As an entrepreneur, there are different types of business entities that you can form. In addition to operating as a sole proprietorship or general partnership, you have the option of organizing a limited liability company (LLC), a corporation, or one of the many variations or hybrids of these entities, such as a closed corporation or public benefit corporation.
1. Introduction to Business Entities
As an entrepreneur, there are different types of business entities that you can form. In addition to operating as a sole proprietorship or general partnership, you have the option of organizing a limited liability company (LLC), a corporation, or one of the many variations or hybrids of these entities, such as a closed corporation or public benefit corporation. Today, we’ll focus on a comparison of the two entities that are most commonly selected: the limited liability company (LLC) and the corporation, with and without subchapter S status. For anyone considering their formation, it is important to understand the differences between LLCs and corporations so you can decide which entity is right for your business. The entity you form at the outset could have a significant impact on your liability exposure, tax liabilities, and the general management of your company.
In basic terms, a sole proprietor operates a business of one without the formality of creating a separate business entity. A partnership operates in a similar manner, but involves two or more persons who have a right to participate in the profits and losses of the business. A limited liability company (LLC) is a flexible and unique business structure that, though not without exceptions, may help shield the personal assets of its members from the liabilities of the company. While an S corporation is a legal entity separate from the party that owns and controls it, it allows profits, losses, and certain deductions to be passed through to the tax return of the responsible parties rather than having the company taxed itself. The organization is entitled to indemnify shareholders or officers for costs and judgments arising from legal claims associated with decisions made on behalf of the organization. A corporation may have an unlimited amount of independent individuals and other business entities as its members.
2. Distinguishing Features of LLCs and Corporations
Owners have different motivations and will want to form a partnership, a limited partnership, a corporation, or an LLC. Each entity provides different legal, tax, and business structure features and options. This text will concentrate on the most often used company structure types: limited liability companies (LLCs) and corporations. One reason that LLCs have grown in popularity is that they allow business owners who form the LLC to structure the management and formalities of the business in a different way than what is normally required of a corporation. The other reason that LLCs and corporations are the most common ways to structure a company is that they provide personal liability protection.
In considering forming a company, business owners often wonder what the difference is between an LLC and a corporation. In reality, there are many differences. Here are the highlights: LLC – (a) flexibility in management and management types (managers run, members micromanage), (b) tax options to be an ‘S’ corporation for tax or retain profits, (c) a multi-member LLC is formed by a members’ agreement, (d) annual filings, and (e) sign contracts, but record keeping is simpler. Corporations – (a) lots of formalities – like mandatory board meetings, (b) personal liability protection, (c) easy change of ownership (sell stock), and (d) can be ‘S’ or ‘C’ taxed based upon profit distribution options. Two of the more important differences between a corporation and an LLC are tax and personal liability protection.
The personal liability protection of both corporations and LLCs is pretty much the same; if sued, the plaintiff can take your investment in the company’s shares or partnership interests or the perquisites you were taking out of the company business. They can’t come after your physical assets like your house or bank account. This feature is quite different from being a sole proprietor or half owner of a general partnership. On the other hand, corporations can be owned and managed by one family or a small number of people, and the company is separate from the shareholders’ personal bank accounts and homes. The owners are not considered acquirers of the company’s debts. The profits of a corporation may be subject to income taxes or none, depending on some choices the business makes. An LLC is also considered a separate entity from the member owners, but the LLC has the option of being taxed at the individual rate, called a pass-through tax. If the LLC doesn’t make that election, they are taxed as a corporation. Purchasers of a member’s portion of the LLC need to discuss an operating agreement, and any kind of inherited potential liabilities become very clear in the operating agreement as well.
3. Comparing S Corporations and C Corporations
Two main types of corporations exist under IRS tax rules: S corporations and C corporations. In general, the big difference between an S corporation and a traditional C corporation is the way they are absorbed from a fiscal perspective. Most business owners are LLCs or small business corporations owned by stock. In C corporations, profits are taxed at the corporate level, usually around 21%. In addition, if any profits are distributed to shareholders as dividends, the dividends will also be taxed at the shareholder level. This is what is called double taxation. People tend to shy away from forming C corporations because it doesn’t make much sense to pay tax on the same profit twice.
Profit taxation is the main difference between an S corporation and a C corporation. S corporation profits are passed directly to the shareholders, who then report the profits on their personal tax return. Any tax due is paid on the shareholder’s personal income tax return, avoiding double taxation. The profits and losses of a C corporation belong to the corporate entity. They can choose to distribute the earnings to their shareholders as dividends. If the corporation chooses to retain profits, they reinvest those earnings back into the corporation. The choice to distribute earnings or to reinvest them is totally up to the corporate owners. Therefore, the decision of whether to retain or distribute earnings can add a layer of tax planning complexity to a C corporation.
4. Factors to Consider When Choosing Between LLC and Corporation Structures
Small business owners must carefully consider several factors when choosing between LLC and corporation structures. The nature of a business can be a crucial factor. For instance, some businesses require special permits. In such a case, a standard corporation structure might be the best choice. A primary concern for entrepreneurs looking to buy a franchise might be the structure that they would be allowed to use – some franchises require franchisees to use an LLC structure. The formality and nature of management desired, as well as the potential ability and desire to grow, are also considerations.
Owners of a promising start-up tech firm are advised to start as an LLC to save on taxes. All profits earned by an LLC flow directly to the owner’s tax return at much lower tax rates than with a corporation. All net income flows through to the entrepreneur at preferential rates. While most corporations will lose money in the initial years, a small business will often show profits early in the business. Corporations show a profit later in their business cycle. In short – for a tech company, start as an LLC and convert to a corporation just before selling.
5. Benefits of Hiring a Professional for Business Entity Selection
Selecting between an LLC or a corporation is a complex decision that impacts your liability, taxes, reporting requirements, levels of control, and many other issues. Because you will receive specialized advice from a business attorney or an accountant, you can expect them to be intimately familiar with the legal and tax differences between operating as an LLC and as a corporation. Furthermore, they will be able to consider how the combination of these differences will affect your unique situation and provide tailored advice based on several additional factors. These factors include the total investment required, your ability to pay any taxes out of your own pocket, and the level to which you strive to build and protect your reputation and your company’s assets. By seeking the help of someone who is experienced in business entity selection, you will be more likely to comply with all the technical legal and regulatory issues that come with your choice between an LLC or a corporation, and having someone around who has filed countless times before will save you a significant amount of time, as they’ll be able to complete the process quickly and perfectly the first time. Hiring an expert to complete the work of entity selection can significantly reduce the chances of common mistakes occurring when a business owner attempts to do it alone. Finally, because of their familiarity with either entity structure and with your unique situation, a professional is more likely to provide you with a sense of clarity and peace of mind as you continue to grow and evolve your business.
