Is it better to form a Limited Liability Company (LLC) or a C Corporation? Many entrepreneurs ask that question as they work through the many facets of transforming their dream of business ownership into a reality.
The business structures have similarities and differences, as well as advantages and disadvantages, so it’s important to consider all of them when deciding on the right business entity type for your company.
So, how do LLCs and Corporations compare?
1. State Registration
Both LLCs and Corporations are formed by filing registration forms with the state. The paperwork required, filing costs, and formalities vary from state to state:
- Forming an LLC – In most states, the official document to form an LLC is called Articles of Organization. Some states call it by other names, such as Certificate of Organization or Certificate of Formation. Owners of an LLC are called members An LLC may be formed by a solitary member (single-member LLC) or multiple members (multi-member LLC). Some states also require that an LLC file an Initial Report shortly after they complete their registration filing. There may also be other requirements, depending on the industry, type of business, and location. Learn more about registering an LLC.
- Incorporating as a C Corporation – When entrepreneurs want to incorporate a business, they must file Articles of Incorporation (sometimes called Certificate of Incorporation) with the Secretary of State office (or comparable agency). Owners of a Corporation are called shareholders. While most Corporations are formed by more than one individual or entity, states will allow an individual or entity to incorporate and solely own a Corporation. When starting a Corporation, the business’s stakeholders must elect or appoint individuals to serve on a board of directors, which meets regularly to review and approve the company’s financial statements, review management policies, make strategic decisions, and oversee other facets of the business. Learn more about registering a C Corporation.
2. Entity Governing Documents
Whether an LLC or Corporation, a registered business must follow the provisions in the internal management document that spells out the essential aspects of operating the company. Governance documents help maintain the all-important legal separation between a business entity and its owners’ personal interests. The LLC and C Corporation use two different documents for this purpose:
- LLC Operating Agreement – While states do not require an LLC to have an operating agreement nor file it with the state, it can be instrumental in ensuring all LLC members understand their rights and responsibilities, how profits will be distributed, how disputes should be resolved, what happens if a member decides to leave the business, and other considerations. For an LLC operating agreement to be valid and legally binding, all of the LLC’s members must sign it. An LLC should keep its operating agreement at its principal place of business.
- Corporate Bylaws – Corporations must create and maintain bylaws that outline the rules governing how their affairs will be conducted. Bylaws also identify how often a Corporation must hold its board of directors and shareholder meetings. While bylaws typically do not get filed with a state office, a Corporation must keep the document and make it available to shareholders upon request.
LLC operating agreements and corporate bylaws must be updated when significant changes occur, such as when the company introduces new members or shareholders, profit distribution percentages change, or when other policies reflected in the governance document are modified.
3. Limited Personal Liability
Both structures limit their owners’ liability. Typically, each member or shareholder can be held responsible only for the amount they invested in the company. Therefore, owners’ personal assets (such as homes, cars, savings, retirement savings, etc.) are protected from the business’s legal and financial liabilities and risks. Note that the limited liability protection may not apply under certain circumstances, such as if a member or shareholder personally guarantees a loan for the company, commits fraud, or causes harm intentionally or through personal negligence.
Liability protection is an important consideration when starting a business. The sole proprietorship and general partnership structures provide no personal liability protection because they are considered the same legal entities as their owners. LLCs and Corporations must remain vigilant in fulfilling their ongoing compliance obligations because failure to do so could pierce the corporate veil. As an example, a court could rule that personal liability protection for the business owners does not apply because the entity neglected its corporate formalities.
4. Income Tax Structure
LLCs and Corporations are taxed differently, and both offer some tax treatment flexibility, so it’s important to research which option will be most financially beneficial for your company. It’s helpful to talk with an accountant or tax advisor to assess your situation when deciding on how to have your entity taxed.
