If you’re starting a new business, a key decision that you have to make is the type of business entity to form. Two of the best choices are a limited liability company (LLC) and a corporation. An LLC and a corporation have some similarities, but they’re very different in many ways.
Here you’ll find details of the main differences between an LLC and a corporation so that you can decide which is the best choice for you.
An LLC is a common choice for new entrepreneurs and offers personal liability protection for owners. Unlike a sole proprietorship, an LLC and its owners, called members, are considered separate entities, meaning that the LLC has its own assets and debts. The LLC members are not personally responsible for the obligations of the business.
An LLC also offers pass-through taxation, meaning that profits and losses are passed through to the members, who report the profits or losses on their personal tax returns. The LLC itself is not taxed.
A corporation is also a separate entity from its owners, called shareholders, therefore corporation shareholders have personal liability protection.
A corporation, however, is subject to corporate taxes, and the dividends paid to shareholders are also taxable, which is referred to as double taxation.
LLC vs. Corporation
Now, let’s examine the similarities and differences between an LLC and a corporation.
Forming a legal business entity, whether it’s an LLC or corporation, involves filing documents with the state. Often, entrepreneurs turn to a business formation service to help with this process to ensure that it’s done correctly. Those services also offer additional help to new business owners with products such as an operating agreement template.
The documents to form an LLC are typically very straightforward, while corporation documents are a bit more complex, and often best filed with the help of an attorney. Corporation shareholders must also create corporate bylaws that define how the corporation will be managed and governed. These bylaws must be consistent with the laws of the state of formation.
As mentioned, LLC owners are called members, and their ownership is defined in percentages in an operating agreement. An operating agreement, while not required in most states, defines many important provisions for the LLC, including the ownership percentages of members, how profits and losses are distributed, and how ownership can be transferred.
A corporation, on the other hand, is owned by shareholders, and the ownership of each shareholder is a number of shares. These shares can easily be transferred or sold. In contrast, transferring the ownership of an LLC is much more complicated.
LLCs have much management flexibility, and only require a designation of being member-managed or manager-managed. In a member-managed LLC, all members are actively involved in managing the business. In a manager-managed LLC, one or more members are designated as managers, while other members are silent partners. Outside managers can also be hired by a manager-managed LLC.
Beyond that designation, LLC members are free to manage the business any way they choose, as long as they comply with the law.
In contrast, a corporation must appoint company officers and elect a board of directors. The board of directors may have directors that are shareholders, but some must be non-shareholders. The board of directors has oversight of the corporation’s officers, and can make key decisions for the company. Generally, an annual meeting of the board of directors is required, but all states have different meeting and reporting rules that corporations must follow.
Personal Liability Protection
Both LLCs and corporations offer personal liability protection for owners. Exceptions to this protection, however, can come if an owner commits fraud or engages in illegal or reckless behavior in regard to managing the company.
Another exception comes when an LLC member or a corporation shareholder personally guarantees a business loan. In such cases, that member or shareholder is personally responsible for paying back the loan.
As mentioned, LLC profits or losses are passed through to the members, and taxes are paid at their personal income tax rate. However, LLC members must also pay self-employment taxes which come with a total rate of 15.3% and fund Medicare and Social Security.
A corporation is subject to corporate taxes, which are 21% as of 2023. Dividends paid to shareholders are also taxable, which again, is referred to as double taxation. However, those dividends are not subject to self-employment taxes. But while LLC members typically pay themselves with distributions from the LLC, managing shareholders of a corporation must be paid by salary, and that salary is subject to employment taxes, which are equivalent to self-employment taxes.
Profit Sharing and Distributions
In a corporation, the profits are paid to shareholders in dividends based on the number of shares they own. In an LLC, on the other hand, profits or losses as well as distributions can be allocated any way the members choose. While usually, these amounts are based on the ownership percentages of members, they don’t have to be. For example, if one member is more involved in the business, members may determine that that member receives a bigger allocation of profits and larger distributions.
Making the Choice
For many businesses, an LLC is the best choice because of the flexibility and simplicity they offer, as well as the pass-through taxation. If your LLC has only one or a few members and you’re just starting out, an LLC is likely right for you.
However, if you plan to grow your company by raising investment capital from an angel investor or venture capitalist, a corporation may be a better choice. This is due to the fact that the ownership of a corporation is much easier to transfer than that of an LLC. With a corporation, an investor can simply offer to invest a certain amount of capital in exchange for a certain number of shares.
This makes corporations much more attractive to professional investors.
LLCs and corporations both have advantages and disadvantages, but both offer personal liability protection, which makes them better choices than sole proprietorships and partnerships, which do not offer that protection. Whether an LLC or corporation is right for you depends on specific factors relating to your business type and future plans. If you’re uncertain, consult with your attorney and tax advisor to be sure that you’re making the decision that will give your new business the best chance of success.
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