When first investigating how to start a business, you may be unsure of the various business classifications and overwhelmed by which one to choose for your company. Along with looking into things like how to trademark a name for your small business, choosing between an LLC business, sole proprietorship or S, C or B corporation is a fundamental business decision.
According to a 2020 survey by the National Small Business Association, about 34% of businesses described themselves as S corporations, and 36% are LLCs. Read on for the differences between LLCs and corporations so you can make an informed choice about how you’ll structure your business.
What is an LLC (limited liability company)?
Like most business entity structures, an LLC (limited liability company) secures its owners’ personal assets from business debts, such as bankruptcy or lawsuits. An LLC can have one or many owners, also referred to as members.
Limited liability companies are not taxed at the corporate level. Members are considered self-employed, so profits and losses are “passed through” the LLC to members as personal income. Members then file federal and state taxes on those earnings or losses. Deductions for certain business expenses are possible.
There’s some flexibility here, though. Owners of an LLC can choose to file as a sole proprietorship (if there’s only one LLC member), a partnership, or a corporation. Regardless of the tax filing status of an LLC, its members retain their protection from personal liability.
What is a corporation?
Like an LLC, a corporation exists to limit the liability of the investors, whose personal assets, such as a vehicle or a home, would otherwise be at risk of seizure in situations of debt and lawsuits against the business.
While it may seem there are many different types of corporations, it’s a lot simpler than it looks:
- C corporation: This is the most common type of corporation and is typically considered the standard. A C corporation pays corporate income tax on business profits and its owners file personal taxes for their earnings. This type of corporation is usually publicly traded, but not always.
- S corporation: This is a type of corporation with specific tax status that allows the corporation to avoid corporate taxes by passing income, losses and deductions to shareholders. S corps cannot have more than 100 shareholders, which makes the entity ineligible for public trading. All shareholders must be U.S. citizens or legal residents.
- B corporation: A B corp, or benefit corporation, is a special certification that shows a for-profit corporation has met certain standards in social, environmental and transparency categories. Annual benefit reports showing their contributions to these areas are required in some states. B corps file corporate taxes and pay the corporate tax rate on taxable earnings. Shareholders are subject to individual income taxes.
LLC vs corporation: key differences
LLC stands for limited liability company, yet because LLCs are business entities, some mistake the acronym for “limited liability corporation.” It’s important to understand that an LLC is not a corporation, but instead a company. There are several distinctions between the two types of business structures.
Both LLCs and corporations must be built around the “corporate veil,” which is to say a real, legal separation between the liability of the owners and that of the business itself. Where they differ is that an LLC is formed of and by the members, or the owner-investors, while a corporation sells shares to its owner-investors.
To form an LLC, members file Articles of Organization, which includes the company name and address, member names and the name of a registered agent (person or entity that will receive legal and government correspondence) in their state. An operating agreement detailing day-to-day management and member ownership percentages will be filed, unless not required by state law.
Corporations of any kind must file Articles of Incorporation with the state. This legal document details the business purpose, shares offered, value of shares, directors and officers. Bylaws, also known as resolutions, are also required in most states. This document stipulates the duties, powers, and responsibilities of shareholders and officers.
An LLC may distribute its ownership stake to members without taking into account each member’s financial contribution upfront. For example, an agreement could say that all members receive an equal share of ownership, regardless of whether they’ve invested equally. LLCs can be owned by other corporations, trusts or foreign individuals. Depending on state law, the LLC may be automatically dissolved when a member leaves the LLC.
A corporation sells percentages of ownership to shareholders, who are then part-owners. These are called stocks, which are usually expressed in the number of shares owned. Stock owners can transfer shares to other owners, buy more shares (thus owning a greater percentage of the business) or own less of the company by selling off stock.
An LLC may be taxed as either a partnership, corporation or C corporation. In any of these cases, the LLC is called a pass-through entity because profits "pass through" to the owner-members of the LLC, who then file personal taxes that include that income.
Profits and losses are reported on members’ personal tax returns only, rather than taxing at the level of the LLC. This makes filing taxes much simpler for members, who can deduct losses or operating costs on their individual returns. An LLC is also subject to employment tax when distributing profits.
Here’s how it works:
- Say an LLC makes $100,000 in a year and has two equal members. Each of them would file income taxes on $50,000. The operating agreement could also define more partners, each with a different ownership percentage.
- If the LLC profit is $100,000 and Don has 30% ownership, Peggy has 20%, and Betty has $50, they would receive $30,000, $20,000 and $50,000 each, respectively. They would then pay taxes on each of their individual earnings.
