The LLC or Corporation dilemma is a common one faced by many new business owners. You know you want to get the limited liability protection offered by a corporation and LLC. But which legal entity is right for you and your business?
As you probably know by now, there is no clear answer to whether to form an LLC business or an incorporated one. The ultimate answer really depends on each situation. And, if you have tried to research the issue, you probably feel even more lost because the more you read about the relevant factors, the more confused you get.
In this article Meredith Karter will attempt to summarize the major factors to consider while deciding which entity is best for your business. Please note that this article is a summary of the relevant factors but it is not a substitute for professional tax, accounting and legal advice.
There are really three main categories of factors relevant to a choice of entity decision: Legal, Business and Tax.
Legal Factors
Liability Protection – Legally, both entities give you legal liability protection if you properly maintain the entity in accordance with law.
Maintenance and Paperwork – The laws impose less legally required paperwork and formalities (such as meetings), but, in reality, you will want to undertake some formalities and paperwork for an LLC because this effort is important to preserving your liability limitation. There is some comfort under the LLC laws knowing they are not legally required as a governance requirement.
Management Structure – A corporation is generally required to have two layers for overall governance – an ownership level (shareholders) and a management level (the Board of Directors). The LLC offers more flexibility because the LLC can have a simple single management structure (member managed) or it can tailor a management structure to meet the needs of the particular business.
When you form an LLC business, you are not required to have a centralized and separate management body (like a Board). For a solo owned business or a small business with a small group of active members, the single management layer is easier to maintain and apply. The management can occur at the ownership level by giving the members the authority to make management decisions. An LLC will still be required to have meetings to discuss LLC decisions and to document LLC decisions with resolutions or written governance consents. An LLC can have a centralized management structure like a corporation if it is more appropriate for the business (manager managed).
Established Laws – Corporations have been in existence for over a hundred years and so there is a well established body of law to govern corporations. LLCs, on the other hand, have only been in existence for a few decades and did not really become a mainstream choice for businesses until 1997 when the tax laws changed. Some conservative business owners feel more comfortable with corporations because of their history. But, for the small business owner, there is no real legal advantage to either. LLCs were created to provide the same benefits as corporations when it comes to liability.
Also, when an LLC issue is brought to court, the courts often apply corporation law principles in specific situations when the LLC law has not been developed. So, in reality, there is no advantage to corporations for having a more established body of law except in those limited cases of larger businesses and with publicly traded companies that have multiple layers of shareholders and investors.
Business Factors
This category of factors are either going to be decisive factors for your business or not really relevant at all to your LLC – Corporation decision.
Going Public – If you plan on building an empire and taking your business public with an initial public offering (IPO), then you will need to use a corporation as a legal entity.
Require Venture Capital Equity Investors – If your business will have a venture capital or other professional investor, that investor will most likely require that you use a corporation as the legal entity. Although there is a trend for some professional investors to make investments in an LLC, the overwhelming majority of them will require the use of a corporation not only because corporations have been the standard investment vehicle for venture capital but also because in some cases, the use of a corporation provides them with tax benefits. If you plan on using your own money or only having yourself, your business partners, friends and family as owners of the business, then this factor is not relevant.
Special Distribution Percentages – If you would like to distribute business profits to owners in a manner other than in direct proportion to the ownership interests held by the owners of the legal entity, you will need to use an LLC. Corporations must distribute profits according to the relative stock ownership in the corporation. LLCs on the other hand can use whatever allocation proportion the members choose as long as it meets certain requirements under the Internal Revenue Code. If you are considering a special allocation, you will need to use an LLC and you will definitely need to retain a CPA professional to advise you and draft the relevant tax provisions of your LLC operating agreement.
Tax Factors
Tax matters are important to any business – After all, tax issues determine how much you have to pay the government in taxes and so these factors are directly relevant to how much of the money that you get to keep at the end of the day!
The limited liability company offers more tax choices than a corporation. When you form an LLC business, you can elect for profits to be taxed pursuant to a pass through structure (single layer of taxation) or pursuant to a C corporation (double taxation) or S corporation structure (single taxation but with many requirements and ongoing compliance requirements). The corporation only has the choice of C corporation or S corporation taxation.
Small business owners many times prefer the LLC pass through taxation because it allows them to avoid double taxation of profits and in many cases be able to take business losses to reduce taxes from other income WITHOUT having to worry about meeting a laundry list of S corporation requirements.
S corporation requirements restrict the number and type of persons who can be owners of a business and there are other requirements as well so check with your accountant for the specific details.
As a business evolves, things change and with an S corporation tax status, you need to always be checking the latest S corporation requirements. The failure to meet a requirement, even if by accident or temporary, can result in significant taxes owned and penalties.
The S corporation can have some tax benefits over the standard pass through for some LLC businesses when it comes to self employment taxes. If this is the case for you, your LLC can elect S corporation taxation so this option is available for both the LLC and corporation.
Many people who prefer the flexibility of an LLC still form a corporation because they want C corporation or S corporation taxation. Unfortunately, they do not know that an LLC can be taxed as a C corporation or S corporation. This has been the case since 1997, when the IRS passed the Check the Box Regulations.
Summary
For most small businesses, when it comes to the LLC or Corporation decisions, the limited liability company provides more benefits and flexibility. After all, this legal entity was specifically designed to give the same advantages and features of a corporation but without many of the increased formalities, restrictions and disadvantages of corporations.
As a result, the LLC has already replaced the corporate entity as the business entity of choice for small business and the # of LLC formations each year greatly surpass incorporations for small businesses.