When business professionals want to know the legal differences between a limited liability company (LLC) and a corporation, the underlying issue is which entity will benefit the business most. This is a complicated question that will depend on your business plan and issues like tax obligations, asset protection, foreign investment needs, and much more.
It is imperative that businesses choose the right structure when forming a business since it is a known fact that switching from one entity to another is generally a difficult thing to do. In other words, it is important to make the right decision the first time when choosing a business structure, as it is often the only chance the business will have to get it right.
Since two of the most common business structures are LLCs and corporations, this article will serve to highlight the key differences between these structures, helping you best determine which entity is ideal for your business.
While the word "corporation" is not found within the phrase "limited liability company," know that the requirements of forming an LLC are of substantial similarity to corporations. That said, an LLC is actually a hybrid legal entity that bears characteristics of both a corporation and a sole proprietorship/partnership (depending on the number of business owners).
An LLC is unique when compared to corporations in that the owners of an LLC are its members. This effectively gives the LLC freedom to distribute ownership stakes to members without concern for any member's particular financial contributions to the entity itself. In contrast to an LLC, a corporation is owned by shareholders, meaning that it is a legal entity wholly and separately distinct from its owners.
While this language is certainly complex at first glance, the reality is that an LLC is protected from liability in much the same way that a corporation is protected from legal liability. This is where the "limited liability" terminology comes into effect. However, the LLC is taxed as if it is an unincorporated business, meaning that business and income losses can be passed on to the owners for reporting on their individual tax returns.
Note that an LLC's business and income losses pass directly to owners, whereas a corporation's profit is taxed via a "corporate tax," and then shareholders are taxed as individuals after receiving dividends.
To demystify these admittedly broad and complex concepts, breaking the topic down into subsections will prove fruitful to set out the distinct and meaningful differences between these business structures.
Legal classification refers to how a business is viewed by the government, business contractors/partners, and the court system in the event that a legal dispute arises.
Tax classification, however, refers specifically and exclusively to how the Internal Revenue Service (IRS) and state tax boards view the business.
A corporation, as a legal entity, will also then be given a designation as a tax entity (either an S corp or C corp designation). Alternatively, an LLC chooses its tax identity. This degree of choice empowers an LLC to choose a tax structure that is most beneficial to its members, but this does not always mean that an LLC is ideal.
One of the key downsides to a corporation at first glance is the double taxation issue. As hinted at in the initial section on LLC and corporation differences, a corporation can be taxed traditionally as a C corporation.
For C corporations, the corporation will pay corporate taxes on its profits as a legal entity. Then, shareholders may receive dividends from the profits, and those individual shareholders will then be obligated to pay personal income tax on those dividends. For many reasons, this can be a disadvantage, which is why so-called S corporations are often preferred.
S corporations will not pay corporate income tax as C corporations are required to do. For these corporations, all corporate profits pass to the shareholders, who then pay personal income tax on those profits. This is a concept known as pass-through taxation, which again can also be an advantage enjoyed by an LLC.
There are many advantages to this form of corporate structure, but corporations can be excluded from classifying as an S corp if:
The tax implications of an LLC, again, involve a great deal of choice and flexibility. Since single-member LLCs are treated as sole proprietorships and multi-member LLCs are treated as partnerships, all LLC income and expenses are included on members' personal income tax returns. Given that the members have already paid tax on their share of the profit, the LLC can choose to be taxed as an S corp or C corp.
Why would an LLC want to be taxed as a C corp? There are a number of good reasons. Suppose, for example, that the LLC plans to do business with foreign investors. Given the S corp limitation on foreign shareholders, it would make sense to instead take the "double taxation" hit and choose to form as a C corp.
Alternatively, suppose owners work in the business as well. In such a case, it traditionally makes sense to legally incorporate as an S corporation and not an LLC to take advantage of the self-employment tax savings offered by S corporations.
These are the types of legal issues that should be considered when choosing whether to form a corporation or organize an LLC by way of an LLC operating agreement.
While tax implications are often a primary concern for most businesses, there are many other factors that deserve significant consideration. One prominent example is asset protection.
Depending on state law, LLC assets can be given what is referred to as "charging order protection," which means that if a business owner is sued, those pursuing assets may only receive a lien to the LLC's distributions itself. Some states even have this protection in place for a single-member LLC that is treated as a sole proprietorship, but more commonly, the LLC must have at least two owners. Still, it should be noted that some states, like California and New York, have the authority to compel a sale of the business assets, so this protection does not apply nationally.
C and S corporations, alternatively, provide a clear delineation between corporate ownership and management. This means that the corporation will receive personal liability protection from any liabilities the corporation incurs. This, however, does not mean individual shareholders will not be liable for financial contributions and investments to the corporation, but these shareholders' personal assets will also typically be given protection.
This same protection is also usually afforded to corporate management as well. However, suppose you are sued and are a legally responsible party in an accident. In the event that you own shares in the corporation, those shares can be reached by a judgment creditor in the vast majority of states, which is an important limitation to keep in mind.
An LLC is generally, but not always, the best entity of choice when foreign investments will play a significant role in the business. Since the LLC is flexible with the possibility of pass-through taxation and also capably protects assets as described above, foreign investors will typically be more attracted to an LLC entity structure.
Recall, as well, that an S corporation is the only United States entity structure that is not capable of being used by a foreign investor. As such, the S corporation is removed from consideration by default for any business that plans on courting foreign investments. C corporations, however, provide meaningful benefits for foreign owners, particularly in nations like Canada that have similar tax structures.
That said, an LLC can choose to be taxed as a C corporation, thereby providing the same C corporation benefits in addition to the easier taxation management that is generally true of an LLC.
An additional and often overlooked benefit of an LLC is the flexibility of management. In a corporation, management teams and directors will be tasked with overseeing daily operations, but these formalities are not needed for an LLC.
Another important consideration is the legal status of both LLCs and corporations. It is helpful to understand that, in comparison to corporations, an LLC is a relatively new entity. Corporations have existed around the world for literal centuries, whereas the LLC has been around for just decades in comparison. This does not mean the LLC is anything to shy away from as a general rule for its sheer novelty, but this does mean that the treatment of an LLC is more state-law driven and less uniform than laws on incorporation.
Over time, it is likely that laws concerning LLCs will become more uniform, but for the time being it is important to carefully consider the laws of your specific state before making headwind on an LLC operating agreement.
Sure, corporations have existed for centuries, but this does not mean that a corporation is right for you simply because laws concerning corporations are more uniform and ironclad. As discussed, corporations come with real disadvantages that may make them entirely untenable for your business.
Instead, gather valuable information in the pursuit of answering key questions about whether an LLC or corporation is best for your legal needs. To this end, our LLC operating agreement help guide will help you fully decide whether an LLC is ideal for your business.
As stated at the outset of this article, this is a legal decision that is not to be made lightly. One chance is typically all that is allotted for this lasting and crucial question for your business.
If you are having difficulty weighing the competing and complex factors of a multivariate analysis regarding your business plan, LegalNature is here to help.
We provide legal products and documents that are fast, reliable, easy, and designed to cover all bases for your business formation needs. Our business products and plans will help you with either articles of incorporation or LLC articles of organization, depending on what is the best fit.
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