Here I’ll aim to give you a complete understanding of limited liability companies vs limited liability corporations so you can make a more informed decision on which option to take for your business.
Understanding a Limited Liability Company (LLC)
A limited liability company, also commonly known as an LLC, is a private company that combines the pass-through taxation of a sole proprietorship and a partnership and offers the limited liability structure of a corporation.
So, if you have formed an LLC, you would have limited liability on its debts and liabilities, and you would be entitled to having a pass-taxation on its earnings. Furthermore, with an LLC, you can add as many partners/owners/members as you want with only having to make some changes in the operating agreement of your LLC.
Forming an LLC can be the simplest way to structure your business that protects your assets when your business is sued. Since it is an extensive guarantee that almost every business owner looks for, LLCs have become very trendy in the USA over the past decade. Practically every tiny to prominent entrepreneur is looking to structure their business as an LLC.
Understanding a corporation
A corporation is also a business entity, just like an LLC, but it varies from an LLC in many ways. Individuals, shareholders, or stockholders create it with the primary purpose of operating for profit.
Like LLCs, corporations are not legally barred from entering into contracts, and they can sue and be sued. They are also entitled to own assets, remit all kinds of federal and state taxes, and borrow money from almost every financial institution.
Much like an LLC, a corporation can also be formed by a single owner or many individuals who come together for a common goal. Furthermore, corporations can be formed as for-profit and not-for-profit organizations, and we shall look into these types in detail.
What is Incorporation?
Incorporation, as the name suggests, is the process of registration of a corporation. Once a corporation is incorporated, it ensures that it is on the legal records, and its owners are officially protected from the liability owed by the business. Incorporation effectively separates the assets and income of the organization from the assets and income of its investors and owners.
While the incorporation process varies from state to state, the primary concept of incorporation is almost identical. This process involves drafting articles of incorporation of the organization. These articles list all the basic information about the organization – from the purpose and location of the business to the stock and number of shares that have been issued.
However, the articles of organizations do not always include the number of shares issued by the corporation, as not every corporation issue shares. For example, a closed corporation does not issue shares. Since the owners own corporations, and the number of owners is not defined, there could be organizations with a single owner and thus a single shareholder.
What Does an LLC Have in Common with a Corporation?
As we have discussed already, an LLC is an amalgam of partnership, sole proprietorship, and corporation; some aspects are shared between a corporation and an LLC. The shared characteristics between a corporation and an LLC are more than they have in contrast, and the primary shared aspects are:
- Limited Liability Protection
Both LLCs and corporations offer limited liability protection to the owners. It means that the loss incurred by a corporation and LLC shall not exceed the principal amount invested in the corporation, hence not making their respective owners personally responsible for the incurred losses.
- Business Name Reservation
It is another common aspect between an LLC and a corporation. Reserving the name allows both corporations and LLCs to protect it for a given time — usually for four months in many states. However, the exact period can still vary a bit depending on your state. In this period, no other company can incorporate using the name that you have already reserved.
How an LLC and a Corporation are Different?
While there are many similarities between a corporation and an LLC, many differences make these two structures very different from each other. For example, the first difference between these two legal structures is how these business entities are formed.
- How they are formed
One or more business people form a limited liability company as members or owners. The members/owners file for the Articles of Organization for their LLC with the office of the secretary of the state. After that, the members/owners of the LLC come up with an agreement – the operating agreement, which decides the share of ownership of every member and day to day activities of the LLC.
On the other hand, a corporation is formed by filing the articles of incorporation to the relevant state agency for business filings. After a corporation is incorporated, the corporation forms a board of directors that oversee the business activates. Instead of an operating agreement, a corporation agrees on bylaws that rule over the internal working of the corporation.
- Ownership & Management Structure
The ownership structure of a corporation and an LLC varies drastically. For example, in an LLC, the owners of the LLC, who are also known as members, are the principal owners of the LLC depending upon their contribution in the initial capital contribution. All the decisions are made by the members/owners of the LLC, and no big decision can go ahead without the consent of their owners.
The ownership structure of a corporation is different. All the shareholders of a corporation are its owners, and their share in ownership is decided by the number of shares they hold of the corporation. However, not every shareholder gets to make the corporation’s decisions, as the board of directors make the decisions.
- Corporate Taxes
Corporations are taxed at the corporate tax rate, which is currently 21% in the United States. Furthermore, the shareholders of the corporations pay taxes on dividends when they receive them.
On the other hand, LLCs offer pass-through taxation. LLCs don’t pay direct taxes; instead, their owners/members pay taxes on the LLC profits in their income taxes.
- Self-Employment Taxes
As the IRS considers LLC owners self-employed, they have to pay the self-employment taxes. The self-employment taxes generally involve Medicare and social security taxes.
On the other hand, since the corporations’ owners (shareholders) are not considered self-employed, they don’t have to pay any self-employment taxes. However, the corporate owners who also work as corporation employees pay the self-employment taxes that are usually deducted from their monthly salaries.
- Handling of profits and losses
The handling of profits and losses is a very major difference between an LLC and a corporation. So far, we must understand that the limited liability companies, just like sole proprietorships and partnerships, are pass-through entities, and they are taxed so as well.
