Many business owners create separate legal entities for their businesses for taxation and liability purposes. Additionally, creating a separate legal entity for your business helps protect your individual assets from exposure to the company's debts and obligations. In order to make an educated decision on how to structure your business, it is important to understand the differences between business entities such as a Limited Liability Company (LLC) and a corporation.
LLCs and a corporations have different taxation calculations, structures, and reporting standards. This article will help business owners become familiar with the key differences between the two in order to help you decide whether an LLC or a corporation is best-suited for your business.
What is an LLC?
An LLC affords its owner limited liability and shields a business owner's personal funds from his or her business obligations. An LLC's structure can be fluid. Any member who split the LLC's ownership interest can be listed as an owner of the LLC, based on ownership percentage. However, the transfer of ownership interest requires approval from all other owners of the business. As a result, attracting investments to an LLC may require a longer approval process.
When it comes to taxation and reporting, LLCs enjoy flexibility in how they are taxed and may benefit from pass-through taxation. Pass-through taxation happens when a business' income is categorized as personal income and the business owner only has to pay taxes on the income once. This is an LLC's distinct advantage as the owner of a corporation often has to pay taxes on the business income in addition to his or her own personal income.
What is a Corporation?
Corporations have a set of rigid structure and enjoy perpetual life, meaning that it is relatively easy for a corporation to exist long after the original owners have left or passed away. Corporations have more stringent requirements regarding formation, which include having a board of directors, holding board meetings, and adhering to extensive recordkeeping requirements. The owners of corporations are known as shareholders and it is relatively easy for shareholders to transfer their shares to others. As such, corporations make easier investment targets as investors are able to simply exchange capital for shares of ownership. It is also easier for investors to sell their ownership interest later on to someone else. For this reason, many venture capitalists and other investors will only invest in companies that are corporations.
When it comes to taxation, corporations are taxed as either S Corporations or C Corporations. Shareholders of S Corporations are eligible for pass-through taxation as corporate profits are passed onto shareholders' personal tax returns. However, not all corporations qualify to be taxed as an S corporation. Corporations that have more than 100 shareholders might include shareholders who are corporations themselves, partnerships, or non-resident aliens subject to different taxation requirements. Additionally, certain shareholders might have different classes of stock that are not eligible to be taxed as an S Corporation and must be taxed as a C Corporation. C Corporations are required to pay a corporate income tax on their profits, and shareholders must pay income tax on the earnings they receive from the corporation.
Why choose an LLC?
Small businesses that are managed directly by their owners benefit the most from structuring their business as an LLC. An LLC offers the business owner tax benefits and limited liability protection without the rigid requirements of a corporate structure. Additionally, the relative difficulty of transferring ownership interests makes it difficult for a hostile takeover.
Why choose a Corporation?
Businesses that are looking for outside investors should establish a corporation due to the fluid transferability of shares. Corporations and their shareholders can benefit from pass-through taxation if they meet the requirements of an S Corporation. Business owners who are looking to go public in the future should also consider structuring their companies as corporations.
Making a Decision
Deciding what type of business entity is right for your company comes down to the balance between the tax benefits, ease of ownership transferability, and reporting and structure requirements. LLCs can offer tax benefits and greater flexibility; however, they are not attractive to most outside investors. S-corporations offer tax benefits and ease of ownership transferability, but place corporate requirements and restrictions on shareholders. Owners of C-corporations are subject to "double taxation" in addition to corporate requirements, but in exchange they offer the greatest flexibility for shareholders. Initially, the tax benefits of an LLC can lead many business owners to make the decision without much thought; however, this can be problematic for a business looking to expand and secure additional capital in the future. On the other hand, business owners may underestimate the hassle and cost of a formal corporate structure.
Speaking with an experienced attorney and an accountant is the first step in determining what business entity is right for your company. In order to fully understand the advantages and pitfalls of each entity type, be prepared to discuss not only the current details of your business, but also your vision for the company's future.