When starting any new business, the owners will need to decide under which type of entity the business will operate. While there are several choices such as sole proprietor/DBA, LP, PC, PLLC or Not-For-Profit, it is likely that this choice will boil down to two common entities: a Corporation or Limited Liability Company (LLC).
There are two ways to look at the differences between these structures
1. Differences in Formation Process and Management: the way the company is registered with the State registry and how it operates
2. Tax Differences: how the IRS and State tax departments classify the company.
First, let’s review similarities between the two types. Then we’ll examine formation process and structure differences, which are a little more cut and dry. Finally we’ll touch on tax differences.
First, the formation of both Corporations and LLCs provide owners with limited liability protection. Limited liability protection is very important, and provides that business owners are not liable for the debts, obligations and liabilities of the company. This is the most common, and most valuable, reason to form a Corporation.
Second, both a Corporation and an LLC create an entity which is legally separate from its owner. This will also have its own Federal Tax ID number.
Third, in the case of an LLC and a Corporation (which elects S-Corporation status), both entities will enjoy the benefit of pass-through taxation. “Pass-through” taxation means any income produced by the organization will not be taxed at the company level but is “passed through” to the shareholders or members of the organization. This means that any income (or losses) will be reflected on the owners’/members’ individual tax returns.
Finally, both types of entities will most likely have annual state filing requirements due to the Department of State in the form of an annual report, along with associated filing fees. Please note that all states differ in the annual filing requirements and associated costs.
The formation fees and initial requirements can be quite different for Corp vs LLC. Most states do not charge the same fees to file the Articles of Organization for an LLC as they do to file the Certificate of Incorporation for a Corporation.
Further, signature requirements may be very different. For example in South Carolina the Certificate of Incorporation for a Corporation must be signed by an attorney. There are also states that have mandatory newspaper publication requirements which apply to newly formed companies. LLC’s are required to publish in Arizona, Nebraska and New York; while Corporation’s are required to publish in Arizona, Georgia, Nebraska and Pennsylvania.
A Corporation commonly consists of the shareholders (owners of the company) that elect a board of directors (key decision makers) who elect the officers (President, Vice President, Secretary & Treasurer) who handle the day-to-day operations of the Corporation
An LLC commonly consists of members (like the shareholders of a Corporation) who elect managers (like the officers of a Corporation) to handle the day-to-day operations of the LLC. In both entity types, common with smaller companies, all positions may be held by the same person. The management structure rules, voting rights, election, etc., are designated in the Bylaws (for a Corporation) and Operating Agreement (for an LLC).
Corporations are required to adopt Bylaws, issue stock, keep stock ledgers, hold annual meetings of the directors and shareholders and keep records of these meetings. If a Corporation does not follow these requirements it could lose its personal limited liability protection advantage.
While LLCs do not have these annual requirements it is highly recommended to adopt an Operating Agreement, issue membership certificates, keep membership ledgers and hold annual meeting of members and managers and keep records of these meetings.
Of all the differences between Corporations and LLCs, it is taxation that is likely the most important. It can be the difference between saving or paying thousands of dollars. Corporations are initially taxed as a regular corporation (formally C-Corporation), unless they elect S-Corporation status.
The biggest difference is between a C-Corporation and an S-Corporation is that an S-Corporation has “pass through” taxation. This enables S-Corporations to avoid taxation at both the corporate and personal levels, regularly referred to as “double-taxation.”
However, there are restrictions with electing S-Corporation status. S-Corporations have restrictions on who can be shareholders, they cannot have more than 100 shareholders and S-Corporations can issue a single class of stock only.
Flexibility and Tax Implications
One reason the LLC structure has become increasingly popular is due to its inherent flexibility. For instance, an LLC can elect to have officers and a board of directors, as a corporation does. Further it can elect to be taxed as a C-Corporation or S-Corporation in order to take advantage of various tax savings while maintaining the annual filing and record-keeping requirements of an LLC.
Additionally, an LLC can elect S-Corporation status and avoid paying self-employment taxes on profits above a reasonable salary.
Leverage Your Team
Due to the myriad structural, reporting and taxation factors, it is important that any business owner obtain legal and tax counsel when considering these types of decisions.
These professional advisors have knowledge of your personal and business situation and are best equipped to offer recommendations best suited for your specific situation.