Should You Form an LLC or a Corporation?
To form an LLC, or a corporation, that is the question. What is the answer, though? Here are some of the differences.
Legal Entity vs. Tax Entity
Before going any further, let’s make a distinction between a legal entity (LLC v. corporation) and a tax entity (sole proprietor/partnership vs. C-corporation v. S-corporation). Some new entrepreneurs get these two different ideas mixed up and create unnecessary confusion. A tax entity classification is how the IRS (and the state tax board) sees the business. The legal entity is how everybody else sees the business, like courts, the state and contractual partners. A corporation (legal entity) gets a corporation (C-corp or S-corp) designation as a tax entity. However, an LLC (legal entity) gets to decide if it wants to be classified as a sole proprietor/partnership, or as a C-corp or S-corp (there is no true LLC tax entity and so an LLC is instead seen as one of the traditional business designations). As such, an LLC has more flexibility and can choose the tax identity that most benefits its members. With this in mind, here are some big differences:
As mentioned, an LLC has flexibility with its tax designation whereas a corporation is more limited. One disadvantage of the corporate designation is its double taxation implications. A corporation’s profit is taxed (corporate tax), and then dividends its shareholders receive are taxed (individual tax). The S-corporation designation does allow flow-through taxation (no corporate tax), but there are requirements to qualify as an S-corp that may be less than ideal for some businesses. Depending upon a corporation’s circumstances, it may have no choice but to be a C-corp and face double taxation.
An LLC, no matter its structure or organization, can choose how it wants to be taxed. By default, an LLC is treated as a “pass-through” entity (single taxation), but can choose to be taxed as a C-corp or an S-corp (if it qualifies). It may seem counterintuitive to choose double taxation, but for certain specific situations, an LLC filing as a C-corp for tax purposes can make financial sense. However most of the time this is not the case.
The tax difference between LLC and S-corp is more nuanced. Both an LLC and an S-corp offer flow-through taxation (no double taxation). However, the LLC’s profit distribution is subject to employment tax, while an S-corp’s dividends aren’t. With planning, a small business can avoid employment taxes by becoming an S-corp. Beyond the drawbacks of an S-corp, there are other reasons (i.e. a lot more paperwork) that may deter a small business from taking this route. Most importantly, consult a professional before deciding between an LLC and an S-corp for tax purposes.
The owners of a corporation are the shareholders. The owners of an LLC are members. Beyond the names, there are other differences between the two. An LLC has freedom to distribute ownership stake to members regardless of their capital contribution to the LLC. This is important when profits are distributed to members. Although some members may not have invested as much as others, an LLC’s operating agreement can specify that all members receive an equal share of the profits.
A corporation can achieve the same thing by creating a unique stock class structure, but this is limited to C-corps. Unfortunately, a business that wants to identify as an S-corp is unable to create a unique stock class structure. An S-corp must have a single class of stocks with dividends distributed in proportion to the capital investment of the shareholders. Thus, if a corporation wants to create a unique stock class structure, it must also submit to double taxation.
An LLC’s management structure is more centralized. Any member can act as manager and the LLC can elect to have no distinction between LLC owner and manager.
A corporation must have a Board of Directors handling management responsibilities and corporate officers running day-to-day operations. As a class, shareholders are considered owners of the corporation, but are separated from daily business decisions of the corporation (except for approval of major corporate decisions) and retain power only to elect directors. However, individual shareholders may be elected as directors or appointed as officers.
There are also legal considerations when choosing between an LLC and a corporation. To help illustrate the difference, one analogy is that an LLC is the “new kid on the block” while the corporation is the “senior citizen.” The corporation classification has been around for hundreds of years, and part of US history even before the US existed. The importance of this is that the corporate form has matured and developed to the point where laws for corporations have essentially become uniform. Centuries of case law provide precedents for resolving a dispute involving corporations. Financial planners can be comfortable guiding a corporation into the future knowing how the laws will work.
The same cannot be said about LLCs. LLCs were not recognized until the 1970s. The LLC takes on the characteristics of both the corporate and sole-proprietorship/partnership form. As a consequence of being a “newer” legal entity and having these dual characteristics, different states treat LLCs in different manners. Many states have similar LLC laws, but the differences are significant enough that a particular business may choose to be an LLC in one state, but a corporation in another. As LLC laws become more uniform throughout the country, this point will eventually become irrelevant. Even now, the discrepancies between LLC laws are not a factor for most businesses, but for the few, the discrepancies could be a deciding factor.
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