LLC Income Tax
- Default Tax Treatment – An LLC is considered a disregarded entity for tax purposes, meaning its income tax obligations pass through to its owners. So, the LLC is not subject to (corporate) income tax at the entity level. Business income or losses are reported on the individual tax returns of the LLC’s owners. Business profits reported on those individual tax returns are subject to self-employment taxes (Social Security and Medicare taxes). Because members of an LLC are not on the company’s payroll (members get paid through owner’s draws), they receive no paychecks from which taxes are withheld. Therefore, LLC members must make quarterly estimated tax payments throughout the year.
- S Corporation Tax Election – Members may elect to have their LLC taxed as an S Corporation by submitting a special filing (Form 2553, Election by a Small Business Corporation) with the IRS. It must first meet the IRS’s eligibility requirements. As an S Corporation, members working in the business must be put on the payroll and receive a reasonable wage for their work. Only wages and salaries paid to LLC members through payroll are subject to self-employment taxes. The remaining profits paid as distributions to LLC members don’t get hit with Social Security and Medicare taxes. For some business owners, having their LLC taxed as an S Corp may help reduce their personal tax obligations.
- C Corporation Tax Election – An LLC can opt to be taxed as a C Corporation by filing IRS Form 8832 (Entity Classification Election). By doing so, the company will be taxed at the entity level and subject to corporate income tax. I’ve provided more information about C Corporation tax treatment below.
- Potential Tax Benefits of the LLC
- A simplified tax filing process – All tax reporting flows through to the individual owners’ tax returns.
- No double taxation – I explain double taxation in the C Corporation default tax structure information below.
- Tax flexibility – LLCs may elect to be taxed as an S Corporation or C Corporation.
Corporation Income Tax
- Default Tax Treatment – A C Corporation is a tax-paying entity separate from its owners. It gets taxed on its profits at the corporate income tax rate. Many people use the term double taxation when referring to a Corporation’s income tax treatment. That’s because the Corporation pays taxes on its profits. Then, the individual shareholders pay taxes on the dividend income they receive from the business. Profits paid out to shareholders as dividends may not be included as a deductible expense for the Corporation. Therefore, those profits get taxed twice — once at the corporate level and then again at the individual shareholder level.
- S Corporation Tax Election – Corporate shareholders have some options to help avoid double taxation. One of them is to elect to be treated as an S Corporation. S Corp tax treatment means that the Corporation’s profits and losses flow directly to its shareholders’ individual income tax returns. With pass-through taxation to the business owners, the company does not pay income tax at the corporate level. As with LLCs that elect to be treated as S Corps, only shareholders’ wages and salaries — not profit distributions — are subject to self-employment taxes.
- Potential Tax Benefits of a C Corporation
- More business tax deductions – C Corporations can potentially qualify for more business tax deductions than other types of business structures.
- Lessen owners’ self-employment tax burden – Shareholders pay Social Security and Medicare taxes on their wages and salaries but not on any company profits distributed to them.
- Ability to carry losses forward – A C Corp may carry over a significant portion of its losses in one year to reduce its taxable income the following year.
- Tax flexibility – A C Corporation may elect to be taxed as an S Corporation if it meets the IRS qualification requirements.
5. Ownership
C Corporations and LLCs can be formed by one or multiple owners — with no limit on the number of shareholders or members. However, LLCs and C Corporations that elect to be S Corporations may not exceed 100 shareholders.
Most states do not restrict who may own a C Corporation or LLC. Generally, owners can be individuals, Corporations, LLCs, and foreign entities. However, the IRS imposes some ownership restrictions on S Corporations. Allowable shareholders include individuals, certain trusts, and estates. Partnerships, Corporations, and non-resident aliens may not be S Corporation shareholders.
6. Ability to Raise Capital
Both the LLC and corporate structures allow a business to borrow money and sell equity to raise capital. Some other key points about funding them include:
- LLC Capital Options – LLCs may not issue stock. However, they may bring on new members (if the operating agreement allows it) to contribute financially to the business. With no limit to the number of members an LLC may have, existing members may bring on new owners at their discretion to help fuel business growth and expansion. However, there could be challenges in securing outside financing. Generally, venture capitalists and sometimes angel investors may not be interested in (or they might be prohibited from) financing a business formed as a pass-through entity.
