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Choosing between a limited liability company (LLC) and a corporation is one of the first big decisions a new business owner faces. Your choice affects how you’re taxed, how much paperwork you’ll deal with, and how protected your personal assets are.
While both structures offer liability protection, they differ in ownership, tax treatment, and complexity. Here’s what you need to know to choose the right fit for your business.
Key Takeaways
- LLCs are generally easier and more flexible to set up and manage than corporations.
- LLCs offer tax flexibility, allowing owners to choose how the business is taxed.
- Corporations may be more complex to manage but offer advantages like retained earnings and access to capital through stock.
- LLCs and S corporations both avoid double taxation by passing profits to owners.
- Your choice depends on your business goals, growth plans, and preferred tax structure.
Advantages of an LLC
Easier to Form and Manage
Creating a limited liability company (LLC) is a much simpler process than creating a corporation and generally takes less paperwork. LLCs are under the jurisdiction of state law, so the process of forming an LLC depends on the state where it is being filed.
Most states require filing articles of organization with the secretary of state, and some states allow for them to be filled out online. A few states require an additional step of filing a public notice, often in local newspapers. Once these steps are completed, the LLC is officially formed. There are lots of LLC filing services that can help, too.
Once an LLC is formed, it’s good business practice to set out the roles and responsibilities of the members. The members are individuals with an ownership interest in the LLC. Most LLCs use an operating agreement to define these roles.
Drafting an operating agreement is not necessary for an LLC to be valid, but it is a prudent course of action. If no operating agreement is created, then an LLC is governed by the default rules contained in state statutes.
Tax Flexibility
LLCs are not recognized as a separate tax entity by the Internal Revenue Service (IRS). Instead, profits and losses pass through to the members, who report them on their personal tax returns. This avoids double taxation, a common downside of corporations.
Members can choose how their LLC is taxed:
- As a sole proprietorship (for single-member LLCs)
- As a partnership
- Or elect to be taxed as an S corp or C corp
This flexibility is a major reason why many small business owners choose LLCs.
Disadvantages of an LLC
Self-Employment Taxes
Although an LLC does come with plenty of advantages, there are some disadvantages to consider. LLC members have to pay a self-employment tax, which includes a 12.4% tax for Social Security and a 2.9% tax for Medicare.
Potential for Automatic Dissolution
There are other drawbacks to an LLC as well. The purpose of an LLC is to protect its members from any liability. If the company fails to meet its obligations, then creditors can target only the LLC, not the assets of the members. However, there are certain situations in which an LLC can be automatically dissolved, leaving members open to risk.
Automatic dissolution can be triggered if an LLC fails to report its filings on time; a death or withdrawal of any member occurs unless succession provisions are outlined in the operating agreement; a change in the structure of the LLC, such as a merger; or any terms with expiration dates. In these situations, an LLC can continue doing business, but the liability structure of the members may alter, defeating the initial purpose of creating the LLC.
Before the passing of the Tax Cuts and Jobs Act in 2017, an LLC treated as a partnership for tax purposes could automatically be terminated due to tax reasons as well. The automatic termination was triggered if there was a transfer of 50% or more of an LLC’s total interest or profits within 12 months. This rule no longer applies from tax year 2018 and beyond.
Varying State Laws
Another major disadvantage is the differences among states in the statutes that govern LLCs. This can lead to uncertainty for LLCs that operate in multiple states. The differences in rules and regulations can result in additional paperwork and inconsistent treatment across different jurisdictions.
Advantages of a Corporation
Despite the ease of administration of an LLC, there are significant advantages to using a corporate legal structure.
S Corporations vs. C Corporations
Two types of corporations can be formed: an S corporation and a C corporation. An S corporation is a pass-through entity, like an LLC, where the owners are taxed on the profits and losses of the corporation.
A C corporation is taxed at the corporate level, separately from its owners, through a corporate income tax. C corporations are the most common type of corporation.
Important
C corporations have the advantage of allowing profits to remain with the corporation and paying them out as dividends to shareholders. Also, for businesses that eventually seek to issue stock, a C corporation can easily issue shares to raise capital for further expansion of the business.
More Control Over Profits
Corporations offer more flexibility when it comes to their excess profits. Whereas all income in an LLC flows through to the members, an S corporation is allowed to pass income and losses to its shareholders, who report taxes on an individual tax return at ordinary levels.
As such, an S corporation does not have to pay a corporate tax, thereby saving money, as corporate taxes are higher than ordinary taxes. Shareholders can also receive tax-free dividends if certain regulations are met.
Disadvantages of a Corporation
Complex and Costly Administration
There are significant disadvantages to creating a corporation regarding the amount of complexity involved. It requires a great deal more paperwork, meeting many more guidelines, electing a board of directors, adopting bylaws, having annual meetings, and creating formal financial statements. They generally have more burdensome record-keeping requirements than LLCs.
Double Taxation (C Corps)
There is also the issue of double taxation for corporations. This refers to taxes being paid twice on the same income. This is because corporations are considered separate legal entities from their shareholders. Thus, corporations pay taxes on their earnings, while their shareholders also pay taxes on any dividends that they receive from the corporation.
Am I Required to Have a Limited Liability Company (LLC) or a Corporation to Hire Employees?
No. You can hire employees or contractors as a sole proprietorship, although you may expose yourself to greater risk. A limited liability company (LLC) or a corporation protects your personal assets by creating a structure for your business separate from your personal finances.
Which Is More Expensive to Set Up: An LLC or a Corporation?
Fees for incorporating or creating an LLC vary from state to state. Forming an S corporation can range from $100 to $250 for only the state incorporation fees, not including lawyer fees. An LLC can range from $50 to $500, depending on the state.
Does an LLC Require More Than One Member?
No. An LLC only limits liability; it doesn’t establish anything about the structure of the business. A single-person business can be an LLC.
The Bottom Line
LLCs and corporations both offer liability protection, but the right structure depends on your business goals, tax preferences, and plans for growth. Choose an LLC for flexibility, ease of setup, and pass-through taxation. Choose a corporation if you need to retain profits, raise capital, or issue stock.
As an individual starting their own business, it’s important to understand all of the nuances involved and choose the right structure for your company. When in doubt, consult a tax professional or legal advisor to decide which structure best supports your business long-term.
