LLC vs Corporation - All You Need to Know
14 November, 2019
If you are about to start your own business, then you will be faced with a decision of choosing the entity type. And before you decide that the decision is not that important to focus on, you need to read this blog. There are a lot of things that come under choosing an entity such as, the way the entity is taxed and so on. With this clear, there are two main entity types that are always chosen by many business owners. This includes an LLC and a corporation.
In fact, you might have seen business names that have abbreviations like INC and LLC at the end. And the "LLC" stands for a "Limited Liability Company," while the "Inc." or "Corp." stands for a corporation. As a matter of fact, both of these entity types are formed by filing the form to the state and both offer the owners with limited liability for their business. But there are a lot of other things that make them different.
Let us get deeper into this to understand it better. But before we can talk about the difference, let us understand some basic things.
What Is Limited Liability?
Limited liability is the kind of protection where you do not lose your personal assets if the company is attacked or sued. With this, you are ensured that the business obligations and business debts are not more than the amount you invested in the company. In short, with limited liability, your automobiles, home, and any other asset would be protected from any debt that you business encounters.
Without the limited liability protection, your home can be used as collateral to repay the debt of the business even after a bankruptcy or lawsuit. That is why this is one of the greatest benefits that you can get from an entity. And this is something common for both business entities.
Legal Entity vs. Tax Entity
Another thing that a lot of new business owners are confused about is the difference between the tax entities and legal entities. So, let us talk about these as well. The IRS sees your business as a tax entity and it lets the IRS know how you will be taxed. The tax entities include sole proprietorships, S Corporations, and C Corporations.
On the other hand, the legal entities are the business structures and these entities have the right to be identified as which tax entity would the IRS view them as. Both the LLC and corporation can file to be viewed and taxed as an S Corporation. You will understand this in detail below.
Now that the main terms are clear, let us talk about the main differences between an LLC and a corporation for each topic as shared below.
By default, the LLC is normally taxed as a pass-through entity. So, whatever the company earns as profit is "passed through" to the owners, who are also called the members of the LLC. This means that the losses and profits of the owners are reported on the personal tax return forms and not on the corporate level. This makes filing taxes easier for the LLC owners. In fact, if there are any operating costs or losses in the business, all will be deducted on the personal tax returns.
But the income tax rate for an LLC is based on the total income earned by the owner just like it is for a sole proprietor. Additionally, the owners would also have to pay self-employment taxes while some states require LLCs to pay a franchise tax, which is a tax paid to the state for being allowed to do business in that state.
A corporation is taxed as a separate legal entity and is responsible for paying taxes on the profits they make. Along with this, the shareholders also have to pay tax for the dividends they get. And since the dividends are not tax-deductible (like bonuses and salaries), they are taxed twice. The situation here is called double taxation. Just to be clear, this is not an issue for the small corporations where the owner works for the company and receives a salary that is in turn deductible.
And while double taxation is considered to be a demerit for a business that wants to file as a corporation, this additional tax responsibility can often be offset by federal deductions that are only available to corporations. For instance, a company can easily deduct all its business expenses. This could include the amount used for operating and advertising. Additionally, they can also deduct the expenses used for the medical and retirement plans. All these deductions would add up to substantial savings over time for the business.
In fact, the corporations have to pay just 215 of tax on the profits that they earn, which is much lower than what others pay. And this helps the double taxation a bit. Other than this, the C Corporation can easily apply to be taxed as an S corporation. But for this, the corporation should have only about 100 shareholders. Once approved, the C corporation would be taxed as an S corporation.
S Corporation Taxes
As mentioned above, the LLC does enjoy pass-through taxation benefit but the profits that are distributed in an LLC is subjected to the employment tax, unlike the S corporation's dividends. That is why it is better for the LLC to elect to be taxed as an S corporation. Nonetheless, there are many drawbacks of the S corporation that can affect a small business from taking huge advantages. That is why it is better to take the help of a professional before making a decision.
The next difference between the LLC and a corporation is in the structure of the ownership. Both have different structures for ownership. But both of them have a clear purpose that also makes selecting the right entity a bit easier. To be clear, a corporation can easily issue shares of stock and sell percentages of the business to its owners (based on how much the person has added into the business), which are called the shareholders of the company.
Furthermore, the shareholders can easily transfer the shares and purchase more stock to own a larger part of the company. They can then even sell off the stock to own less based on their choice. In case your business wants to attract investors from outside, a corporation is the best choice for you.
On the other hand, the LLC has more freedom to distribute its stake to the members regardless of the financial contribution of the member to the LLC. Not just this, the LLC can also be owned by foreign individuals, any kind of trust or other individuals. So, if these are the conditions for you to start a business, then an LLC is the right choice for you.
Talking about management, an LLC has very flexible management. This means that the company can be managed by either one manager, a group of managers or by the members of the company. In fact, the LLC can also elect to have no distinction between the manager and the owner. And this kind of flexibility in the management makes an LLC is less formal.
Just to explain better, in a member-managed LLC, the owners are the ones who take care of handling the day to day operations. On the other hand, in the manager-managed LLC, the investors sit on the sidelines and do not have an active role in the company.
In a corporation, the management is a bit stricter. The corporation needs to have a much formal structure with the board of directors who handle the overall management and profit generation of the company. Furthermore, corporate officers have to handle the day to day operations of the company. And the shareholders are kept aside when it comes to business decisions even if they are considered as the owners of the company.
Nonetheless, the shareholders have the power to elect the directors. They can even select one of the shareholders to be the directors of the company or appointed as an officer. The rules of the corporation are dictated by the company bylaws that are prepared by the Board of Directors when the corporation is formed.
Both the LLC and the corporation has to fulfill maintenance and reporting requirements based on their state's needs. With this, the business stays in good standing and the Limited Liability Protection is maintained. Even though every state has its own requirements, the corporation usually has more annual requirements as compared to the LLC.
As explained above, both the LLC and the corporation are great choices. But they have their own little differences which matter a lot based on your plan for your company. So, choose wisely!
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