When starting a small business, one of the most important decisions you’ll make is how to structure your business entity. Small business owners commonly choose to structure their companies as LLCs or corporations. In a survey by the National Small Business Association, 42% of businesses were S-corporations, and 23% of businesses were limited liability companies (LLCs).
Your choice between an LLC and a corporation will impact two things that are paramount for any small business owner: your money and time. Your tax burden, ability to raise money from investors, and the ease with which you can expand in the future all depend in part on your business entity. The LLC vs. corporation decision also impacts the time you spend informing your business entity and maintaining your business in good standing.
LLC vs. corporation: An overview
Single-member LLC with one owner or multi-member LLC with multiple owners.
Shareholders, directors, and officers divide up the ownership.
Usually difficult to find investors.
Shares and stock in the company help corporations get investors on board.
Owners decide whether to be taxed as a C-corporation or as a pass-through entity.
C-corporations have to pay a corporate tax rate while S-corporations must pay personal taxes.
Limited liability protections.
Limited liability protections.
Key differences between LLCs and corporations
The LLC vs. corporation decision might seem a little murky. But the differences are likely what will matter most for your business. LLCs and corporations differ in terms of formation, ownership, taxes, and governance requirements.
When forming an LLC, you first have to file a document called the articles of organization with your state’s business filing agency. The articles of organization contain basic information about your LLC, such as the LLC’s name, address, and the names of the LLC’s owners. After filing your articles of organization, the best practice is to draft up an LLC operating agreement. An LLC operating agreement is like a blueprint for your business and sets out the partners’ respective shares in the business, as well as their rights and responsibilities.
There are two types of corporations — S-corporations and C-corporations. In either case, you start by filing articles of incorporation with your state’s business filing agency. Articles of incorporation contain basic information about the company, such as the company name, company address, and the number of shares. After filing your articles of incorporation, you have to take a series of steps to complete the setup process that aren’t required for LLCs. You’ll need to create corporate bylaws, elect a board of directors, hold the first board meeting, hold the first shareholder meeting, and issue shares of stock.
Ownership and raising money
A corporation has a more complicated ownership structure than an LLC, but is the preferred structure if you plan to raise money from investors in the future.
In a corporation, responsibility is divided among three parties—shareholders, directors, and officers. Shareholders own stock in the company. Shareholders elect a board of directors, who engage in long-term strategic planning. The directors appoint officers — such as the CEO, CTO, and CMO — to run the business on a day-to-day basis. It’s entirely possible to have a one-person corporation, where the owner is the sole shareholder, director, and officer.
The owners of an LLC are called members. You can have a single-member LLC with one owner or a multi-member LLC with multiple owners. In some multi-member LLCs, called member-managed LLCs, all members participate in running the business on a day-to-day basis. In other LLCs, called manager-managed LLCs, members appoint one of the members or an outside individual to manage the business.
In most cases, investors prefer to work with corporations over LLCs. Stock in a corporation is designed to be easily distributed to investors, and investors can easily retain their interest in the company by holding onto stock or divest their interest in the company by selling off stock. C-corporations also allow for different classes of stock to incentivize venture capitalists and angel investors. It’s certainly possible for an LLC to attract investment, but it’s much harder, and many investors insist on working only with corporations.
One of the biggest differences between corporations vs. LLCs has to do with taxes. A C-corporation is subject to corporate income tax. The owners of an LLC can choose to have the business taxed as a C-corp or as a pass-through entity. Owners of pass-through entities pay taxes on business income on their personal tax returns.
Many entrepreneurs steer clear of C-corporations due to double taxation. For a C-corp, business income gets taxed once at the corporate level, and then shareholders get taxed again on their personal tax returns if they receive dividends from the business. The only way to avoid double taxation for a C-corp is to reinvest all profits back into the business, minus what you take out to cover a reasonable salary.
However, it is worth noting that while a C-corporation is the default type of corporation, you can also elect to file forms with the IRS to create an S-corporation. This type of corporation is taxed as a pass-through entity; however, you will be limited to 100 shares of one class of stock and your shareholders must be U.S. citizens. In this way, your tax options are more attractive but if you want the ability to take on significant investment from various sources, you’ll be much more limited.
Owners of an LLC, on the other hand, can decide whether the LLC should be taxed as a C-corporation or as a pass-through entity. If you choose to be taxed as a C-corporation, then taxes will be no different from a standard C-corporation. If you choose to be taxed as a pass-through entity, then you’ll report your share of business income on your personal income tax return (like with an S-corp). You’ll pay taxes on that income at your personal income tax rate.
2019 tax changes
Starting with the 2019 tax season (covering the 2018 calendar year), the tax implications for LLCs, corporations, and other types of businesses changed. That’s when the Tax Cuts and Jobs Act (TCJA) took effect.
The TCJA changed the corporate tax rate on C-corps to a flat 21%, down from a range of 15% to 35%. The dividend rate went unchanged, and you’ll still get hit with double taxation if you distribute dividends. Owners of pass-through entities will be able to claim a 20% deduction on business income. Limits apply based on the income level and type of business, but for many LLCs and C-corps, the TCJA will mean a reduction in taxes.
