Limited Liability Company vs. Corporation – How do you choose?
When I talk with business owners, I continually am surprised to learn how many of them have not put a legal structure around their business operations. These businesses range from retail, consulting, technology and professional service to other companies. The owners are hard-working, entrepreneurial and often highly educated with significant business experience. I am still after my friend, a Harvard Business School alum, to get his legal house in order and put a structure around his successful consulting business. Please see related post – Why Incorporate Your Business.
These business owners often explain that they really want to incorporate or set up an LLC, but they have been distracted by other, more pressing business issues. I often hear that they have researched the issue on the Internet, but were left more confused than when they started. Some of them are concerned about the cost and the administrative paperwork, and others simply have procrastinated and perhaps do not see the immediate benefit.
We are here to help! We explain below the high-level advantages and disadvantages of setting up your business as a corporation or LLC. (Read this post to learn more about the California corporation vs. Delaware corporation decision!)
General Comment About Limited Liability
Each of the business structures discussed below is created under state law as a separate and distinct legal “person” from you as an individual. If properly structured and maintained, each will provide a legal wall so that your personal assets are separated from the operations of your business. As the owner of a corporation or LLC, you will not be personally liable for the debts and obligations of the business. However, you may have to personally guarantee certain debts and obligations of the business.
Below is a breakdown of some of the key advantages and disadvantages of using a Corporation vs. an LLC:
Note: a Subchapter-S corporation (S-corp) has many of the same features and characteristics as a Subchapter-C corporation (C-corp), except for certain ownership restrictions and an IRS election to not be taxed at the corporate level.
- Protect Your Assets – There is limited liability protection for the Stockholders.
- Familiar – Investors, employees, and others generally understand the corporate structure (i.e., Stockholders, Board of Directors, Corporate Officers) and how corporations operate. This familiarity often helps to facilitate operations without a lot of explanation.
- Employment Tax Savings – Stockholders are not required to pay Social Security and Medicare taxes on profit distributions. There may be tax savings for certain businesses, which are not available to LLCs.
- No Double Taxation for S-Corp – There is no taxation at the corporate level, and profits and losses of the S-Corporation are passed through to the Stockholders on a pro-rata basis relative to stock ownership.
- Incentive Stock Options – Corporations can grant tax-advantaged Incentive Stock Options (or ISOs).
- Investor Friendly – The investment structures and documents used by corporations to raise money will help facilitate investment. Also, certain venture capital investors cannot invest in an LLC given its tax pass-through structure.
- IPO Ready – Corporations can go public.
- C-Corps Can Help with Taxes – A C-Corporation actually may allow for more flexible tax planning. For some businesses, a C-Corporation can help lower taxes, given the graduated corporate tax rates, lower rates on corporate dividends, exemption from payroll taxes and the ability to retain profits in the C-Corporation.
- Qualified Small Business Stock – There can be significant tax savings when you sell your C-Corporation stock at a gain if it qualifies as Qualified Small Business Stock (or QSBS), because you may be able to exclude part of the gain from your income. Read more about the “10 Million Reasons to Start Your New Company as a C Corporation.”
- Double Taxation – With a C-Corporation, there are taxes at the corporate level and then taxes at the Stockholder level when dividends are distributed. Note, however, that C-Corporations and double taxation may work to help lower taxes in certain situations.
- S-Corp Restrictions – There are certain structural restrictions to qualify as an S-Corporation, including a limit of 100 Stockholders, only one class of stock, only individual Stockholders (with limited exceptions), and Stockholders cannot be non-resident aliens.
- Corporate Formalities – A corporation requires certain procedures, including Annual Meetings for the Stockholders and Board of Directors as well as notice and approval requirements for certain corporate actions.
- Less Flexible – An S-Corporation only may allocate profits and losses on a pro rata basis. Also, the corporate structure is fixed and does not allow the same level of customization as an LLC.
- Losses Limited – A Stockholder of an S-Corporation is limited in recognizing the losses generated by the S-Corporation to the amount of his or her basis in the shares. This limited recognition of losses may not benefit Stockholders with little or no basis in their shares.
Limited Liability Companies (LLC):
- Protect Your Assets – There is limited liability protection for the owners.
- Flexible – With an LLC, you can customize the ownership, governance, distribution, tax allocation and other features of the LLC.
- No Double Taxation – Profits and losses of the LLC pass through to the owners of the LLC (i.e., no tax at the LLC level), with additional flexibility to allocate these profits and losses in different ways.
- Less Formalities – There is no requirement to hold annual meetings (unless specifically required under the LLC operating agreement), but you should consider what level of oversight or approvals should be in place for major business decisions depending on the structure of the LLC.
- Customization Can Be Costly – Especially at Startup, the ability to customize the management, governance, and structure of an LLC may result in extra decisions, documentation, and costs.
- Tax Driven – Given the hybrid nature of the LLC (features of partnership and corporation), you may need to focus more on the tax features and consequences. In addition, some companies find the annual preparation of Schedule K-1s (to report the members’ share of income, credits, deductions, etc.) creates extra administrative burdens.
- Not Stock Option Friendly – Equity incentives, such as Stock Options, can be more complicated with LLCs and there is no opportunity to grant Incentive Stock Options (ISOs).
- No to IPO – The LLC structure is not used to take companies public.
- Less Investor Friendly – Certain investors, such as many venture capital funds, cannot invest in an LLC due to tax restrictions.
- Employment Taxes – LLC owners must pay Social Security and Medicare taxes on their profits.
- Higher Taxes – The annual fees and taxes of an LLC vary by state and can make the LLC structure less desirable financially. For example, the California Secretary of State charges an annual LLC fee of $800 together with an additional annual tax based on the LLC’s total annual income above $250,000.
Practical Tips and Next Steps
- Double taxation and additional paperwork may not be as bad as they sound – do not let buzz words or short-form explanations lead you to a quick decision that may be wrong for the overall needs of your business.
- As a starting point, consider the Delaware C-corporation as your initial business structure and then review the pros and cons of alternative structures to make the right choice for you and your company.
Want to learn more about forming an LLC or corporation? Check out our other blogs: