“LLC or Inc.?” When it comes to choosing the best structure for your business there is no single, one-size-fits-all answer.
What is the difference between LLC and Inc?
LLC stands for "limited liability company". It combines the most sought after characteristics of a corporation (credibility and limited liability) with those of a partnership (flexibility and pass-through taxation).
The initials “Inc” may be applied to companies that have incorporated their business (i.e., registered with a state to become a corporation). A corporation can either be an S corporation or a C corporation.
An S corporation is a corporation that has elected to be taxed under Subchapter S of the Internal Revenue Code, making it a “pass-through” entity for tax purposes.
A C corporation is a legal entity that protects the owners’ personal assets from creditors. It can have an unlimited number of owners and multiple classes of stock. Unlike an S Corporation or an LLC, it pays taxes at the corporate level.
Both LLCs and corporations involve properly completing and filing your documents with the state, appointing a registered agent, and fulfilling ongoing requirements.
Note: People often use the term “incorporate” in relation to creating an LLCs. LLCs are technically formed, while corporations (S corporation or C corporation) are incorporated.
The decision making process
To help you decide between an LLC and incorporation, you need to consider what matters to you most in these four areas:
- Limited liability protection
- Management and control
- Funding options and opportunities
- Tax consequences for the owners and the business
1. Limited liability protection: LLC or Inc?
Both corporations and LLCs provide limited liability protection. Corporations and LLCs are legal entities that are separate from their owners. The corporation or LLC is the business owner and is liable for the business’ debts and liabilities.
The shareholders of a corporation or the members of an LLC are not liable for the business’ debts. Their liability is limited to their investment.
CT tip: Keep in mind, whether the business operates as an LLC or a corporation, all the entity’s assets are at risk for the entity’s debts.
However, sometimes the entity may also need protection from the debts and liabilities of its owners. While both an LLC and a corporation offer some protection, there are differences in the way that protection operates.
Corporation: Potential risk from creditors of shareholders
While incorporating may protect a shareholder's assets from the company’s creditors, the company itself may be at risk from the shareholder’s creditors.
Judgment creditors of a shareholder can attach the shareholder’s stock and assume all the shareholder’s rights. These rights may include voting for directors which will shape the direction of the company. If the shareholder has a controlling interest, the creditors may even be able to vote to dissolve the corporation.
LLC: Better protection in some circumstances
Limited liability companies also protect the members’ assets from business creditors. And, in some circumstances, this entity choice may offer better protection for the entity.
Why? Because many state LLC laws limit what a member’s judgment creditor can get from the member to what is called a “charging order”. That’s a court order requiring the LLC to pay any distributions due the member to the creditor instead.
But a member’s creditor cannot touch the member’s ownership in the LLC or become a member with management rights.
2. Management and control: LLC vs. Inc.
The second issue when deciding between an LLC and a corporation is management and Control. Who will be calling the shots—both tactically (day-to-day) and strategically (long-term)?
Corporation: Shareholders have limited governance rights
In a corporation, the ownership is separated from control. Shareholders own the corporation, but they only have limited governance rights. These include the right to elect the board of directors, to remove directors under certain circumstances, and to vote on fundamental transactions that affect their economic, ownership rights such as mergers, asset sales, and dissolution.
It is the directors that establish the strategic direction of the company, who set the policies and who appoint the officers that run the corporation’s day-to-day affairs.
Statutory close corporation: Shareholders have direct control (but with limitations)
While the limitations on shareholders management rights hold true for most corporations (including those that have made an S corporation election for tax purposes), there is a special type of corporation—the statutory close corporation—that vests control directly in the members.
Not many states allow this type of corporation. In those that do, there are strict limits on the number of shareholders and the transferability of stock. Other states allow shareholders to enter into shareholder agreements that give them management rights. There are strict limitations here too, including that all shareholders must consent.
LLC: Members decide how to manage the LLC
In an LLC, the members themselves decide how the LLC will be managed. In fact, management by all the members is the default method of management in most states.
However, the LLC’s operating agreement can override the state default by specifying that it be manager-managed. In this case, the management can be much like that of a corporation, but with much less formality regarding meeting and notice requirements.
But an LLC is flexible enough that it can be set up with all the corporation-like formalities if the members so desire.
3. Funding options and opportunities for LLC vs. Inc.
Business growth objectives should also be taken into consideration since the choice of business structure can affect the company’s ability to receive financing.
Corporation: More attractive to passive investors
Because of the split between ownership (economic rights) and management (control), corporations have a much easier time attracting passive investors. In fact, many venture capitalists not only prefer to invest in a corporation, but their governing documents don’t let them invest in LLCs.
It is also far easier for a corporation to offer stock options—a key way to attract talent to the business. It is generally easier for a corporation to obtain bank financing. This factor can be especially important in capital intensive businesses.
Financial rights of the investor
Distributions during a corporation's existence are based strictly on the number (or percentage) of shares owned. A shareholder who holds 10% of the corporation share will get $100 if the corporation declares a $1,000 dividend. Allocation of profits and losses depend on the type of corporation. In a regular corporation (a C corporation for federal income tax purposes) there is no allocation to the shareholders—the corporation is its own taxpayer. In an S corporation, income and losses are allocated to the shareholder in according to their percentage ownership. Also, directors decide whether dividends will be paid. The shareholders do not have a say.
LLC: Can be difficult to obtain financing from banks and venture capitalists
In order to get obtain equity investment, an LLC must make the investor a member which generally carries with it far more rights to control the organization than shareholders have in a corporation.
Although an LLC can have passive members too, people who chose to invest in an LLC instead of a corporation may want to have a say in how the business is run. Also, because of the disinclination of banks and venture capitalists to provide money to an LLC, the owners may find themselves having to personally guarantee debts. This effectively destroys limited liability.
Financial rights of the investor
Distributions are based on the operating agreement. There doesn't need to be any correlation between the percentage of ownership and the percentage share of the distribution. The operating agreement also determines how annual profits and losses are allocated to the members. As with distributions, this allocation doesn't need to correlate with the ownership interest. What's more, profits and losses can be allocated differently if that is what the operating agreement provides. Also, the members may have the right to decide whether dividends are paid.
4. Tax consequences for the owners and the business for LLC vs. Inc.
Taxation is a huge deciding factor when it comes to choosing between an LLC, a C corp and an S corp. Conventional wisdom touts the LLC as the tax-preferred entity type.
However, for many businesses, this might not be the case.
C corporation: Potential for double taxation
A C corporation is a separate tax-paying entity. This means that it pays corporate income tax on its income, after offsetting income with losses, deductions, and credits. A corporation pays its shareholders dividends from its after-tax income. This is the often mentioned “double taxation.” However, there are ways to reduce or eliminate double taxation, which your tax adviser can advise you on.
S corporation: Pass-through taxation
S corporations are corporations that have made an election with the IRS to be taxed as a pass-through entity. All the company’s income, deductions, and losses are passed through to the owners who report these items on their individual income tax form.
LLC: Tax flexibility
In an LLC the members can decide whether they want to be a pass-through entity or be taxed as a C corporation. By default, an LLC with one member is disregarded (like a sole proprietorship) while an LLC with more than one member is taxed under the pass-through rules applicable to partnerships.
However, an LLC can elect to be taxed as a C corporation and also as an S corporation.
LLC vs. Inc?
Considering your priorities with the four factors listed above can help you determine which entity structure is best for your business. As always, you should talk to a trusted legal and tax advisor before making a final decision.