LLC vs.Corporation: everything you need to know
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What is the difference between an LLC and a Corporation?
The first decision to make when creating a new business is choosing the type of business form. Most entrepreneurs choose to form a Corporation or a Limited Liability Company (LLC).
Setting up a business allows you to establish credibility, professionalism and more protection for you and your personal assets.
What does limited liability mean?
Limited liability is a type of protection for your personal property. It ensures that your liability for corporate debts and obligations doesn’t exceed the amount of money you have invested in the business.
This protects your home, car, and other personal assets from being used to pay off debt accumulated by your business.
Without limited liability protection, your home could be used as collateral to pay off corporate debt after a lawsuit or bankruptcy. This is by far the most important benefit you will have if you set up an LLC.
Now that we’ve seen what both types of business forms have in common, let’s look at what makes them different.
LLC vs. Corporation: Tax
One of the differences between corporations and LLCs is how taxes are paid.
Taxes in an LLC
An LLC is taxed as a transfer entity by default. This means that the profits from the business are “passed on” to the owners (called members). Gains and losses are reported on individual tax returns for owners, and not on a business level. As a result, filing taxes is often simpler for LLC owners. Any business operating costs or losses can be deducted on personal tax returns, which can help offset other income.
The rate at which an LLC is taxed depends on the owner’s total income, as it does when filing as a sole proprietor. LLC owners may also be required to pay self-employment taxes. Some states require LLCs to pay a franchise tax. This is a state-issued tax for the privilege of doing business in that state. Franchise taxes are generally paid annually and vary from state to state.
What happens if you don’t pay your taxes? Failure to pay on time or at all could result in penalties and even the involuntary dissolution of your business.
Fortunately, incorporating as an LLC provides flexibility to entrepreneurs. An LLC may choose to be taxed as a Corporation or a C Corporation. While it is a rare option, filing an LLC as a C Corp tax designation makes financial sense for some businesses.
Taxes in a Corporation
Corporations pay taxes as a separate legal entity based on the profits they make.
Corporations are responsible for paying taxes on their profits and taxes on dividends that the company distributes to its shareholders.
Dividends aren’t tax deductible like salaries and bonuses. Dividends are taxed twice. This is known as double taxation. This isn’t a problem for smaller companies where only the owners work for the company. Instead, the owners receive tax-deductible wages and bonuses.
Although double taxation is considered a disadvantage for companies choosing to form as a corporation this additional tax liability can often be offset by federal deductions available only to corporations.
For instance, a corporation can deduct all of its business expenses. These can include advertising and operating costs, as well as some additional employee benefits, such as medical and retirement plans. All of these deductions add up to significant savings over time.
Since 2018, corporations pay a flat 21% tax on their profits, which is lower than the top five individual tax rates. While this is largely offset by double taxation, any income the corporation chooses to keep at the end of the year will only be taxed once at the new 21% rate.
This allows the owners of the company to save on taxes by investing some profits in the business.
LLC vs. Corporation: Business Ownership
Ownership is another important aspect to consider when deciding between setting up an LLC and a corporation. The ownership structure in each is very different, and each has a clear purpose that makes it a little easier to choose the right one for your business.
A corporation can issue shares and sell percentages of the company to its owners, called shareholders. These shareholders can transfer shares, buy more shares to own a larger percentage of the company, or sell shares to own less. If your business is the one that wants to attract outside investors the corporation might be the best way to do this.
A corporation exists separate from its owners, which means that it will continue to exist even if an owner leaves it and disassociates itself from it.
A limited liability company (LLC) is free to distribute its ownership stake to its members regardless of a member’s financial contribution to the LLC. Let’s use the example where a member of the LLC may not have invested as much capital as another member. An LLC operating agreement might specify that all members still receive an equal share of the profits. This creates additional flexibility when establishing corporate ownership.
An LLC can also be owned by foreign persons, other corporations or trust funds. This can make it the right choice for companies in certain circumstances where these factors are important.
The operating agreement of an LLC also describes the details of how membership interest can be transferred between its members, and what happens when a member leaves the LLC.