Pass-through entities are the ones where the profits and losses of the entities pass through directly to their owners/shareholders. However, the proportion of the profits and losses received by the LLC owners depend upon their initial capital contribution in the LLC.
On the other hand, corporations’ profits and losses are distributed among the shareholders after they have paid the tax incurred on their profits. It is to say that corporations are legally separate entities from their shareholders, while LLCs are not separate entities from their owners/members.
After the corporations have paid their corporate taxes, they divide their dividends to shareholders. However, it is not always the case that corporations pay the total profit to their shareholders after paying taxes, as corporations can hold specific amounts for various purposes.
LLC vs Corporation: Formal Requirements (Maintenance and Annual Reports)
Every state has listed the formal requirements for both LLCs and corporations to fill in over a certain period. Only after the LLCs and corporations fulfil their formal requirements is their limited liability protection protected, and they can enjoy a good standing and rating.
When it comes to formal requirements of corporations, they are legally required to hold annual shareholders’ meetings. The decisions made in the shareholders’ meetings are documented as corporate minutes. Furthermore, corporations are also required to file annual reports for any changes in the structure of the corporations during the year.
On the other hand, LLCs aren’t required to file as many reports as corporations, but some. LLCs have to file for a change in their operating agreement and articles of organization if there are any structural or capital changes in the LLC. However, LLCs aren’t required to hold any annual meetings or record minutes.
LLC vs Corporation: Legal Discrepancies
While both LLCs and corporations primarily offer limited liability protection, corporations are slightly older entities than LLCs. Corporations have been around for many decades, and LLCs are relatively new, thus making corporations mature business entities.
Furthermore, the laws of various states also define how corporations and LLCs are looked at in these states. For example, Delaware is heaven for LLCs, as its laws offer excellent protection to LLCs with shallow charges and paperwork. Other states may not be as friendly to LLCs as they are to corporations.
It is why many companies register in one state as a corporation and LLC in the other. We can easily say that corporations have matured as business entities over decades, and LLCs are a relatively new concept. So, many people can prefer corporations over LLCs. Still, times are changing, and LLCs are gradually becoming trendy, especially with the young entrepreneurs setting up smaller projects with bigger dreams.
Who Can Help You Make This Decision (LLC or Corporation)?
It is a critical decision, and only after you have completely understood what you want from your business you can decide which business structure will suit your quest better. For example, if you plan to start a small setup yourself or with one or two partners, an LLC structure suits you better.
Contrariwise, if you are planning a more significant business structure and need to raise the capital for your business, opting for a corporation should suit you better. As a corporation, your quest for raising capital will become more accessible. Still, it would require you to give more attention to the process of registering for a corporation, unlike for an LLC, where the registration process is straightforward.
Furthermore, the tax consequences of both these structures will also vary drastically, as we have already discussed the tax structure differences between these two entities. At times, this could become a problematic situation for you, and you can seek help from:
- An attorney
Attorneys are well-read when it comes to business laws, and they can guide you effectively about which business structure will suit you better. Seeking an experienced attorney with experience in business incorporations can offer great help to you to decide.
- A CPA
CPAs are professional accountants, and while attorneys understand the laws better, CPAs understand the tax differences between these two structures. If you want to decide between a corporation and an LLC based on taxes, a CPA can guide you better than anyone else.
Frequently Asked Questions
In this section, I’ll answer some frequently asked questions regarding LLCs and corporations:
- What is Limited Liability?
Limited liability is a legal structure for corporations where the loss incurred by a corporation shall not exceed the principal amount invested in the corporation. In other words, we can say that, in limited liability, owners’ and investors’ assets are not at risk if the corporation fails.
- Why choose an LLC over a corporation?
While both corporations and LLCs offer limited liability options, an LLC comes with an extra benefit of pass-through taxation. It ensures that not only the owners of LLC can enjoy tax cuts, but there is also less paperwork involved in tax filing as there are no separate taxes for owners’ income and LLCs’ profits.
- Does an LLC protect you?
Yes, it does, as long as you are working within legal constraints defined by the law. However, if you are involved in malpractices barred by law, a limited liability structure will not protect you.
- Can I change an LLC to a corporation?
Yes, an LLC can be transitioned to a corporation. However, this conversion might require more taxes and more paperwork for you. For it to happen, all the owners/members of the LLC need to give their consent.
- What is an example of a limited liability company?
Many successful businesses around the globe work under the structure of limited liability. Some famous names are Pepsi-Cola, Blackberry, Nike, eBay, IBM, Sony, etc.
- What are the types of limited liability companies?
LLC is the parent structure that offers limited liability protection to business owners, and there are many different types of limited liability companies. The most popular LLC types are series LLC, restricted LLC, L3C company, general partnership, limited family partnerships, single-member LLC/sole proprietorship, anonymous LLC.
- What are the four types of corporations?
The parent structure of a corporation can be further divided into four primary types. These types are C-corps, S-corps, non-profit corporations, and limited liability companies. While these are four primary types of corporations, these types can be further divided into many sub-types.
- Can the owner of an LLC be sued personally?
For as long as the owner of an LLC has acted within the legal constraints, the owner can’t be sued for LLCs’ failures. However, suppose there are any malpractices involved by the owner of an LLC, of course. In that case, the owner of the LLC can be sued personally, as the limited liability protection is lost in cases of mala fide practices.