LLC or Corporation – Which is better for you?

November 7, 2021by Brian Walsh

According to the U.S. Census Bureau, more than 430,000 new business applications were filed in September 2021 across the country, almost 51,000 in Florida alone. Most new businesses are established as sole proprietorships or small partnerships initially due to their small scale. As the company expands, the limitations of the simple legal structures become more restrictive and troublesome.

A transition to a corporation or limited liability company is necessary for most companies due to internal and external pressures after their initial formation. For example, eBay’s online auction company began as a sole proprietorship in early 1995 and incorporated later to accommodate investors. Similarly, the natural food company Annie’s Homegrown was founded in 1982, deferring incorporation until 1989.

Some founders initially recognize that the scale of their dream will require external equity, so they incorporate at the time of the company’s founding. Jeff Bezos incorporated Amazon in 1994 with funds from his parents, and he was working out of his garage. Elon Musk incorporated his first company, Zip2, knowing that the corporate structure was necessary to attract venture capital firms.

Six Considerations

Choosing Between
An LLC And Corporation

Each legal structure – corporation and LLC - has characteristics that affect business owners differently at various stages of a businesses life cycle.

1. Personal Liability of Owners

A sole proprietor or partnership business exposes its owner(s) to the loss of personal assets to fulfill business obligations. Owners may be legally responsible for business taxes, debts, and court judgments. Limiting individual liability and protecting one’s personal assets is the most critical reason owners elect to form an LLC or corporation.

Corporations – C and S types – and limited liability companies eliminate the exposure of personal assets to business liabilities in most circumstances.

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2. Funding Requirements

Growing businesses often need an infusion of capital in addition to cash flow from operations. A corporation or LLC limits personal liability and expands the pool of potential investors in the business. Subject to legal regulations regarding investment solicitations and sales, C-corporations and LLCs can raise an unlimited amount of funds from an unlimited number of shareholders or members, respectively.

However, the importance of ownership transferability increases as the number of owners increase. The LLC’s potential limits on members’ ability to sell their interests is an important consideration in the decision to establish a corporation or an LLC.

An S-corporation or an LLC electing to be taxed as an S-corporation cannot have more than 100 shareholders or members. All members must be U.S. residents, if not U.S. citizens. In addition, only one class of stock or member interest is permitted (no preferred treatment for some owners versus other owners).

A C-corporate structure is warranted if raising funds from venture capital organizations or Angel investors due to the VC’s preference for convertible preferred shares and bonds as investment types and the less restricted transferability of investment interests. 

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3. Taxation of Profits And Losses

The cost of income taxes significantly impacts a company’s profits and the amount of income ultimately received by an owner. Sole proprietorships and partnerships are “pass-through” entities for tax purposes, i.e., any profit or loss is taxed on the owner or partner level, not as a business entity. Accordingly, a sole proprietor or a partner in a business pays income taxes and self-employment taxes at rates up to 37% and 15.3%, respectively.

The two structures – C-corporation and Limited Liability Company – are taxed differently. The S-corporation and S-LLC give owners a choice, subject to specific requirements, to pay taxes at the business or personal investor level:

  • C-corporation. Taxes are paid on the profits of the business at a flat 21% rate. Unless profits are distributed to shareholders as dividends, individual shareholders have no liability for the corporate taxes. Qualified dividendsdistributed to individual shareholders are considered “unearned income” and taxed at a capital gains rate. The payment of taxes on the business profits initially at the corporate level and a second time at the individual level for dividends is “double taxation.”
  • Limited Liability Company. An LLC is considered a “pass-through” entity for income tax purposes. In other words, the LLC doesn’t pay taxes on its income, so that each member of the LLC is responsible for paying their share of taxes on their personal level. A member is liable for tax payment regardless of the distribution of any dividends. An LLC avoids the double taxation effect. LLC members must pay self-employment taxes on their share of the profits each year.
  • S-corporation/S-LLC.  S-corps and their S-LLC counterparts – so named for their creation under Subchapter S under 26 U.S. Code § 1361– elect to be taxed at the corporate level (like a C-corporation) or as a pass-through entity like an LLC. S-corporations are the most common type of corporation due to their liability protection and avoidance of double taxation. Even so, the restrictions may limit the use of the election for some businesses.

The decision to select a business structure typically depends on the long-term expectations of the company. Small and medium-sized family-owned businesses may find the less regulated LLC structure suitable and less expensive than a corporation. On the other hand, a corporation might be appropriate if a public offering or significant capital event (merger, acquisition, sale) is likely. 

4. Ownership Rights

Investor rights typically vary and include a shareholder’s or member’s control of the business operation. Control decisions include the assumption of debt, distribution of profits, the acquisition and sale of business assets, and the addition, reduction, and transfer of ownership interests and changes in the business’s financial structure.

Shareholder rights in a corporation are recognized legally and often confirmed in the corporate Articles of Incorporation and Bylaws. However, specific rights may be limited by State law. Shares are typically transferable under Federal and State securities laws, effectively extending the life of a corporation in perpetuity.

The LLC’s Articles of Organization and Operating Agreement delineate members’ rights. Members may be individuals, other business entities, or both. While restrictions on the sale or transfer of membership interests, if any, are defined in the organizing documents, the sale or transfer of membership interests is generally more restrictive than the shares of a corporation.

Members may participate in the business’s day-to-day operations (member-managed) or appoint a separate manager for its operation. An LLC may be dissolved on a specific date, the occurrence of a particular event, or by a majority vote of members unless the operating agreement requires a supermajority.

A corporate legal structure is generally warranted if the number of potential owners is significant, and the transfer of ownership interests is likely. 

5. Management of Operations

Corporations are managed through a Board of Directors elected by a majority of the shares outstanding. The Board controls the business operations by appointing company officers, establishing purpose and financial objectives, determining a capital structure and policies, and general oversight. Individual shareholders indirectly influence company operations by their votes for a company director.

LLCs may be managed by

  • its members, each of which has the authority to bind the LLC. A member-managed LLC works best if the business is small with a limited number of skilled, experienced members to manage their responsibilities effectively. Member-managed LLCs are common in family-owned businesses where the company employs each member., or
  • a manager selected by the members who make all operating decisions for the business. The Operating Agreement defines the roles and responsibilities of the manager. While members cannot interfere with the manager, they can replace them or change to a member-managed structure.

6. Administrative Requirements and Costs

All businesses must comply with state and federal laws regarding the establishment, continuation, transfer, and dissolution of a company or its assets. Corporations are typically more complicated and expensive to establish and maintain than LLCs.

Corporations in America have existed since the late 1790s. The first Limited Liability Company, created by the State of Wyoming in 1977, slowly spread to other states to encourage new business formation. Consequently, regulation of LLCs is less formal and varies from state to state.

Final Thoughts

Each legal structure – corporation and LLC – has characteristics that affect business owners differently at various stages of business growth. All businesses operate in a fluid economic environment where the only constant is change. An ideal business structure is agile enough to respond to new environments quickly with minimal stress on its owners, customers, and employees.

Whether to incorporate or form an LLC should be made only after considering the existing conditions and needs of the business and how it might change in the future.

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