Choosing Between a Corporation and an LLC
Choosing Between a Corporation and an LLC
February 23, 2018
When you're starting a business, one of the first questions you might encounter is whether you should incorporate as a corporation or as a limited liability company (LLC). Many people do not take this decision seriously, and often default to selecting an LLC, but this legal entity may not be the best form for your company.
Liability to Third Parties
One of the most common misconceptions perpetuated by many people that are skeptical of LLCs is that they provide less protection for personal assets than a corporation. This is not true.
In fact, most states actually use the exact same language for limitation of liability for corporations and LLCs, so the level of protection is virtually identical between both LLCs and corporations from one state to the next.
Let's get a common misconception out of the way: There's no such thing as an "S-Corporation" as a legal entity. A Subchapter S election, when applied to either a corporation or an LLC, changes the way the entity is taxed, but does not change how the entity legally operates. The tax treatment is divisible and separate from how the legal entity operates.
Tax treatment is often the most important deciding factor in selecting you business entity. That tax treatment only affects about 10% of how a company operates, but it often becomes the "tail that wags the dog" of business entity selection. This misconception is also compounded by the default tax treatment for both corporations and LLCs.
The primary difference between a corporation and a LLC for is the default tax treatment. By default, corporations are subject to corporate taxation and even double taxation to their owners where profits are taxed at the entity level and again at the shareholder level on distribution. An LLC, on the other hand, can elect partnership tax treatment in which the entity is essentially disregarded for tax purposes and the profits and losses of the entity “flow through” to the owner, thereby being taxed only once. However, this is just the default rule for both entities. Both entities have other tax regimes that they can "opt-into," meaning that they aren't available by default.
For instance, Subchapter S of the Internal Revenue Code (i.e., an S election), provides an number of beneficial deductions and categorizations that are not available in either a partnership or a C-Corporation (the default). What many people don't know is that both a corporation and an LLC can elect to be treated as an S-Corporation for tax purposes.
In fact, an LLC can potentially elect to be treated as under any number of tax regimes, from S-Corporation to Disregarded Entity to even non-profit, as long as it otherwise meets the criteria. In the alternative, a corporation can only be treated as a C-Corporation or an S-Corporation.
The single biggest difference between a corporation and an LLC is how they are managed. This is also the most over-looked element considered when forming a business entity.
By default, an LLC is managed by its owners, which are called Members. These Members may appoint someone to run the company on their behalf, who is called a Manager. However, any power the Manager holds flows through the Members.
A corporation is quite different. A corporation's owners (called Shareholders) elect a Board. The Board is charged with supervision of the company, but they don't manage the day-to-day operations. Instead, the Board selects a President and other Officers to manage the business. The power in a corporation flows through the President, who serves at the will and at the direction of the Board. Most importantly, this three-tiered operating structure doesn't change when there is less than three people in the company, so one individual often serves multiple roles within the same corporation, even within large, publicly traded corporations.
The way LLCs and corporations are managed is the single biggest difference in how an LLC and a corporation operate. For instance, any owner of an LLC has the ability to execute contracts, sign checks, open bank accounts, etc. If you've ever owned stock in a publicly traded company, on the other hand, you might have some difficulty in attempting to sign that company's checks. However, I have seen far too many instances in which a rogue owner in an LLC obligated the company to do something, with no knowledge of the other owners, that cost the company significant amounts of money.
The other major departure between a corporation and an LLC is the compliance aspect, which requires significantly more from a corporation than an LLC.
Most states require corporations to do certain things in order to remain in good standing with the state. For example, most states require that a corporation's Board meet at least once a year, that the corporation maintain written minutes, that the corporation's shareholders be disclosed to the Secretary of State, and that a periodic fee be paid, all at least once per year, in order to keep the corporation in good standing.
As for LLCs, you usually only have to pay an annual fee to keep the company in good standing.
Admittedly, most of the requirements placed on corporations were implemented over decades by implementing best business practices developments. Each requirement placed on corporations was usually founded in a legitimate need to keep a certain aspect in a corporation predictable and functional. The problem is that these requirements, while ideal for corporations with dozens and even hundreds of owners, are overly burdensome on small, closely-held businesses.
Selecting the proper business entity is rarely as simple as it might first appear. It requires consideration of a number of factors and not just potential tax liability. After all, few people care that they saved a few bucks on their tax return if their partner steals all the company's money.