There comes a time when many entrepreneurs consider turning their small business into a legal entity.
It can be to establish credibility and professionalism, avail of limited liability protection, or a more favorable tax structure.
When that time comes, you can choose between an setting up an LLC, S, or C corporation, all of which offer significant advantages and disadvantages.
Together, we’ll look at how they differ regarding liability protection, formation, ownership, management duties, and taxes so you can choose the proper structure for your business.
LLCs are easy to form; simply select a state, LLC name, and a registered agent, then prepare an operating agreement and file articles of organization with your state.
LLCs are easier to manage with fewer formal annual requirements than a corporation. You can run an LLC yourself or employ someone to manage it for you.
LLCs are pass-through entities meaning owners pay tax on their returns.
Single-member LLCs pay tax as sole-proprietorships and multi-member as partnerships. And LLCs can choose to be taxed as an S or C corporation.
You must file Articles of Incorporation for a C-corporation to form an S-corporation. Then file Form 2553 with the IRS to elect an S-corporation tax status.
Shareholders own S corporations and elect a board of directors to manage the business on behalf of the corporation.
S corporations are pass-through entities and do not pay income tax at the corporate level. Instead, profits/losses of the business pass through to the owners, who report them on their tax returns.
To form a C-corps, you must file articles of incorporation, draft corporate bylaws, and a shareholders’ agreement.
A C-corps management structure includes shareholders (owners), directors, and officers.
C corporations must adhere to numerous federal and state regulations. And pay double taxation, once at a corporate level and again on any profits taken by shareholders.
The 3 main differentiators you need to know about S and C Corporations are formation, ownership, and tax.
Let’s begin with formation:
Limited liability is the fundamental similarity between an LLC and a corporation.
Limited liability aside, LLCs and corporations differ in other ways.
For example, shareholders own percentages of shares of a corporation. In contrast, one or more individuals own an LLC, and corporations have to hold annual shareholder meetings while LLCs do not.
LLCs are also adaptable and can become a corporation later, making an LLC an excellent choice for a start-up business.
Some other ways they differ are:
The limited liability company structure makes life easier for small to medium business owners.
For instance, LLCs are easier to form and have fewer regulatory requirements than corporations. To create an LLC, you choose a business name, select a registered agent, and file articles of organization with your Secretary of State.
Corporations, however, are more complex to form and require more administrative paperwork and an attorney. You create one by filing “articles of incorporation” with your Secretary of State.
LLC owners are members who invest in the business when forming it, owning an equity share. Owners can have equal management rights and control the business’s daily operations.
Corporate owners are stockholders or shareholders who buy stocks or shares in the business, often after its creation.
Corporation shareholders can have varying levels of involvement and control in the daily business operations but often leave it to a designated management team.
LLCs are pass-through entities, which means new business owners get the best parts of a corporation and a sole proprietorship.
The corporation part gives you limited liability protection. At the same time, the sole-proprietorship bit makes paying tax easy as you add any profits on your tax return.
An LLC can have one member similar to a sole-proprietorship or multiple members equal to a partnership.
Corporations comprise shareholders/owners, a board of directors, and a management team. The board of directors often includes inside directors, who control daily operations, and outside directors, who make impartial judgments.
Shareholders must organize the managers and give them responsibilities in compliance with state corporation law.
Your new business management structure is essential to its success, so now you must decide who will manage it and what level of control they’ll have.
And management is where LLCs and corporations become two very different business entities.
Tax is unavoidable; however, different business structures offer various tax benefits that could make paying them much less painful.
The key is choosing an entity that suits your business model.
An LLCs simple tax structure could fit a small to medium size business more than a corporation.
However, a corporation’s tax structure could prove more beneficial for start-ups that require investment with an eye on national growth.
With tax, there’s a lot to learn, and it’s advisable to seek the help of a certified tax accountant to ensure you choose the correct entity for your business model.
That said, here’s a breakdown of how it works:
Business entities that do not pay corporate tax and avoid double taxation are pass-through entities. Structures that avail of pass-through taxation include LLCs, limited partnerships, general partnerships, sole proprietorship, and S corporations.
Instead, business profits pass to the owners/members who pay personal income taxes on their share of income.
Double taxation is when a business pays corporation tax on income and shareholders pay income tax on any dividends (wage) taken on their tax returns.
C-corporations are separate from the owners and the only business entity that pays double taxation.
No, dividends are not tax-free; the tax rate for ordinary dividends ranges from 10% to 37%, depending on an individual’s earnings.
Qualified dividends pay the same tax rate as capital gains tax which is lower than average income tax rates.
Paying steady dividends enables a corporation to show present and future shareholders that the business’s performance and prospects are in good standing, increasing the likelihood of higher investments.
A tax loss carryover is an accounting strategy that enables a business or individual to move a tax loss in one year to offset profits in another, reducing future tax liability.
An NOL is when a business’s allowable tax deductions exceed its earned taxable income within a single tax period. Using the IRS tax carryover provision, you can offset your business tax payments in other periods.
The answer to that question depends on your start-up needs and plans for your business.
To help you choose, here’s the critical difference between an LLC and a corporation.
And that’s a wrap on LLC vs. Corporation, which to choose for your business.
The key takeaway is both structures provide owners/shareholders with liability protection.
However, many small business owners decide to form an LLC because it’s easier to start and run.
Only start-ups that require outside investors or expect to carry over profits year on year (reducing tax liabilities) should consider creating a corporation.
No worries, here are the 7 most popular FAQs:
For small to medium start-ups, the LLC structure is easier and cheaper to register than a corporation, and you avail of pass-through taxation avoiding corporation tax.
Because C corporations pay double taxation, shareholders often pay more taxes than an LLC or S corporation.
S corporation shareholders can pay less tax than LLC owners as they must pay self-employment taxes on the business’s total profits, regardless of whether they take a wage.
Both corporation shareholders and LLC members avail of limited liability protection.
No, they don’t.
Corporations and LLCs can both lose their limited liability protection if found to have acted fraudulently, resulting in breaking the corporate veil.
The corporate veil is the shield of protection between a company’s liability and its owners. It makes the LLC and corporation entities attractive to new business owners.
Apart from breaking the corporate veil, LLC members can be liable for business debts if they sign as personal guarantors or are negligent in their obligations to the business.
Most states allow an LLC to convert to a corporation by filing a statutory conversion with the Secretary of State.
For those states that do not allow conversion, an LLC must merge into or with another corporation.
And you can convert a C corp into an S corp by completing IRS Form 2553 (Election by a Small Business Corporation) and a C corp into an LLC.
The best entity for you depends on your business model and future objectives.
However, there are 3 main things to consider when deciding on an entity; asset protection, business funding, and taxation.
The LLC entity is an excellent option for entrepreneurs who want to keep control of their start-ups and run their daily activities. And when selling a percentage share in your LLC to raise funds for expansion, you can negotiate the terms in your favor.
But when starting a business to maximize profits by expanding and selling equity, a corporation could be the right choice for you.
This portion of our website is for informational purposes only. Tailor Brands is not a law firm, and none of the information on this website constitutes or is intended to convey legal advice. All statements, opinions, recommendations, and conclusions are solely the expression of the author and provided on an as-is basis. Accordingly, Tailor Brands is not responsible for the information and/or its accuracy or completeness.