Everyone loves to give advice to new business owners. One common piece of advice goes like this: "Don't form an LLC. Form a corporation." Or, "Corporations are too complex. Just form an LLC." Confused? Let's sort out the differences between an LLC and a corporation so you can decide which business type is best for your business.
This article gives you some information on differences and similarities between LLC and corporation business forms.
Why Is an LLC NOT a Corporation?
There's no such thing as a "limited liability corporation." An LLC is a limited liability company. It's not a corporation, and you don't incorporate a business as an LLC. Both register with a state, but an LLC doesn't "incorporate."
Corporations, LLCs, and Limited Liability
Both corporations and LLCs limit the liability of the investors (owners and shareholders) from the debts of the business and against lawsuits against the business. The concept of limited liability is usually expressed by stating that liability is limited to the extent of the person's investment.
Both business types must work to keep their operations separate from the activity of the owners to maintain their liability protection. This is called the "corporate veil," meaning that there is a separation between the liability of the business and the liability of the owners. If a court finds that the operations are not separate, the owners or shareholders can be personally liable for the actions or debts of the business.
First Difference - How the Business is Formed
Business organizations (not including sole proprietors) must register as a specific business type with the state where they do business. All states recognize businesses formed as corporations, limited liability companies (LLCs) or partnerships, or variations of these forms.
Forming an LLC. An LLC is formed by one or more business people, as owners. The owners, called "members," file Articles of Organization with a state. Then they put together a contract called an Operating Agreement to use in managing the day-to-day activities and decide on each member's percentage share of ownership.
Forming a Corporation. A corporation is formed (incorporated) by filing corporate organization documents (Articles of Incorporation or similar) in the state where the corporation is located. The corporation also creates a Board of Directors to oversee the corporate business and the board agrees on bylaws (operating documents).
Second Difference - Business Ownership
LLC's and corporations both have owners, but the form of ownership is different.
LLC members have an equity (ownership) interest in the assets of the business because they have made an investment to join the business.
Corporate owners are shareholders or stockholders who have shares of stock in the business.
How you are paid - and taxed - as an owner of an LLC or a corporation could be a major factor in determining which form of business you choose.
Third Difference - Profits and Losses
The profits and losses of an LLC and a corporation are handled differently. LLC profits and losses are passed through to individual owners, while corporate profits and losses are held by the corporation.
LLCs as Pass-through Businesses. Limited liability companies, like partnerships and sole proprietorships, are pass-through entities. Pass-through businesses are those in which the profits and losses of the business pass through to the owners or shareholders. The owners pay their share of the company's profits on their personal tax return (Form 1040 or 1040-SR).
Corporations as Separate Business Entities. Corporations are separate from the owners. The corporation pays income taxes on its profits or losses, not by the owners directly. Some of the corporation's earnings may be paid to the owners in dividends, but this isn't direct. Some earnings may be kept by the corporation.
Fourth Difference - LLC and Corporate Income Taxes
Corporations and LLCs pay income taxes differently. Both entities pay tax on their profits for the year, called net income for an LLC and net earnings for a corporation.
Corporate Income Taxes
Corporations are taxed at the corporate tax rate, currently 21%.
Shareholders of corporations pay tax on dividends when they receive them.
Corporations are sometimes said to have double taxation because the corporation is taxed on its net earnings and the shareholders are taxed on the dividends from those net earnings.
LLC Income Taxes
Owners of an LLC are taxed like partners in a partnership; that is, they receive a distributive share of the profits each year and pay taxes on that share on their personal tax returns (that pass-through concept discussed above).
For example, if the LLC's net income is $120,000, the members split up the income between them based on their operating agreement. Two owners with equal shares in the business would each pay income tax on $60,000 of net income.
The owner of a single-member LLC reports the business income tax on Schedule C of their personal tax return. Members of a multiple-member LLC receive a Schedule K-1 showing their share of the business income, and they report this income on their personal tax return.
Fifth Difference - Self-Employment Taxes
LLC owners are considered to be self-employed and they must pay self-employment taxes (Social Security and Medicare tax) on their share of the LLC's profit each year.
Corporate shareholders aren't self-employed so they don't have to pay this tax. Corporate owners who also work as employees have Social Security and Medicare tax taken from their paychecks.
|Limited Liability Company vs. Corporation|
|Limited Liability Company (LLC)||Corporation|
|Has limited liability||Has limited liability|
|Formed by state filing Articles of Organization||Formed by state filing Articles of Incorporation|
|Owners are called members||Owners are called shareholders|
|LLC doesn't pay income taxes||Corporation pays income taxes|
|Members pay LLC taxes on personal tax return (Form 1040 or 1040-SR)||Shareholders pay taxes on dividends received|
|Members pay self-employment taxes||Shareholders don't pay self-employment taxes|
A Third Possibility - An LLC Taxed as a Corporation
You might want to consider forming an LLC and then electing to have the LLC taxed as a corporation or S corporation. The S corporation is not formed separately; it's a tax status. It combines the simplicity of the LLC with the tax benefits of a corporation. You would first need to form the LLC in the usual way, then make the election.
Your LLC can elect to be classified as a corporation by completing an election form, Form 8832, and filing it with the IRS. If your LLC wants to be classified as an S corporation, file Form 2553.
To have your LLC taxed as a corporation or S corporation doesn't change the way your LLC does business or how the company is organized as a legal entity; it just changes the way taxes are paid.
There are some regulations and restrictions on filing this election, and it must be completed within a specific time, so get help from your attorney to make sure it's done correctly.
Who Can Help Me Make This Decision?
Still confused about whether to start an LLC or a corporation? It's a complex decision and one you shouldn't make quickly. As noted above, the tax consequences can be a deciding factor. and every business situation is unique. Before you make a decision, talk to two people:
1. An attorney who has experience with both LLCs and corporations. A good attorney will consider LLC's in addition to traditional corporations.
2. A CPA who understands the tax differences between LLCs and corporations.
This article about 7 questions to ask before deciding on a business type might also be helpful.