- Corporation Capital Options – Corporations may sell shares of company stock to raise capital. This offers expanded opportunities for growth, especially for C Corporations, because they can have an unlimited number of shareholders and issue multiple classes of stock. If a Corporation files as an S Corporation, it may issue only one class of stock and cannot have more than 100 shareholders. This may not be an issue for some companies, but for others, it may inhibit their growth goals.
7. Duration of Existence
In most states, the law allows the LLC and corporate entity types to continue operating indefinitely (i.e., have perpetual existence), even if members or shareholders leave the business or pass away. However, an LLC’s operating agreement or corporation’s bylaws may have provisions that specify otherwise. If owners intend to operate the company for a limited duration, they may state a dissolution date or term of existence in their formation documents, LLC operating agreement, or corporate bylaws.
If an LLC or Corporation continues in perpetuity, business owners must file Articles of Dissolution with the state to officially close the entity.
8. Profit Distribution Among Business Owners
Some differences exist in how LLCs and C Corporations may distribute profits to their owners:
- How LLCs Split Profits – By default, an LLC’s profits and losses will be divided among the members according to the percentage of their ownership interests. However, if approved by the IRS, the LLC may allocate profits and losses of the business to its members as agreed upon by all members. This allows the business owners to consider not only monetary contributions but also expertise and participation in running the LLC when determining profit distribution.
- How C Corporations Distribute Profits – A Corporation’s profits may be reinvested in the business (with limits), or a portion may be paid as dividends to shareholders. Dividends can only be paid pro-rata (proportionately) to ownership of shares in the Corporation. Losses of a Corporation are not reported or claimed by the company’s shareholders on their personal tax returns.
If an LLC or C Corporation is taxed as an S Corporation, it follows its underlying entity’s method for distributing profits.
9. Management
The upper-level management and oversight of LLCs and C Corporations differ slightly:
- LLC Management Options – An LLC may have its members or managers handle the company’s day-to-day management responsibilities. If members have that responsibility, the LLC is referred to as a member-managed LLC. If the members wish to appoint or hire a manager instead and operate as a manager-managed LLC, the entity’s formation documents or operating agreement should reflect that.
- Corporation Management – C Corporations must appoint a board of directors to establish policies and oversee the business. A board of directors has fiscal responsibility for the Corporation and is tasked with ensuring the entity fulfills its corporate compliance tasks and follows its bylaws. The board of directors also elects or hires corporate officers — e.g., Chief Executive Officer (CEO), Chief Operations Officer (COO), and Chief Financial Officer (CFO) — who manage the day-to-day management responsibilities.
10. Reporting and Ongoing Compliance
The compliance requirements and laws vary from state to state. Generally, LLCs have less government oversight and fewer formalities than Corporations. Failure to stay on top of compliance tasks may result in fines, penalties, loss of liability protection, and even involuntary dissolution (forced closing) of the business entity.
A few of the compliance requirements most LLCs and Corporations must fulfill include:
- File a Beneficial Ownership Information (BOI) Report
- Maintain a registered agent at all times
- Obtain an EIN (federal tax identification number)
- Report and pay applicable taxes and fees
- Keep owners’ personal finances separate from those of the business
Other possible compliance requirements include the following:
- Register for payroll taxes and remit them to the appropriate tax authorities
- File an annual report with the state
- Renew business licenses and permits
- Hold annual meetings and record minutes (e.g., LLC member meetings, corporate shareholder meetings)
- Hold board of directors meetings (Corporations must hold these according to the terms of their bylaws.)
Remember, states’ laws vary, so it’s critical to research the rules and requirements that apply to your business.
Additional Resources to Help You Decide
It’s helpful to consult an attorney and accountant (or tax advisor) for guidance specific to your unique circumstances because no two businesses are exactly alike!
You can use CorpNet’s free Business Structure Wizard to help you answer key questions to determine which business is right for your new venture.
