One of the first things you’ll need to decide when starting a company is what type of business structure to use. As you explore your options, you might want to know the difference between a limited liability company (LLC) and a corporation – and what is the best option for you for tax benefits and personal liability protection.
It’s a good question, as your decision will affect the future of your business. And because it’s our mission at Invoice2go to empower small businesses worldwide, we want to help you make the right choice.
Today, we will look at various business structures and take a deep dive into the differences between limited liability companies, S corporations, and C corporations. It is essential to understand your options here – as choosing wisely will save you a lot of hassle at tax time and down the road.
If you are a freelancer, independent contractor, or small business owner, a sole proprietorship or partnership might be the easiest and most economical way to go. But more complex business needs might require the kind of personal liability protection that only incorporation offers.
When you incorporate, you’re creating a business entity that exists outside yourself. Essentially, even if you’re the one running the company, the company itself is its own mechanism—a living, breathing body (corporation comes from the Latin word “corpus,” which literally means body) that can buy, sell, and own property, bring lawsuits, enter into contracts with other people and companies, collect money, pay tax, and even commit crimes.
Costs, taxes, and personal assets: the pros and cons of incorporating
Of course, there are pros and cons to every business decision, so let’s look at that first.
On the plus side, corporations are taxed at a much lower rate, and that’s always attractive. But incorporation is not cheap, nor is the cost of doing corporate taxes. You’ll also be required to keep detailed records, which could mean a lot of extra work for you and the added expense of hiring a corporate accountant, lawyers, and so on.
One of the main reasons you might choose to incorporate is that it protects you and your personal assets from liabilities and debts related to the business. In other words, if somebody sues your company or you go bankrupt, you can’t be held personally responsible for the damages.
More to the point, however, incorporation means your business exists independently of you and your partners. As such, it is not dependent on any individual(s) and can continue to operate indefinitely, even after you’re gone.
What is a limited liability company?
A limited liability company (LLC) is a hybrid structure that combines specific features of a corporation with those of a partnership. As its name would indicate, LLCs limit your personal liability. That means you and your business are separate entities, and you are personally protected from the company’s debts and liabilities, much like a corporation.
As a member of the LLC, you are only liable to the extent of your investment in the business—and that’s where the term “limited” comes in. For example, if the business is sued, the company’s assets would be in jeopardy, but your personal assets are protected.
What are the pros and cons of an LLC?
The pros of an LLC are that you have total control and flexibility over how you run your business. It also sets you up to have creditors extend your credit if needed. You receive all business profits and LLCs typically make it easier to stay organized.
However, on the downside, with an LLC, you’re personally liable for all debts. Creditors can come after your personal property to satisfy a claim if they argue your business assets aren’t enough. It can also be harder to get a bank loan because LLCs usually have smaller assets.
Is an LLC a corporation?
LLCs are not technically a corporation, although they do have some attributes of a corporation. The legal definition of an LLC is a state-governed business structure where the owners (members) are not personally liable for the company’s debts and liabilities.
However, an LLC might be better described as a hybrid business structure with some aspects of a corporation and others that are more like a partnership or sole proprietorship.
One of the most significant differences between LLCs and corporations is in the way the business is taxed. For tax purposes, LLCs allow flow-through taxation. That means that business profits are passed through the company directly to its members, investors, or owners, who are personally responsible for declaring that income on their tax returns.
In corporations, the corporate entity pays the tax on business profits.
Is it better to have an LLC or a corporation? What’s the best business structure for me?
Choosing LLC over a corporate business structure is something you’ll need to consider carefully. In the end, your choice will depend on:
- Your business objectives
- Whether you intend to pursue investment
- The anticipated size of your business
- What tax structure you prefer
As a corporation, you are also obligated to appoint a board of directors and meet annually to discuss things like compensation, dividends, and other significant matters affecting shareholders. You’ll keep official records (minutes) of what’s discussed at each meeting and file an annual report that details all these things.
LLCs are not required to meet or file any reports (at least in most states). This flexibility makes LLCs more attractive to small businesses as there is less of an emphasis on filing and other corporate requirements.
How LLC and corporate management and recordkeeping are different
Each state has its own recordkeeping mandates for corporations and LLCs operating within their borders. In general, they fall into four categories:
- Organizational/operational documents
- Ownership and investment contribution
- Financial and tax records
- Documentation re: actions taken
Where it differs from state to state is the level of detail required. Many states also have rules about digital data privacy and storage, how long you must retain records, and when records must be available for inspection.
Corporations must document all decisions made on behalf of the business and voting records of shareholders and directors. Yearly meetings must be held in the state where the company was initially incorporated.
LLCs typically have fewer requirements, but that doesn’t mean you’re off the hook entirely. At a fundamental level, you will have to maintain records of:
- All members and management, including contact information, addresses, and full legal names
- Organizational documents and any amendments
- Details on each members’ contributions
- Financial statements
- Tax returns
- Operating agreements and amendments
- Records of major transactions
There might also be additional records and certifications to keep up to date, and on hand, depending on the industry niche you operate in.