Unless defined in the prior operational agreement, the LLC dissolves when a member leaves it.
LLC vs. Corporation: Administration
An LLC has a flexible management structure, can be managed by its members or a group of managers, and any member can act as the manager of the LLC. The LLC may also choose not to differentiate between entrepreneur and manager due to its flexible nature, the management of the LLC is less formal, which can make it an ideal entity for some entrepreneurs.
What is the difference between a “manager-managed” and a “member-managed” LLC?
In a member-managed LLC, the owners themselves control day-to-day operations, while a manager-managed LLC generally has investors who don’t play an active role in the business.
The administrative structure of a corporation is much more rigid. A corporation must have a formal structure with a board of directors that takes care of administrative responsibilities and generating profits for shareholders. Corporate officers are assigned to manage the day-to-day operations of the company.
Shareholders are considered to be owners of the company, but remain separate from business decisions and the day-to-day operations of the company (with the exception of approving key business decisions).
However, shareholders retain the power to elect directors and individual shareholders may be elected as directors or appointed as officers.
The individual rules of any corporation are dictated by its corporate charter, which is a detailed set of rules adopted by the Board of Directors after its incorporation.
LLC vs. Corporation: Formal Requirements
Both corporations and LLCs are required to meet the maintenance and / or reporting requirements set forth by the state in which it was incorporated. This keeps the business in good shape and maintains the limited liability protection gained from its establishment.
Although each state has its own rules and regulations governing both corporations and LLCs, corporations generally have more annual requirements than LLCs.
Corporations must hold a shareholder meeting every year. These details are documented, along with any discussions. Generally, a corporation must also submit an annual report. This helps keep company information up to date with the Secretary of State. Any action or change in business will require a corporate resolution to be voted on in a meeting with the board of directors.
LLCs, on the other hand, have fewer record-keeping requirements than their business counterparts. For example, an LLC isn’t required to hold annual meetings or have a board of directors. While some states still require LLCs to file annual reports, others don’t. Check with your local secretary of state to determine which requirements apply to your LLC entity.
Legal Entity vs. Tax Entity: What's the Difference?
Many new entrepreneurs get confused when it comes to understanding the difference between legal entities and tax entities. Let’s take a moment to see the differences.
A tax entity is the way the IRS views your business. Subsequently, this reflects how your business will be taxed. Examples of tax entities include type C corporations, type S corporations, and single-member companies.
Legal entities have the option of choosing the tax entity they wish to identify with. Both an LLC and a Type C corporation can vote and choose to be taxed as a Type S corporation, even if they are still of different legal entities.
In general, LLCs have more options in choosing a tax entity than corporations. However, legal and tax entities offer benefits that are best consultewith a certified public accountant or attorney first.
LLC vs Corporation: Legal Discrepancies
Both LLCs and corporations provide benefits to their owners when it comes to legal protections, although there are differences between the two and how they are viewed by the justice system.
Corporations have existed since the beginning of American history. For this reason, the corporation as an entity has matured and developed to the point where the laws have become uniform. The courts of the United States have centuries of legal history to help resolve disputes and corporate matters. This creates significant legal stability for companies.
Limited Liability Companies (LLCs) are still considered relatively “new”. Their entity was first recognized in the 1970s as a descendant of the corporate and individual / partnership form.
Due to this dual nature, an LLC acquires the characteristics of both legal entities. However, being a “new” legal entity and having characteristics of both a company and a partnership, regions (states) differ in the treatment of LLCs.
Although most states have similar LLC laws, there are differences that can lead a company to choose to become an LLC in one state and a corporation in another.
Over time, LLC laws will become more uniform across the United States.
For most companies, such discrepancies between state LLC laws should not be an impediment, not to mention that for others, the same discrepancies can be a deciding factor in deciding the type of company.
Is an LLC a corporation?
An LLC isn’t a type of corporation. Indeed, an LLC is a unique hybrid entity that combines the simplicity of a one-man firm with the liability protections offered by starting a corporation.
Both corporations and LLCs each offer their own benefits, providing protection for the property of their owners