What is the difference between an LLC and a Corporation?
Limited Liability Companies (LLC) and corporations are two of the more popular types of business structures that entrepreneurs create. These legal entities share many similarities but also have differences that create advantages and disadvantages for the business owner.
Major differences include:
- Formation: An LLC is formed by one or more owners by filing Articles of Organization with the state. A corporation becomes incorporated after filing corporate organization documents, appointing a board of directors, creating bylaws, and then distributing company stock.
- Ownership Structure: The owners of an LLC are called members. They have an equity interest in the business. Corporations are owned by shareholders who have shares of stock in the business.
- Profits and Losses: An LLC is a pass-through entity meaning that the profits and losses pass through the company to the owners. In a corporation, income taxes are paid by the corporation itself, not by the owners directly. This allows the corporation to keep some earnings.
- Taxes: Owners of an LLC pay taxes based on their individual tax rate because they file the company’s profit and losses with their individual tax returns. They also are required to pay self-employment taxes. A corporation is taxed at the set corporate tax rate and does not pay self-employment taxes.
To learn about more difference between LLCs and Corporations, read this article.
How LLCs Work
When an LLC is formed, it becomes its own legal entity separate from the business owner or owners. An LLC must have a registered agent and must file articles of organization or a certificate of formation with the state in which they are doing business.
Although LLCs are not required to have bylaws like corporations, many companies choose to write an operating agreement for their business.
How to Form an LLC
Every state has their own laws regulating the formation of LLCs. Generally, LLCs are required to file articles of organization or a certificate of formation with the Secretary of State. This document will require information about the company like:
- The name of the LLC
- The effective date of the formation of the LLC
- The name and address of the registered agent of the LLC
- The company’s principal office
- The business purpose or sometimes called “general character” of the LLC
- Duration of the business
- The name and address of one member of the LLC
- The name and address of each organizer of the LLC
- Some states require a copy of the name registration certificate
- Signature of the authorized representative
Pros of an LLC
- Limiting Personal Liability for Business Debts: An LLC protects an owner from certain liabilities like business debts. In the event of a lawsuit or claim of a creditor, only business assets are at risk to be claimed to satisfy a business debt. An owner’s personal property and assets like real estate or personal bank accounts are protected.
- Tax Advantages: An LLC owner does not have to file a separate tax return for the business. LLCs are “pass through entities” because profits and losses from the business pass through the business to the owner’s personal tax return. LLCs with more than one owner also have the option to choose to be taxed as a corporation if they choose.
- Flexibility: LLCs offer business owners maximum flexibility. They are not regulated like corporations.
Cons of an LLC
The largest disadvantage of an LLC when compared to a corporation is the difficulty an LLC may face securing outside financing. LLCs do not have stock like a corporation to entice investors.
LLCs and Taxes
An LLC is usually taxed by what is called “pass-through taxation”. Profits and losses of the business pass through the business and are filed with the owner’s personal tax return.
Using a Schedule C form, the LLC owner will report their businesses profits, losses, and deductions to the IRS. If there is more than one owner, each owner will file profit and losses with their own personal tax return.
LLCs owners have the option to be taxes like an S Corp . An LLC owner can file Form 2553 , Election by a Small Business. If approved, an LLC will now be treated like an S Corp by the IRS for tax purposes.
For more help deciding which business structure is best for you, read this article about LLCs and Corporations.
How Corporations Work
A corporation is a legal entity and just one way to establish a new business. Corporations are separate and distinct from its owners which offers owners liability protection from business risks and debt. Shareholders may take part in the profits through dividends and stock appreciation but are not personally liable for the company's debts.
How to Form a Corporation
Incorporating your business requires completing these essential steps:
Step 1: Business Name- Your corporation will need a unique name that does not infringe on any registered trademarks. Usually, the name will also have to include a corporate designation like “Incorporated”, “Limited”, or “Corporation”. To make sure you’re using a unique name, you can run a trademark search .
Step 2: Appoint Directors- Every corporation is required to have appointed directors. This can be the owner but doesn’t have to be. Different states have different laws on how many directors are required.
Step 3: Articles of Incorporation- To be recognized as a legally operating corporation, articles of incorporation need to be filed with the Secretary of State. At this time you will also have to appoint a registered agent.
Step 4: Create Corporate Bylaws- Corporate bylaws are rules and regulations governing how your business will be run. These are usually required by state business laws; however they do not need to be filed with the state.
Step 5: Hold First Board of Directors Meeting- At this initial meeting, the corporation will adopt the bylaws, appoint officers, and decide how stock will be issued.
Step 6: Issue Stock- Once your company has decided how stock will be distributed to shareholders, stock certificates can be issued.
Pros of a Corporation
Forming a corporation over an LLC offers a business owner many advantages. The following are some examples:
- Attracting Investors: Corporations have stock that can be issued to investors. This is a great selling point when looking for outside financing.
- Stock Options for Employees: Just like attracting investors, corporations can attract employees with employee stock options . This will allow the corporation to attract higher caliber employees.
- Organization: Corporations have a very organized management structure made up of directors, officers, and shareholders. This allows each group to have their own roles and responsibilities.
- Right to Due Process and Equal Protection: Corporations are protected by the fifth and fourteenth amendments in the United States Constitution. They are the right to due process and equal protection just like individuals.
Cons of a Corporation
- Double Taxation: Corporations are taxed at both the corporate level and shareholder level. This is called double taxation. A smaller corporation can choose S Corp status to avoid this.
- Expensive and Complicated: Corporations are more expensive to start and more complicated to maintain than an LLC. They require more legal documents, scheduled meetings, and higher fees. The management of corporations is referred to as corporate governance .
- Subjected to Strict Government Regulation: Corporations must adhere to government formalities to be a legally functioning business. This includes adhering to all state business laws.
Corporations and Taxes
How a corporation files taxes depends on whether the business is classified as an S Corp or a C Corp.
C Corp: A C Corp will file IRS Form 1120 to report income and losses. C Corps are required to pay corporate income taxes at a specified rate set by the federal government. Shareholders of a C-Corp only pay taxes on distributions they receive from the corporation like salary, bonuses, dividends, and fringe benefits.
S Corp: S Corps are not subject to double taxation like C Corps. S Corps are a pass-through entity so instead of being taxed like a corporation, they are taxed similarly to an LLC. Business income, losses, deductions, and credits will pass directly to shareholders avoiding federal corporate taxes.
S Corp shareholders will report all financial information relating to the business on their individual tax returns and pay taxes at their regular income rates. This allows shareholders to avoid the double taxation usually associated with a corporation.
S Corps vs C Corps
S Corps and C Corps are similar in that they are both incorporated, for-profit companies governed by state corporation laws. They both offer liability protection to the owners, are comprised of a board of directors, must have corporate bylaws, and have shareholders meetings. The biggest difference between these two entities is the tax status.
C Corps are subject to federal corporate taxes which is usually described as a double tax. C Corps are required to pay taxes on 21% of their income and then owners will also pay tax on the dividends they receive.
S Corps avoid corporate taxes so owners will only pay taxes on income once, on their personal tax returns. For a smaller business just starting out, these savings on taxes can be extremely beneficial.
Unlike S Corps, C Corps do have several tax advantages to consider. A C Corp can deduct charitable contributions from their earnings. They can also offer untaxed benefits to their employees if 70% of employees receive the benefits.
Due to the strict regulations placed on S Corps by the IRS, C Corps offer more flexibility and ownership options than an S Corp. Owners of C Corps do not have to be US citizens or permanent residents and C Corps have more options for classes of stock. Furthermore, C Corps also have less restrictions when it comes to raising funds.