C-corporation vs. LLC tax example
Let’s say you own a retail shop that generates $200,000 in business profits this year, and you have one business partner with whom you equally share the business. If you have a C-corporation, you’d end up paying the 21% corporate tax rate on the profits, or $42,000. Then, if you took $50,000 out in dividends, you’d pay a dividend tax rate (15% for most people) on that amount, which equals $7,500 in this case. For each partner, the tax burden ends up being $28,500.
Now assume that you have an LLC taxed as a pass-through entity. You and your partner would each pay taxes on half of the business income — $100,000 — on your personal tax return. Under 2018 tax brackets, your tax rate would be 24%, bringing your tax bill to $24,000. In this example, the tax bill is slightly lower for an LLC vs. a corporation.
Ongoing governance and paperwork
Ideally, after forming a business, you could just focus on day-to-day tasks like marketing and hiring. But to maintain your LLC or corporation, there are ongoing government requirements that you need to satisfy. These requirements are more onerous for owners of corporations.
Corporations typically need to do all of the following post-formation to remain in good standing with the state:
Create, adopt, and follow corporate bylaws (and update when necessary).
Elect a board of directors and hold regular board of directors meetings.
Hold regular shareholder meetings.
Document meetings with meeting minutes.
Issue stock certificates.
Provide periodic reports to shareholders.
In most states, with the exception of creating an LLC operating agreement and filing an annual report, none of these formalities are required of LLCs. It’s recommended that LLCs maintain documentation of each member’s equity interests and hold regular member meetings, but it’s not required to keep your company in good standing.
Since LLCs have fewer formalities, they generally owe lower fees to the state annually and are able to get by with lower accounting fees and legal fees.
Similarities between LLCs and corporations
While LLCs and corporations have their distinct differences, they are similar in a couple of ways. Both types of businesses are registered business entities, which means that you have to form the business through your state’s business filing agency. Both offer the advantage of limited liability for owners.
Registered business entities
If you were to start a new business tomorrow, you would not be an LLC or a corporation. By default, businesses are either sole proprietorships, if there’s one owner, or partnerships, if there are multiple owners.
To form any type of business, you must first obtain required business licenses and permits. Forming an LLC or a corporation takes a few extra steps. You have to file formation paperwork with the business filing agency in the state where you operate. That process is called incorporation for a corporation and business registration for an LLC. Your corporation or LLC exists only after you file the right paperwork and the state accepts it.
Limited liability protection
As registered business entities, LLCs and corporations both offer one big advantage — limited liability for owners. Limited liability means that, in the ordinary course of business, owners are shielded from personal liability for the debts and obligations of the business.
For example, say you own a delivery company, and a customer loses profits because you deliver a package late. If you’ve organized your business as an LLC or a corporation, then the customer can’t sue you personally or come after your personal assets. They can only sue your company and recover from your company’s assets. However, if you have a sole proprietorship or general partnership, then your personal assets would be fair game.
For this reason, once they start generating solid revenues, most sole proprietors and freelancers “upgrade” to an LLC or corporation to get limited liability protections. That said, you can’t depend on limited liability all the time. For example, if your company acts negligently or if you sign a personal guarantee on a loan, then you’re personally on the hook no matter what kind of business entity you have.
How to choose between an LLC and a corporation
Now that you know the differences between an LLC and corporation, it’s time to see how those differences apply to your business and make a decision. A business attorney or tax professional is the best-qualified person to go through your books and financial statements and determine what’s in your business’s best interest.
That said, here are general things to keep in mind when choosing an LLC vs. corporation:
Flexibility to choose how you’re taxed (you can avoid double taxation).
LLCs usually pay lower annual fees.
Fewer governance requirements.
Easier to raise money from investors and make an initial public offering.
You can offer stock options to incentivize employees and attract talent.
Bankers, judges, and investors are more familiar with corporations.
More difficult to raise money from investors.
C-corporations get hit with double taxation if dividends are distributed.
Corporate governance requirements can be time-consuming and expensive.
Setting up your LLC or corporation
Once you decide between an LLC vs. corporation, you must actually set up your business so you can start serving customers and making money. The quickest route is to set up your LLC or corporation on your own by contacting your state’s business filing agency, but most businesses like a little bit of help along the way.
Sites like LegalZoom and Rocket Lawyer will incorporate your business or register your LLC for a flat fee, typically around $150 or less. If you want guidance through every step of the process, then you can also hire a business attorney to establish your LLC or corporation. A business attorney will walk you through the pros and cons of each type of business entity, give you personalized advice, and help you file all the right paperwork.
The bottom line
Ultimately, the choice between an LLC vs. corporation comes down to your patience for paperwork and governance requirements, your tax bill, and your future goals. For most small businesses, the simplicity and ease of an LLC works. You don’t have to worry about double taxation, and you don’t have as much paperwork to submit and government rules to follow. But if you think you’ll be raising venture capital in the future, then it’s a good idea to set up as a corporation now. Switching entities down the line is possible, but expensive, so it’s best to make this decision now and stick to it.
A version of this article originally appeared on Fundera, a subsidiary of NerdWallet.