- A corporation, on the other hand, is a taxable entity unto itself that earns its own income and pays taxes on its profits and dividends to shareholders. Since dividends aren’t tax deductible like a salary, they’re taxed twice, also known as double taxation.
The first tax is a corporate tax, or tax on the profits of the corporation. The other is levied on the dividends when they’re distributed. Shareholders don’t pay self-employment taxes, but owners who are also working as employees would.
Filing as an S corporation may benefit the business since it treats profits the way an LLC does, which is to say they both have flow-through taxation. Under this structure, they’re only taxed once rather than twice, as with the dividends in a corporation.
In smaller corporations, like those where only the owners work for the business, salaries and bonuses are tax-deductible. And in all corporations — unlike in sole proprietorships or LLCs — many business expenses are deductible, which offsets double taxation. Business expenses that can be written off include advertising, overhead and employee benefits.
Note that you can choose to have your LLC taxed as a corporation rather than the members being taxed individually. An LLC can stipulate in its ownership agreement that taxes will be filed as a C corp, for example. The LLC will then pay the federal, state and local corporate taxes. Members report any compensation or salary as income, and are taxed accordingly. To do so, first, you form the LLC, then you opt to be taxed as a corporation.
LLCs have a more flexible management structure than corporations, and their details are designated by the operating agreement that brings the LLC into existence. Members or managers are in charge of the LLC, and any member may play the part of the manager. In a member-managed LLC, the owners oversee daily operations, and the investors don’t take an active role.
Conversely, a corporation must have a formal board of directors who take responsibility for delivering profits in the form of dividends to shareholders. Officers in the “c-suite,” like Chief Operating Officers or Chief Technology Officers, handle the day-to-day operations. Shareholders don’t actively direct the business beyond voting on major decisions that affect the entire company, like electing directors or changing bylaws.
Profits and losses
In an LLC, including S corporations, your profits and losses are both recorded and taxed (or written off) as personal items. With a standard corporation or C corp, profits and losses are maintained by the corporation itself as a taxable entity.
Both corporations and LLCs offer personal asset protection in the case of business debts, lawsuits against the business or other liabilities. That said, LLC owners as well as corporation shareholders can still risk losing funds invested.
Advantages and disadvantages
While every situation is different, there are LLC or corporation types suited to every kind of business. However, there are also a few pros and cons to keep in mind for each.
The advantages of having an LLC include its range of taxation options, structural flexibility and relative simplicity to start up. LLCs avoid the double taxation of a corporate structure. Members’ incomes are taxed at the personal income tax rate, which is lower than the corporate tax rate.
On the other hand, any internal disruption, even a single owner leaving, may dissolve the LLC depending on state laws. Additionally, in some states, LLCs must pay a capital values tax, also called a franchise tax, that corporations aren’t required to pay.
A corporation is taxed as its own entity, which provides shelter from individual taxation, unlike an LLC. A corporation can write off operating expenses and losses, which could reduce the tax burden on the corporation immensely. Corporations are also structured to accommodate investors, with ownership percentages corresponding to the number of shares of company stock they own.
Disadvantages of corporations include the formalized business structure — which may not stand the test of time — as well as the double taxation (the corporation is taxed and so are shareholders).
Can a business be both an LLC and an S corp?
An LLC can legally file as an S corp. In this case, the entity itself would pay corporate taxes rather than having tax liability split between the members proportionally.
Note, however, that with an S corp, you’re restricted to selling only 100 shares of one class of stock, which makes the LLC ineligible for public trading. Shareholders must be U.S. citizens or residents. To file your LLC as an S corporation, be sure that you won’t want to sell a high volume of shares or branch out globally in the future.
Which legal business entity is right for you?
How do you want your business and personal income taxed?
An LLC is taxed on a personal level only, unless you file as an S corp. Corporations are taxed at the corporate and personal levels.
Do you want to trade publicly?
LLCs cannot issue stock, while C corps and benefit corps can.
How will you finance your business?
Most LLCs are funded by members. C corporations, however, can publicly trade several types of stock and have an unlimited number of shareholder investors.
Do you plan to have international involvement that could impact your tax status?
LLCs are not recognized in some countries, and so your business would be taxed as a corporation in those countries.
If you’re not sure what the future will bring and want to remain nimble, an LLC may be right for you. If you want the stability of a board of directors and corporate bylaws, as well as the ability to sell shares and publicly traded stock, a corporation may be best. Note that it’s possible to switch from a limited liability company to a corporation as your business evolves.