Ultimately, the LLC vs. corporation debate depends on your particular needs. Each case is different, so it’s good to talk to an attorney and a CPA before choosing your entity.
This article is for informational purposes only and does NOT constitute legal or tax advice. As I said, please talk to an attorney and a CPA before forming an entity.