The decision to form either a limited liability company (LLC) or a corporation depends on the type of business an individual is creating, the possible tax consequences of forming the entity, and other considerations. Both types of entities have the significant legal advantage of helping to protect assets from creditors and providing an extra layer of protection against legal liability.
In general, the creation and management of an LLC are much easier and more flexible than that of a corporation. Still, there are advantages and disadvantages to both types of business structures.
Ease of Forming an LLC
Creating an LLC is a much simpler process than creating a corporation and generally takes less paperwork. LLCs are under the jurisdiction of state law, so the process of forming an LLC depends on the state in which it is being filed. Most states require filing articles of organization with the Secretary of State and some states allow for them to be filled out online. A few states require an additional step of filing a public notice, often in local newspapers. Once these steps are completed, the LLC is officially formed.
Once an LLC is formed, its good business practice to set out the roles and responsibilities of the members. The members are individuals with an ownership interest in the LLC. Most LLCs use an operating agreement to define these roles. Drafting an operating agreement is not necessary for an LLC to be valid but it is a prudent course of action. If no operating agreement is created, an LLC is governed by the default rules contained in state statutes.
The operating agreement sets forth the rights and responsibilities of the members. It can define the business relationship and deal with issues of capital structure, the allocation of profits and losses, provisions for the buyout of a member, provisions in case of the death of a member, and other important business considerations.
Tax Flexibility of an LLC
The Internal Revenue Service (IRS) does not view an LLC as a separate vehicle for tax purposes, which allows for greater flexibility. Members can choose how they are taxed. They can be treated as a sole proprietorship, a partnership, or a corporation. The most common tax option of an LLC is taxation similar to a sole proprietorship. A member has to pay taxes themselves on the profits of the LLC as opposed to the LLC paying the taxes. The profits and losses of an LLC are passed through the business to the owner. The owner then has to report the profits or losses on their own personal tax returns. The LLC itself does not pay any corporate tax. This method avoids double taxation, which is a drawback of corporations.
Disadvantages of an LLC
Though an LLC does come with plenty of advantages, there are some disadvantages to consider. LLC members also have to pay a self-employment tax, which includes a 12.4% tax for Social Security and a 2.9% tax for Medicare.
There are other drawbacks to an LLC as well. The purpose of an LLC is to protect its members from any liability. If the company fails to meet its obligations, only the LLC can be a target for creditors, not the assets of the members. However, there are certain situations in which an LLC can be automatically dissolved, leaving members open to risk.
Automatic dissolution can be triggered if an LLC fails to report its filings on time, a death or withdrawal of any member occurs, unless succession provisions are outlined in the operating agreement, a change in the structure of the LLC, such as a merger, as well as any terms with expiration dates. In these situations, an LLC can continue doing business, but the liability structure of the members may alter, defeating the initial purpose of creating the LLC.
An LLC can be automatically terminated due to tax reasons as well. The automatic termination is triggered if there is a transfer of 50% or more of an LLC’s total interest or profits within a 12-month period. This is called a technical termination. When this occurs, the assets are considered to have been contributed tax-free to a new LLC.
Another major disadvantage is the differences among states in the statutes that govern LLCs. This can lead to uncertainty for LLCs that operate in multiple states. The differences in rules and regulations can result in additional paperwork and inconsistent treatment across different jurisdictions.
Advantages of a Corporation
Despite the ease of administration of an LLC, there are significant advantages to using a corporate legal structure. Two types of corporations can be formed. An S corporation and a C corporation. An S corporation is a pass-through entity, like an LLC, where the owners are taxed on profits and losses of the corporation. A C corporation is taxed at the corporate level, separately from its owners, through a corporate income tax. C corporations are the most common type of corporation.
Corporations offer more flexibility when it comes to their excess profits. Whereas all income in an LLC flows through to the members, an S corporation is allowed to pass income and losses to its shareholders, who report taxes on an individual tax return at ordinary levels. As such, an S corporation does not have to pay a corporate tax, thereby saving money, as corporate taxes are higher than ordinary taxes. Shareholders can also receive tax-free dividends if certain regulations are met.
C corporations have the advantage of allowing profits to remain with the corporation and paying them out as dividends to shareholders. Also, for businesses that eventually seek to issue stock, a C corporation can easily issue shares to raise capital for further expansion of the business.
Disadvantages of a Corporation
There are significant disadvantages to creating a corporation regarding the amount of complexity involved. It requires a great deal more paperwork, meeting many more guidelines, electing a board of directors, adopting bylaws, having annual meetings, and creating formal financial statements. They generally have more burdensome record-keeping requirements than LLCs.
There is also the issue of double taxation for corporations. This refers to taxes being paid twice on the same income. This is because corporations are considered separate legal entities from their shareholders. Thus, corporations pay taxes on their earnings, while their shareholders also pay taxes on any dividends they receive from the corporation.
The Bottom Line
Though similar in many ways, LLCs and corporations have quite a few distinctions that bring both advantages and disadvantages to each. As an individual starting their own business, it's important to understand all of the nuances involved and choose the right structure for your company.