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Two of the most popular entity formations for business incorporation are limited liability companies (LLCs) and corporations. Both entities provide startup owners with certain benefits, and one of the biggest benefits is limited liability. This creates a separation between the assets of the business and the owner, and protects the owner’s personal assets in the event of an unforeseen circumstance.
Aside from limited liability, what are some good reasons to choose an LLC or a corporation to incorporate a business? Let’s take a look at the areas where LLCs and corporations differ from each other and what that means for new entrepreneurs looking to incorporate as one of these entities.
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Ownership structure looks a bit different in an LLC versus a corporation and vice versa. It’s important to know how each entity structures ownership before you can pick the best entity for your business.
Let’s start with LLC ownership.
An LLC may distribute its ownership stake to its members (also known as the LLC’s owners) regardless of each member’s financial contribution to the LLC. However, what happens if one member has not invested as much in the LLC as another member?
Situations like these require referring to the LLC’s written operating agreement. This agreement may include terms that specify all members receive an equal share of the profits. The LLC operating agreement may also include additional details about the process for transferring membership interest between members. Creating this written agreement allows the LLC to establish flexibility in its business ownership.
A corporation, on the other hand, has the ability to issue shares of stock and sell percentages of the business to its owners. These individuals are known as shareholders. Once shareholders are issued shares, they may transfer these shares, buy more stock to own a larger percentage of the company, or sell their stock. Corporations also exist in perpetuity. In the event that an owner should leave or divest from the company, the corporation would remain in existence, as it is separate from its owners.
The management structures between an LLC and corporation differ greatly from one another. One entity is flexible while the other is a bit more strict. Depending on the type of business you’re running, you may choose an entity simply because of its management structure.
LLCs are known for being flexible entity formations. The LLC may be managed using one of three methods with its members:
- Single member LLC. If your LLC is run by a single member, then that member runs the business.
- Member managed LLC. An LLC with multiple members allows each member to manage the entity. This management is done equally with all members sharing the same amount of responsibility.
- Manager managed LLC. This option allows a board of managers to oversee the direction and operation of the LLC. It’s usually a good management structure option for members who aren’t comfortable running an LLC on their own.
Corporations, however, tend to be a bit more structured in their management style. A corporation requires a formal structure to run the business. This includes a board of directors to handle management responsibilities of generating profits for shareholders and corporate officers who work on the organization’s daily operations.
Even shareholders, to a lesser degree, are considered to be owners of the corporation. However, with the exception of approval in major corporate decisions, they are often separate from business decisions and the corporation’s daily operations.
Taxes are one of the greatest differences between an LLC and corporation.
Let’s begin with a look at LLC taxes. By default, LLCs are taxed as a pass-through entity. Business profits are able to “pass-through” to members. Profits and losses are reported on individual tax returns, not at the business level. Members may also deduct losses or operating costs of the business on their personal tax returns, helping to offset other income and making the process of tax filing a bit easier.
Since a corporation earns its own income, it is taxed as a separate entity. Corporations have a responsibility to pay tax on their profits and tax on dividends that are distributed to shareholders. Dividends are taxed twice, in a process known as double taxation, as these include salaries and bonuses and are not tax deductible.
One of the most popular options for corporations trying to avoid double taxation is an S Corporation election. Qualifying corporations with less than 100 shareholders may elect to file as an S Corp. This gives corporations the chance to be treated as a pass-through entity, similar to how an LLC is taxed, and save on taxes.
Which entity is the best fit for my business?
Now that you have an understanding of what it’s like to own, manage and be taxed as an LLC and corporation, which entity is the best fit for your business? Ultimately, the decision depends on the type of business you plan to own and operate.
While I personally cannot provide legal advice, the best advice is to consult a legal professional or an accountant. He or she may be able to answer any additional questions you have and guide you toward the entity formation that is best for incorporating a business.