Anybody can open a new business – it’s growing it that’s more challenging. The most successful businessmen would tell you that they didn’t start businesses overnight. They studied every aspect of building and growing a business into a success – how to start, run, and sustain it as well as how maximize profits for the long run. One of the major dilemmas facing entrepreneurs is the type of entity that will benefit their business the most. Will it be LLC or Corporation? Learning the differences between these two types of entities, including their pros and cons, can help the owner determine the best structure for their business.
Defining Terms: LLC vs. Corporation
LLC stands for Limited Liability Company. It is a kind of a hybrid, combining some of the best features of corporations and some other business structures. It considered a “pass-through” type of business. That is, the company profits are also considered the shareholder’s profits. However, each shareholder is responsible for their own personal tax return.
A corporation, on the other hand, is considered a “separate” type of business. That is, both the benefits and the losses are shouldered by the organization as a whole entity, not to the shareholders.
LLC vs. Corporation: Structural Differences and Similarities
Let’s take a closer look at the differences and similarities between LLCs and Corporations:
LLC: Shareholders or owners are protected from being held personally liable from the judgments and debts of the business.
Corporation: Ditto. Corporation is another business entity that protects shareholders/owners from debts and any lawsuit against the company.
LLC: Although LLCs have been around since the 1970s, the principles and theories underlying the entity are still unfamiliar to many, which may put you at a disadvantage when applying for a loan from bank.
Corporation: In terms of trust factor, corporations have it better than LLCs as they’ve been around longer. They are tried and tested to protect shareholders from liability in court systems. Hence, banks are more likely to extend loans to corporations than to LLCs. Getting state approval for any kind of business is easier, too.
Number of Shareholders/ Company Size
LLC: LLCs can have as many shareholders it wants. It is non-exclusive, which means it is open to individuals of any citizenship or country of residence.
Corporation: Corporations put a cap a number of shareholders it can have to 100. Shareholders must hold US citizenship or is a US resident.
LLC: LLC is more flexible, more laid back than corporations. Although members abide to an operating agreement, they are not bound by traditional formalities such as meetings and bylaws. This means less paperwork, less hassles.
Corporation: Shareholders and the board of directors hold meetings on a regular basis and keep up on minutes and bylaws. The administrative formalities that corporate managers must observe can be burdensome.
Distribution of Profits and Loss
LLC: This type of business entity passes down profits and losses to a personal level. It means owners are treated with individual income tax rates. Operating losses may also be deducted against a member’s personal income if they opt to. On the other hand, shareholders or members may also elect to be taxed at the corporate level. It is up to the members to decide how the profits and losses will be distributed among them.
Corporation: Distribution of profits and losses in a corporation depend on capital contributions of members. The corporation is taxed as a business entity.
LLC: As mentioned, LLC offers more flexible taxation terms. Members are taxed individually or as sole proprietors. Hence, their taxes are based on their individual income. The disadvantage members have to pay higher tax rates than corporate members as they are taxed based on their Adjusted Gross Income. For example, a 2-member LLC earned a profit of $500,000 for 2011. Each one is thus taxed based on the $250,000 income on their personal tax return. This amount is considered with the member’s all other income for that year.
Corporation: An organization is taxed as an entity. As such, the company is able to reap larger tax savings, which the company may use for expansion or other business purposes. Not only do corporations have lower tax rates, members are also exempted from Social Security and Medicare taxes. Further, only salaries and not the profits of members are taxed in a corporation. However, corporation shareholders are subject to double taxation.
LLC: Employees receive fewer benefits than a corporation. Another disadvantage is that these fringe benefits (e.g. medical insurance, group insurance, etc.) are also treated as taxable income.
Corporation: Employees and shareholders receive a greater number of fringe benefits than employees of any other business structures. They do not have to pay taxes on these benefits, too.
Choosing Between an LLC and a Corporation
If you ask two people running the same business the question “What is the best entity or tax classification for me?” they would come up with different answers. There’s no universal answer to the question. One has to consider several factors including:
- The trade laws in your area. Some states have specific restrictions on the type of entity a business, trade, or profession can take. In California, for instance, licensed professionals can only set up a professional or a regular business corporation.
- Ownership structure. In DC, Massachusetts and California, you need to have two or more members before you can set up an LLC. If you plan to build a single-member company, then corporation is the only way to go.
- Attracting investors. You may plan later to expand your business. Because the advantages and liabilities of corporations are well understood, investors are more like invest in them.
- Stock options. Stock options and stock bonus incentives are a great way to entice employees. Only corporations can offer stock options.
Determining what structure would benefit a particular business the most is a complex process. This article covers only the most important points of LLC and corporate business structures. It is impossible to cover every aspect of tax and federal laws particular to your business. A financial advisor or a lawyer well versed in business law will be able provide a more detailed advice on the possible benefits and consequences of a business entity.