Choosing an entity type for your small business has far-reaching implications on how you run, grow, and pay taxes on your business. Two of the most common types are a limited liability company (LLC) and a corporation.
They may seem similar at first glance, but in reality, they’re designed very differently. A corporation comes with much stricter regulations governing how the company is managed, but also with more options for fundraising. Explore how each business classification works and how to determine which is best for your business.
What is an LLC?
A limited liability company is a business structure that offers some tax benefits and personal liability protection. An LLC can have one or more owners (called “members”). Both sole proprietors and business partners can form an LLC to protect their personal assets. Additionally, LLCs avoid double taxation because they don’t have to pay corporate taxes. Company profits are passed through to the owner(s) and reported on their personal tax return.
However, LLC members are considered self-employed by the IRS, so they do have to pay self-employment tax. LLCs can opt to be taxed as an S corporation to lower some of the tax liability for the owner (who would be an employee who receives a W2 form from the company). Payroll taxes apply to their salary, but profit distributions aren’t subject to self-employment tax. Although it can be taxed as an S corp, an LLC is not considered a corporation.
What is a corporation?
A corporation is a business entity that is owned by shareholders, but which is entirely separate from its owners. As a legal entity, a corporation can employ people, enter into agreements with other companies, and borrow money. There are a few important elements that distinguish a corporation:
- Only corporations can issue shares. LLCs cannot issue shares, and thus do not have shareholders. Rather, they have owners who are allocated a percentage of the company according to the LLC’s operating agreement.
- Corporations can be publicly traded. Corporations can be privately owned or be a public company listed on a stock exchange, in which case the company is regulated by the US Securities and Exchange Commission.
- Corporations pay their own taxes. As an independent legal entity, corporations are responsible for paying taxes on the corporate level. The federal tax rate for corporations was 21% in 2021. LLCs do not pay this tax; rather, they pass their profit on to the owners, and only the owners pay personal income tax.
- Corporations have special legal requirements. A corporation must create bylaws that govern its operation and issue stock to shareholders (even when private). It must also elect a board of directors. Finally, a corporation must hold annual meetings for shareholders and the board. All of these requirements must be met, even if there is only one shareholder and one board member for the company.
S corp and C corp are subtypes of corporations. They’re also corporate tax designations. A corporation is by default classified as a C corp for tax purposes.
LLC vs. corporation: similarities and differences
LLCs and corporations have some basic similarities—they’re both legal entities that afford their owners liability protection, for example. But they have far more differences, especially in how they’re taxed and what options they have for fundraising by selling ownership of the company.
- How they’re similar: Both LLCs and corporations separate the company from its individual owners, offering personal liability protection. Unless someone signs a personal guarantee, creditors cannot come after personal assets for LLC or corporation owners.
- How they’re similar: Both LLCs and corporations are legal entities that must be formed by filing paperwork with their state.
- How they’re different: The formation process is more complex and expensive with a corporation, including having to elect a board of directors. Once formed, a corporation must hold annual board meetings and shareholder meetings and record the minutes of those meetings for tax and legal records.
- How they’re similar: Both LLCs and corporations may raise money by selling ownership of the company to investors.
- How they’re different: A corporation has more options when it comes to outside investments. It can raise capital from investors by offering company shares, but LLCs cannot. Rather, they have members/owners who are allocated a percentage of the company according to the LLC’s operating agreement. An LLC, on the other hand, can’t offer shares; investors would need to be added to the LLC’s articles of organization as members/owners in order to receive equity for their investment. In the same vein, a corporation can go public, while an LLC cannot.
- How they’re similar: “LLC” and “corporation” are legal entity types, each of which have some degree of choice in how they’re taxed.
- How they’re different: Corporations are taxed by default as C corporations, which are subject to a corporate tax on profits. Corporations with fewer than 100 shareholders (all of whom must be individuals who are citizens or permanent residents of the United States) may elect to be taxed as an S corp rather than a C corp. S corps enjoy pass-through taxation. LLCs may also elect to be taxed as an S corp, or as a sole proprietorship or partnership (depending on the number of members it has).
What are the advantages of an LLC?
Business owners may benefit from a range of advantages as an LLC, including:
- Personal liability protection. Unlike a sole proprietorship or general partnership, an LLC protects the owner(s)’s personal assets from lawsuits and creditors. The exception is if the business engaged in fraudulent activities or if the owner signed a personal guarantee on their business financing.
- Multiple tax options. An LLC can elect to pay taxes as a sole proprietorship, a partnership, or an S corp. One may be better than the others depending on how the business operates.
- Easy formation process. Forming an LLC is a simple process compared to other types of business entities, like an S corp or C corp. The required paperwork is minimal, it usually takes around two weeks for the state to process your application, and fees are typically less than $1,000.
What are the advantages of a corporation?
Forming as a corporation comes with advantages for some types of businesses.
- Some taxation flexibility. A corporation is taxed as a C corp by default. Profits are taxed at the corporate tax rate, then investors are taxed on their dividends as well. Both income tax and self-employment taxes apply to these dividends. However, if it meets eligibility requirements, the corporation can elect to be taxed as an S corp to avoid the corporate tax burden.
- Options for issuing stock and attracting investors. A corporation issues shares to its owners and can offer two types of stock: common and preferred stock. A corporation taxed as a C corp may issue both types of stock to attract different levels of investors, while an S corp must choose one. S corps may also cap their total number of shareholders at 100, and all must be citizens or permanent residents of the United States.
The choice between an LLC or a corporate business structure is a deeply individualized one. It comes down to how you want to manage your company, pay taxes, and use external investment to grow. You might consider these questions when making the decision.
- What is more important to you: ease of formation or potential to attract investors?
- Are you able to take on the operational complexity that comes with a corporation?
- How will you fund your company? Through your own capital investments or through selling ownership?