The Major Differences of a Corporation and an LLC
An LLC or Limited Liability Company is a type of business structure that is often described as a combination of a corporation and a partnership. This blend of the characteristics of corporations and partnerships makes an LLC a flexible business structure. Business owners can get the benefits of a corporate structure and traditional partnership all at once. An LLC combines the limited liability from a corporation and the pass-through taxation element from a partnership.
A corporation, meanwhile, is an entity that helps create a distinction between a business and its owners and shareholders. Some would refer to corporations as a legal person because they have almost the same rights and responsibilities as an individual. As mentioned before, a significant characteristic of a corporation is the limited liability it provides to its shareholders.
In this article, we will discuss more in-depth the differences between a limited liability company and a corporation from structure, taxation, income and loss, and management. When starting your own business, it is important to understand the elements of each business structure. Choosing the right business structure can help you gain more profits and manage the company more efficiently.
Business Formation and Structure
All business entities and organizations are required to register as a certain business type in the state where they conduct their operations. States will recognize entities filed as corporations, limited liability companies, partnerships, and other variations of these structures. Most of the differences between a corporation and an LLC mirror the structural differences between these two types of businesses.
An LLC can be formed by having one or more people as owners. Business owners, referred to as members, need to file Articles of Organization or a Certificate of Operation in their state. Another requirement to form an LLC is an operating agreement. This document is a contract that details the percentage of ownership for each member and how the business’ day-to-day activities will be managed.
Forming a corporation is also referred to as incorporation. The process of setting up a corporation is more complex compared to a limited liability company. To start, corporations are required to file Articles of Incorporation in the state where the entity is located and designate stocks to its shareholders. There are several types of corporations and it’s important to file the correct type of Article of Incorporation.
Next, the shareholders of the corporation need to create and elect a board of directors that will oversee the business. The board of directors will then be tasked to agree on the bylaws. The board of directors represents the shareholders thus they need to act according to the best interests of the shareholders.
Major Differences in Handling Income and Loss
Income and losses are treated differently by LLCs and corporations. One key difference between corporations and LLCs is that LLCs are considered as pass-through entities. This means that any income or loss acquired from normal business operations flows or passes to the owner directly. The income generated by the business is considered as the income of the members or business owners.
For most types of corporations except an S corporation, income and loss are received by the business entity. Although the owners or shareholders do not receive profit directly, they reduce the risk of getting huge losses from the business. Some of the earnings could be distributed in dividends to the owners and some are kept by the corporation.
Taxation on Corporations and LLCs
Corporations and LLC both pay taxes on their annual profits. However, the methods in which they pay their taxes are different. Annual profits of an LLC are referred to as net income while annual profits of a corporation are called net earnings.
Taxes on LLCs
Since the income from Limited Liability companies is passed directly to the members, it is exempted from having a corporate income tax. The pass-through taxation scheme prevents businesses from experiencing double taxation and reduces the overall tax they owe. The owners pay income tax on the share of income that they receive. If an LLC earns a net income of $100,000 and has two owners, each member would have to pay income tax on a $50,000 net income.
For a single-member LLC, the owner or members will report the income tax on Schedule C of the personal tax return. For LLCs with multiple members, business owners will get a Schedule K-1 to report their share of the income. Then, they report that income on their tax return. Members of an LLC are also required to pay a self-employment tax. Some states would also require LLCs to pay franchise taxes. A franchise tax is also called a privilege tax. It is issued by a state for the privilege of conducting business.
Taxes on Corporations
Corporations pay corporate taxes at a fixed rate. The shareholders of the corporation pay taxes on the dividends that they receive. This is the double taxation scenario that an LLC often avoids. The net earnings of the corporation and the dividends from the net earnings are both subject to tax. Currently, in the United States, resident corporations are taxed at a 21% rate.
Although double taxation may appear disadvantageous at first, businesses that choose to incorporate often see that this downside will be compensated by federal deductions which are only enjoyed by corporations. Corporations can deduct all their business expenses such as operating expenses, advertising costs, and fringe benefits for employees. All these deductions will result in generous savings as time passes by.
If a corporation has less than 100 shareholders, it can choose to file for an S corporation tax status. This status will treat a business as a pass-through entity. This is a good option for business entities who want to be taxed the same way as an LLC but also retain the formalities that a corporation delivers.
Managing an LLC and a Corporation
LLC Management
Limited Liability Companies have a flexible structure. The business entity can be managed by the members or by a group of selected managers. In an LLC managed by members, the owners directly oversee the conduct of the daily operations. Meanwhile, in an LLC managed by managers, investors do not play an active role in managing the business and are more likely to step back and watch.
LLCs may also choose to remove the distinction between the owner and the manager of the company. Members of an LLC who contribute directly to the business entity need to agree on who will supervise the typical operations and manage resources. Because of the flexible nature of an LLC, the management of an LLC has fewer formalities. This characteristic makes it an attractive option for many new entrepreneurs.
Some states will require an LLC to file an annual report while other states do not. LLCs will have fewer formal requirements compared to a corporation. You can check with the office of your secretary of state to verify the requirements for an LLC.
Corporation Management
In a corporation, the management is much more rigid compared to an LLC. First, the formal structure involves a Board of Directors that takes the task of generating income for shareholders. Corporate officers deal with the day-to-day conduct of the business operations.
The owners, which are the shareholders, maintain distance from daily operations and business resolutions except for some key corporate decisions. Despite the separation between a corporation and its shareholders, an individual shareholder can also be delegated as an officer or elected to the board of directors. Corporate bylaws detail the rules approved by the board of directors once the corporation is set up.
A corporation is required to hold annual shareholder meetings. The details of these meetings are documented in corporate minutes. Corporations are also required to file annual reports to provide current business information to the office of the secretary of state.
Liability and Indemnity
Despite corporations having a more complicated process of incorporation, business owners in fields with high risks feel that the pros outweigh the cons. Shareholders of a corporate business who experience financial hardships can separate private and personal finances from the corporation’s and maintain a certain amount of flexibility when dealing with bankruptcy as well as debt resolution. By the same token, shareholders of a corporation may enjoy a higher level of legal protection in the event that the corporation becomes the target of a lawsuit.
Wrap Up
Limited Liability Companies are simpler and more straightforward to set up. It also removes double taxation which is an ideal element for new business owners. Corporations, despite the more complicated structure, offer business owners benefits that counterbalance the drawbacks. Certain federal deductions are only enjoyed by corporations.
An LLC and a corporation each have their unique benefits. When deciding what type of structure to use for your business, it’s important that the elements of the business structure align with the goals of your company. It is also crucial to consult with a licensed attorney or CPA when forming your business. Professionals can help you answer questions and offer a deeper understanding of the whole process.