What’s the difference between LLC vs. corporation taxes?
Taxation is an area in which LLCs have more flexibility than corporations.
LLC owners report taxes based on individual members’ returns rather than a corporate return, but it’s flexible based on how the company is set up. If it’s a single-member LLC, the IRS sees it as a disregarded entity—meaning the company is not separate from the owner for tax purposes. In other words, the LLC’s profits are taxed the same way as a sole proprietorship, reported on a Schedule C, and included with the owner’s personal tax returns. If it’s a multi-member LLC, you pay taxes based on each member’s share of the partnership.
Individual members will file a 1040 as they usually do, adding a Schedule E to report their profit or loss.
Individual states have their own rules for filing business taxes. It can either be a flat rate per year or a percentage of the business. Some have specific taxes for franchises or multi-member LLCs that surpass a certain income threshold, and others don’t have to pay income tax at all. Check with your state tax authority to find out your obligations under the law.
LLC filing deadlines are either March 15 or the 15th day of the third month after their fiscal year-end.
C corporation taxes
These must be filed on the 15th day of the fourth month after the end of its fiscal year. Quarterly installments must be paid based on estimated tax liability, either on the 15th of April, June, September, and December, or the 15th day of the fourth, sixth, ninth, and 12th month for fiscal year corporations. No extensions are available, and penalties are levied for any failure to follow the code.
S corporation taxes
These are what’s known as a pass-through entity for tax purposes. That means the corporate tax is passed on to the shareholders, who report income on their individual returns whether or not profits have been distributed.
How LLC vs. corporation impacts business ownership
An LLC acts in much the same way as a partnership or sole proprietorship in many ways, except that the business is separated from the owners for liability purposes. An LLC is owned by individuals, while shareholders own a corporation.
A C-corporation can have unlimited stockholders, some of which can be companies (entity investors), while the S-corporation is limited to 100 shareholders, and all must be natural people—meaning, not companies. In both cases, shareholders must be citizens or resident aliens of the United States. Shareholders can sell or transfer stock to other people without causing any change to the corporate structure.
LLCs can also have unlimited members, but non-residents and non-citizens can be owners, which is a significant difference. However, other aspects of LLC are not quite as flexible.
For example, if you wish to transfer or sell shares or ownership to another individual, you must first obtain the approval of all other members. This is another instance where LLCs are more representative of people and individual interests, which corporations often lack.
LLC vs. corporation management
The LLC management structure is flexible, meaning that any member or group of members can act as management. There might also be no distinction between owners and managers, creating a fluid environment that can be adjusted according to need.
Corporate management is much more stringent, as the board of directors must oversee management as they are accountable to their shareholders. Shareholders are considered owners but do not participate in day-to-day decision-making except in the case of significant corporate changes. Corporate officers are appointed to deal with operations and are accountable to the board of directors.
Formal requirements of LLCs and corporations
Both LLCs and corporations must comply with federal and state reporting regulations. Corporations typically have more hoops to jump through than LLCs.
Corporations will need to appoint a board of directors, have meetings, take minutes, maintain records, and file annual reports. Any changes that affect the business must be documented and filed accordingly.
On the other hand, LLCs don’t need a board of directors or annual meetings, and in most states, do not have to file annual reports. The rules for LLCs are specific to the state where it was formed, so check with the Secretary of State office in your state to find out what you need to do.
What’s the difference between a legal entity and a tax entity?
A tax entity is how the IRS views your organization. Ergo, it relates to how your company is taxed. A legal business entity is the company itself, which chooses how it wants to be taxed.
For example, a corporation and an LLC could both decide they want to be taxed as an S-Corp, though they are two separate legal business entities. LLCs generally have more flexibility in this area, but it’s advisable to speak to a CPA that has experience in these areas so you can make the best choice for your situation.
Legal differences between corporations and limited liability companies
The court system views corporations and LLCs a bit differently. Whereas there is plenty of legal precedents to draw from when dealing with corporate disputes, LLCs are a relatively recent phenomenon. As a result, each state treats cases involving LLCs a bit differently. There is no consistency, and the laws are not uniform from state to state.
Can I form an LLC while employed or working at another job?
If you’ve got a great business idea and want to get the ball rolling, establishing an LLC is a good strategy. There are no rules to say you have to be unemployed while you’re doing it—in fact, it’s smart to keep your day job until your business gets off the ground.
Can I reduce self-employment taxes with a corporation or LLC?
If you’ve been working for yourself for a while, you probably know that with that freedom comes a higher tax bill. Self-employment taxes can take a big bite out of your business income, but you can reduce your tax burden by setting up your business entity as an LLC, S corporation, or C corporation.
To get more specific legal or financial advice, speak to a business tax professional to find out how establishing an LLC or corporation can help you reduce self-employment taxes.