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ComplianceLegalAugust 01, 2023

LLC vs. Inc: Understanding the differences between an LLC and a corporation

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When it comes to creating 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? It can be difficult to understand what the differences are between an LLC and a corporation, 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 looking at what an LLC offers versus a corporation when it comes to things that matter most to you and your business.

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 more than one factor.

Inc. vs. LLC: Both offer separate entity status

If you are looking to have your business be a separate legal entity, both “Inc.” and “LLC” provide this feature. 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. 

What is an “Inc.”?

“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 sole owner) or general partnership (if there are 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.

What is an “LLC”?

“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). 

Inc. vs. LLC: Similar formation processes

The steps and requirements to incorporation (forming a corporation) versus forming an LLC are mostly similar. LLCs and corporations 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
  • creating a legal document that provides a basic framework for how the business should operate 

To form a corporation, a document called the Articles of Incorporation filed with the state. The articles can be used to opt out of or change certain statutory requirements that the corporation will be subject to otherwise. Certain governing provisions also have to be included in the articles to be effective. After the Articles of Incorporation are issued by the state, an organizational meeting is held to adopt the corporate bylaws. These bylaws govern the internal management of a corporation and the rights of the shareholders. (Nonprofit bylaws are often referred to as resolutions.)

The document filed by an LLC is called the Articles of Organization, which contains less information than is required for a corporation. The owners (or members) of the LLC should also create an operating agreement that covers the main provisions for how the LLC will be managed and to clarify 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 does not have to be filed with the state and made public.

If you want less information about the business’ internal affairs available to the public, then an LLC may make more sense than a corporation.

Inc. vs. LLC: Both offer limited liability protection for owners

One of the main reasons for a small business to form a corporation or LLC 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 the 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, LLC members and corporation 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 separate existence of a corporation or LLC. 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. 

Inc. vs. LLC: Varying tax advantages and disadvantages 

Both LLCs and corporations (C corps and S corps) have their own tax advantages and disadvantages. 

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)

For more information, see Taxation implications of LLCs and corporations.

Incorporation Wizard

Inc. vs LLC: Similar post-formation compliance obligations

Both LLCs and corporations have certain obligations they must meet in order to stay in good standing in their formation states. These include filing an annual report, paying franchise taxes, and appointing and continually maintaining a registered agent and office (more on those requirements below).

  • An annual report is a report with information about the company, including its name, principal office address, name and address of its registered agent, and names and addresses of its managing officials. In some states this is a biennial requirement instead of an annual requirement.
  • A franchise tax is a state’s fee for allowing a company to exist and do business in the form of a corporation or an LLC and all the advantages that brings, like limited liability.

There are penalties for failure to file an annual report or pay franchise taxes, such as loss of good standing status, which can eventually lead to administrative dissolution. This applies to both corporations and LLCs.

In order to remain in good standing, LLCs and corporations have to meet post-formation compliance obligations.

Inc. vs. LLC: Registered agent compliance for both

Whether you choose a corporation or an LLC, you will have to appoint and continually maintain a registered agent in your formation state and in every other state where your company is qualified to do business.

A registered agent is an individual or a company appointed to receive and forward service of process and certain official communications from the state such as its annual report form. Service of process is the delivery of court documents — in particular, the summons that tells your company it’s being sued and by whom, the reason why and for how much.

Both corporations and LLCs are required to have a registered agent. Keep in mind that this is a critical decision and choosing the wrong registered agent can lead to consequences for your company like default judgments or a loss of good standing. That’s why we recommend appointing a professional registered agent rather than choosing an employee, attorney, or one of the owners.

Inc. vs. LLC: Different management structures

Corporations and LLCs have different management structures. Management is governed by both the state statute and the governing documents for the business. For a corporation, these documents are the Articles of Incorporation and its corporate bylaws. For an LLC, these are the Articles of Organization and the operating agreement.

Corporation laws have more management requirements than LLC laws. Corporations have to hold annual shareholder meetings, provide notice, hold directors’ meetings, and so on. A corporate director has to be a natural person and cannot vote by proxy.

Many LLC statutes just leave it up to the members to provide in their operating agreement how they will be managed. For example, meetings are not required, and managers do not have to be natural persons and can vote by proxy. This affords LLC owners a degree of flexibility in management that they won’t have with corporations, which is a point generally considered to favor the LLC over a corporation.

In a corporation, by statute, a board of directors manages the business and affairs (and oversees the major business decisions). The board appoints officers who are responsible for the day-to-day running of the business. Shareholder management functions are very limited and include such things as electing directors and voting on certain major transactions like mergers.

In contrast, an LLC has a choice of two management structures. An LLC can be member-managed—meaning all members participate in the decision-making. This is a similar management structure to a partnership. Or it can be manager-managed—in which members, like shareholders, are investors with limited management functions. The managers manage the business and affairs, and their role is akin to that of corporate directors.

If all the owners want to participate in running the business, LLC beats Inc. But if the members want to be passive investors and have the business run by managers with more expertise than they have, and want the extra protections provided by the corporation statutes, then Inc. beats LLC.

Comparing LLC vs. Inc. for ownership

In terms of ownership, corporation shareholders and LLC members have both financial rights and management rights. In addition to the management rights referenced earlier, other management rights include the right to inspect books and records and bring a derivative suit on behalf of the corporation or LLC. The financial rights include the right to share in the profits through dividends and through distributions upon the company’s dissolution.

In a corporation, the shareholders’ rights are based on their stock ownership. If the corporation issues a dividend of 10 cents per share, all shareholders receive 10 cents per share. 

In an LLC, the members can split up the rights so that certain members can get a bigger dividend than others. That financial flexibility is also generally considered a decision in favor of the LLC over the corporation.

Neither the LLC laws nor the corporation laws have restrictions on the number of owners the business can have or who can be an owner. But Subchapter S of the Internal Revenue Code does. So, if you want to have a corporation or LLC taxed as an S corporation, you will have to deal with the restrictions described in the discussion of income taxes.

LLCs can have higher financial flexibility, but there are other factors that can go into determining favorable ownership rights.

Different classes and transferability of interests for LLC's and corporations

A corporation’s shares are easily transferable to others (unless the shareholders have an agreement restricting transfer)—making corporations a good choice for businesses that seek outside investment or are considering a public stock offering.
It’s not as easy to transfer LLC membership interests as it is corporate stock. In most LLCs, the consent of the other members is required before someone new becomes a member.

Corporations can also issue different types of stock interests. For instance, they can have a class of common stock with voting rights and a class without voting rights. Or, they can issue preferred stock with a right to dividends and distributions that have priority over common stock. LLCs can also offer different classes of membership interests.
However, this is not so if you want to be taxed as an S corporation. The tax law requires S corporations to have one class of stock.

When it comes to the ability to sell or transfer an ownership interest, it’s the Inc. over the LLC.

LLCs and corporations have recordkeeping requirements

Various records, including governing documents, shareholder and member lists, and certain tax returns, have to be maintained by both corporations and LLCs. And members, managers, shareholders and directors have a statutory right to inspect those documents.

Members and shareholders can also demand to inspect other records if they have a proper purpose and follow certain statutory procedures.

Recordkeeping is a fundamental requirement for both LLCs and corporations.

Making your choice: LLC or Inc.

As you can see, corporations and LLCs have some characteristics in common and some that are very different. As you decide which business structure is best for you, try our Incorporation Wizard to compare multiple business types by multiple key considerations.

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Heather Huston
Assistant Service Manager
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