When it comes to choosing a legal entity for their business, almost all small business owners choose either a limited liability company (LLC) or a corporation (Inc.).
But which one should you choose? Understanding the differences between an LLC and a corporation can be overwhelming, especially if you’re just getting started. Say you own a flower shop. You know you want to call your company My Flowers. But will it be My Flowers LLC or My Flowers Inc? How do you decide which entity type is the right one for your business? You begin by understanding the differences between an LLC and a corporation.
To make the right decision for your business it is important to understand how LLCs compare to corporations when it comes to taxation, liability protection, management structure, ownership, and compliance requirements. As you will see, there are similarities and differences between corporations and LLCs. And the business structure that’s right for you will depend on many factors.
Inc. vs. LLC: Separate entity status
“Inc.” is short for “incorporated”, and it is the abbreviation that is often used to indicate that a business is a corporation. (Example: Time Inc.) When you incorporate a business, you evolve from a sole proprietorship (if you are the only owner) or general partnership (if you have co-owners) into a company that’s formally recognized by its state of incorporation.
In other words, it becomes a legal business entity of its own — separate from the individuals who founded it and the shareholders who will own it over the course of its existence.
“LLC” stands for “limited liability company”. (More on liability and liability protection later.) Similar to a corporation, when you form an LLC, you are forming a company with its own legal existence — separate from its founders and members (as the owners of LLCs are called).
It’s important to remember that whether you incorporate (i.e., form a corporation) or form an LLC, it is the corporation or LLC that owns the business.
When it’s important to have a separate legal entity, both entity types come out even.
Inc. vs. LLC: Formation
There are similarities and differences in how you form a corporation vs. forming an LLC. Both require filing a document with the Secretary of State (or whatever the business entity filing office is called) in the state that you choose for your home or domestic state. You then have to draft bylaws for a corporation and an operating agreement for an LLC.
A corporation files a document called the Articles of Incorporation, which can be used to opt out of or change certain statutory requirements that the corporation will be subject to otherwise. Also, certain governing provisions have to be included in the articles to be effective.
The document filed by an LLC is called the Articles of Organization, which contains less information than is required for a corporation. The operating agreement covers almost all the provisions for how it will be managed and the rights, duties, and liabilities of members and managers.
Both the Articles of Incorporation and Articles of Organization are public documents. Corporate bylaws may be required to be in the public records. The LLC’s operating agreement is not public.
If you want less information about the business’ internal affairs available to the public, then the LLC would win this round.
Inc. vs. LLC: Limited liability protection for owners
One of the main reasons to form a corporation or LLC for a small business is to avoid personal liability for the business’s debts. As we mentioned earlier, corporations and LLCs have their own legal existence. It’s the corporation or LLC that owns the business, its assets, debts, and liabilities. The liability for shareholders (owners of a corporation) or members (owners of the LLC) is limited to their investment.
Limited liability rules for shareholders and members are well-established and respected. But it is still possible for shareholders and members to be held personally liable. Owners are still liable for their own wrongdoing — such as if they breach the operating agreement. And owners can be liable for certain activities if there’s a statute that imposes liability on those activities.
In fact, members and shareholders can still be held liable for their company’s debts under a legal concept known as “piercing the corporate veil”. Veil piercing is a remedy in which the courts will disregard the corporation or LLC’s separate existence. With the entity no longer in the picture, the shareholder or member becomes liable for the business’s debts.
In deciding whether to pierce, the courts apply various tests. One of the most frequently used tests looks for two things: 1) “a unity of interest” between the corporation or LLC and its owners such that their separate identities cease to exist, and 2) that the corporation or LLC was used to perpetrate a fraud or achieve an inequitable result.
What the unity of interest test basically asks is whether the shareholders or members respected the fact that the corporation or LLC owns the business. There are a number of factors the courts will look at including whether the corporation or LLC was undercapitalized, if the shareholders or members used the business’ asset for personal purposes and whether there was a failure to follow compliance requirements.
In this Inc vs. LLC, they can be judged even.
Inc. vs. LLC: Taxes
How LLCs are taxed
An LLC is a pass-through business entity for federal income tax purposes. That means it does not have to pay federal income tax. Instead, its profits and losses go straight through to the owners. Business income equals personal income, so the owner pays the tax on his or her personal return, and it's taxed at the individual rate. Since only the members pay tax, there is a single level of taxation.
While a single level of taxation is a good thing, it doesn’t guarantee that being taxed as an LLC is better for you. In some circumstances, LLC owners can earn a substantially increased tax bill through the addition of the self-employment tax, currently at 15.3 percent. And it can also depend upon whether the corporate or personal income tax rate is higher and what exemptions and deductions the owners are entitled to.
Pass-through taxation is the default rule. If you do nothing, your LLC will be taxed as a partnership under Subchapter K of the Internal Revenue Code. This is the case when you have more than one member, or your LLC will be disregarded completely for income tax purposes if you are the only member.
But if it is to your LLC’s advantage to be taxed as a corporation, you have that option. You can file Form 8832 “Entity Classification Election” with the Treasury Department, and your LLC will be taxed as a corporation under Subchapter C. Then, if you so desire, and if your LLC qualifies, you also have the option to make a further filing to be taxed under Subchapter S.
How corporations are taxed
For corporations, there are two kinds for income tax purposes.
- C corporations—so named because they are taxed under Subchapter C of the Internal Revenue Code (IRC). C corporations are subject to double taxation.
- S corporations—so named because they are taxed under Subchapter S of the IRC. C corporations are subject to double taxation. S corporations are subject to a single level of taxation.
When you incorporate, your corporation, by default, will be taxed under Subchapter C. Your corporation is a separate taxable entity with the business’ profits and losses taxable to the corporation, not to the owners. As a result, corporations are taxed at the corporate rate. Then, if the corporation distributes its profits to the shareholders, say in the form of a dividend, that is income to the shareholders which they have to report on their personal income tax return. It's a double tax, and it can seriously cut into the real dollars earned in the end.
However, if your corporation qualifies, you can choose to have it taxed as an S corporation. An S corporation is a pass-through tax entity. Although S corporations and LLCs have that in common Subchapter S has several restrictions that LLCs taxed as a partnership or disregarded entity are not subject to.
In order to be eligible to make an S corporation election—and to continue to be an S corporation—the corporation must meet strict requirements on the number and type of shareholders and types of shares. These rules are imposed by federal tax law, and not state corporation law. Briefly stated, these rules include the following:
- Only individuals, U.S. citizens or residents, certain estates and trusts, and certain tax-exempt organizations can be shareholders
- There cannot be more than 100 shareholders (although some family members can be counted as a single shareholder)
- There can only be one class of stock (although differences in voting rights are permitted)
Both LLCs and corporations (C corps and S corps) have their own tax advantages and disadvantages. Read more about the taxation implications of LLCs and corporations.
