Small business owners make game-changing decisions all the time. None of these predicaments, however, can match the significance of choosing the right business entity. This decision will determine the way you pay taxes, your opportunities for growth, and the general, day-to-day responsibilities you will have as the business owner.
It’s common for businesses to begin as sole proprietorships, which remains the most popular business entity in the US. But when the time comes to expand, most business owners choose one of two options: limited liability company (LLC) or corporation. These two structures have numerous similarities as well as stark differences. Your decision will likely depend on your goals and your threshold for paperwork and other legal obligations. The harder road offers more rewards, but maybe you couldn’t care less about those rewards, and that’s just fine.
In this guide, we’ll explain the similarities and differences between corporations and LLCs and how to decide which one makes the most sense for your priorities.
LLCs and corporations have two main similarities that separate them from sole proprietorships and general partnerships. Both of them are registered business entities, and both offer limited liability protection for the business owners. Not sure what that means? Let’s go over each of those terms here:
In order to form an LLC or corporation, you must file paperwork with your home state’s business filing agency. Each entity has its own formation application: LLCs have their articles of organization, whereas corporations must file articles of incorporation. Your business cannot open up shop until the state approves your application.
Sole proprietors and general partnerships do not have to register with their state primarily because they don’t have to file separate business taxes. They just have to attach one more form to their 1040 tax return.
The average sole proprietor’s tax bill, though, tends to run much higher than an LLC or corporation. We’ll get to the many other advantages of the tax systems for LLCs and corporations later on. Still, it’s worth noting that formation paperwork takes time to fill out, and you might already have plenty of licenses and permits to apply for as well.
Limited liability means that the business owners are not personally liable for the business’s debts and obligations. In other words, the business owner cannot be personally sued by creditors, employees or customers for business-related issues. If your business fails to pay back debt, for example, the creditor cannot seize your personal assets. The business owner also cannot be personally sued by disappointed customers or employees who suffer physical or emotional harm at work. Only in certain circumstances, like signing a personal guarantee on a small business loan, would the business owner’s personal assets be at risk.
Sole proprietors and general partnerships, on the other hand, have no such protections. The likelihood of the aforementioned scenarios increases as your business expands, which explains why many businesses become LLCs or corporations before entering this stage.
Major differences between LLCs and corporations emerge when it comes to formation, taxes, legal obligations, and the role of the business owner. As you can probably imagine, these topics become more complicated with corporations. But that doesn’t mean all LLCs have to follow the same rules, with no room for flexibility. Let’s look at the main differences between LLCs and corporations:
The legal journey of establishing an LLC ends once the state approves your articles of organization. You don’t have to meet any other legal requirements. Most LLCs draft operating agreements after filing the paperwork to outline each owner’s responsibilities. It’s extremely helpful to have this information on paper before opening for business. But that’s just best practices. Pretty easy setup, right?
With corporations, on the other hand, the legal journey does not end after the state approves their articles of incorporation. And this document takes much more time to complete than articles of organization. In addition to basic information like number of shares and the business’s purpose, your articles of incorporation must name your incorporator, officers and directors. Once the state approves your paperwork, you must also file initial reports, draft corporate bylaws, hold their first board of directors meeting, and issue shares of stock at their first shareholders meeting. None of these steps are required for LLCs.
The owners of LLCs and corporations are not technically referred to as “owners.” Instead, LLCs have “members” and corporations have “shareholders” or “stockholders.” Both entities, however, can have single owners.
With LLCs, the members can choose to run the business together, appoint one member as the main director, or appoint an outside individual to run the business.
Even though corporate shareholders own the company, they do not make decisions about management, strategy, or company policy. They instead elect a board of directors and leave these decisions up to them. The board of directors then hires officers (CEO, COO, CFO, etc.) to handle day-to-day operations.
The ability to own stock makes it much easier for corporations to attract investors than LLCs. Investing in an LLC requires much more effort from the investor when compared to buying, retaining and selling corporate stock.
Standard corporations (as opposed to S-corps, which we’ll explain shortly) can also offer preferred stock along with common stock. Venture capitalists and angel investors heavily favor preferred stock due to the lower risk and higher yield. So, if your business plan revolves around raising money, it’s very hard to argue against the corporate structure.
The previous section mentioned S-corps. The “S” stands for Sub-chapter of S of the Internal Revenue Code, or tax code. This section of the tax code deals with “pass through” entities, which brings us to the main difference between S-corps and standard corporations, or C-corps.
The widely-disliked tax system for C-corporations is known as “double taxation.” Not only does business income get taxed, but shareholders get taxed personally as well if they receive dividends from business income. In order to escape the second tax, shareholders must take only what the IRS would consider a “reasonable” salary and reinvest all other profits back into the business.
S-corps do not get taxed at the business level. Shareholders only pay taxes on their allocated shares of the business income, and at their personal income tax rate. Since there’s so much more money to go around, S-corps shareholders usually stand to take home substantially higher salaries than C-corps shareholders.
Owners of LLCs can choose whether to be taxed as C-corps or S-corps. Most LLCs tend to choose the latter, and that number will likely go up due to recent changes in tax laws for corporations and LLCs. Only your accountant, however, can confirm which system makes sense for you.
The Tax Cuts and Jobs Act (or the “Trump Tax Plan” went into effect during the 2019 tax season. This law cuts the tax rates for both C-corps and pass-through entities, as seen below:
The new law certainly does reduce the tax bills for corporations, LLCs and other pass through entities. But it probably won’t affect anyone’s decision of how to structure their business. Corporations will still face “double taxation,” and pass through entities will still pay significantly less taxes.
Unlike LLCs, corporations must fulfill myriad legal responsibilities periodically throughout the year just to maintain their corporate status. This includes holding regular board of directors meetings, holding regular shareholder meetings, issuing stock certificates, and more. Holding regular meetings would be much less tedious if corporations weren’t required to document all important decisions that transpire.
Both types of businesses must pay annual fees to their home states, with LLCs paying the lower of the two. And since LLCs have the less complicated tax system, they usually don’t have to shell out hundreds of dollars in accounting and tax filing fees.
In the beginning of this article, we established that this decision would likely come down to your future goals. Unless your goals involve massive growth, it’s difficult to justify choosing a corporation instead of an LLC.
Corporations are more complicated and expensive to manage because they put your business in the position to earn more money. Owners of LLCs would argue that their structure allows them more freedom to grow their businesses through their own efforts, as opposed to attracting investors. Which of those scenarios sounds more appealing to you? It’s up to you to choose the option that best suits your preferred path to success.
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