I have bit of good news and bad news. The good news is that there are more people than ever starting their own businesses. The bad news is that there are more people than ever starting their own businesses. Over the years, I’ve served as a consultant helping a lot of people who were starting their own clothing brands or some small business. One trend that tend to see a lot, especially in social media bios, is people adding the word “Inc.” on the end of their company names even though they have yet to incorporate their business. This act does not make your company a legal entity nor does it protect your or your company’s personal assets. Deciding what type of incorporation you’d want for your business is basically deciding how you’d want yourself and your company to be taxed. Figuring out that whether you should be a Sole Proprietor, General Partnership, Limited Partnership, C Corporation, S Corporation, or an Limited Liability Corporation (LLC), will help you determine what type of taxing structure is right for you and your business.
What’s Best for Me–Corporation or LLC?
You can find articles on this topic on other incorporation sites. The discussions are usually very similar because the factors being discussed are generally about the same. So what’s different about this article? A couple of things. First, many articles highlight distinctions between corporations and LLCs assuming that an LLC will maintain only one tax classification. In fact, an LLC may choose from among several tax classifications including a C Corporation or S Corporation. Secondly, while many discussions are technically correct, they fail to convey the importance of many factors in a small business setting. This will be particularly apparent in our discussion of “non-factors” below.
Factors to Consider
It should go without saying that no one entity or tax classification is right for everyone. Two people running the same type of business might both correctly reach different conclusions on the best entity or tax classification for operating their business. The reason is simple: there are several important factors that must be considered and weighed. Some factors will be more important than others to different people. Also, as circumstances change (adding employees, expanding your business, seeking outside investors, and so on), consideration of these same factors may warrant or require choosing a different type of entity or tax classification.
The essential point to understand, then, is that it is important to know the factors to consider in selecting an entity and tax classification and revisit your decision as circumstances change. With that principle understood, let’s take a look at the major factors to consider in choosing between a corporation and an LLC.
The Nature of Your Business
While most businesses may be permitted to choose either a corporation or an LLC, there may be some restrictions. For anyone who must be licensed to engage in a certain occupation, trade or profession, many states and licensing boards have specific requirements or restrictions on the type of entity a licensee may choose to practice his profession. In California, for example, most licensed persons are prohibited from operating through an LLC. They must choose either a Professional Corporation or regular business corporation.
Your Ownership Structure
-Are you a single owner business or are there multiple owners?
-Do you have or expect to have employees who will be given options to purchase or earn ownership interests in the business?
-If there are multiple owners, is everyone actively involved in running the business or are there one or more passive investors?
A corporation has a well-established, formal legal structure. Every state has very detailed and time-tested laws regulating all aspects of corporations. Every corporation (excluding nonprofits) is comprised of shareholders, directors and officers. A corporation does not offer much flexibility in how the business will be managed.
An LLC, on the other hand, is a relatively new type of business structure. State laws provide less regulation of an LLC, instead leaving it to the LLC’s members to enter into an operating agreement (like a partnership agreement) as the governing document of the LLC. The operating agreement establishes the rights and responsibilities, powers and limitations, and other aspects of the relationship of the members and any managers.
An LLC structure may be managed by its members, much like a partnership, or it may be managed by one or more managers with the members being more passive investors, like a corporation. In short, an LLC offers greater flexibility in managing a business than a corporation.
For a single owner, management flexibility is not an issue and either the corporation or LLC structure will work. With multiple members, the flexibility of management takes the forefront in the entity selection. If the owners desire a more detailed description of their duties and responsibilities as well as other management factors, a customized operating agreement provides far more flexibility that the corporate structure whose management is more rigidly governed by statutory laws and more standardized bylaws.
Raising Capital from Investors
You may need capital from outside investors to start your business or later to expand it. Which entity works best?
First, let’s distinguish between C and S Corporations. There are requirements that must be met and maintained to qualify for S Corporation tax treatment. The more investors you have, the more difficult it will be to maintain these requirements.
The requirements to become an S Corporation do not apply to operating as a C Corporation. There are no requirements on who may become a shareholder-no limitation on the number of shareholders, their residency status, or whether they’re an individual, other type of entity, etc. A C Corporation is therefore compatible with raising money from outside investors or any type.
It is easier to attract outside investors in a corporation than an LLC. Investors understand receiving shares in a corporation and being issued stock certificates. They have a better understanding of the corporate structure and the general powers of shareholders, directors and officers than they tend to have with an LLC. An LLC would require a comprehensive operating agreement to be prepared to cover the relationship of the LLC members and any managers and may be intimidating to document to read and understand for an unsophisticated investor.
If it is anticipated that a business may go public, a C Corporation would be a necessity.
Selecting the Most Advantageous Tax Classification
There are two types of tax classifications for any business type: one where taxes are paid at the entity or business level and one where taxes are paid only at the owner level, also known as a “pass-through” tax entity.
A C Corporation, by definition, is a tax-paying entity and an S Corporation, by definition, is a pass-through tax entity. An LLC may be either depending on several factors and the preference of the members.
A single member LLC may be taxed like a sole proprietor, that is, a pass-through (or disregarded) tax entity. However, a single member LLC can also choose to be taxed as a C Corporation or an S Corporation. Why would a single member LLC choose these other classifications?
In some states, such as California, an LLC is subject to additional taxes or fees that are not imposed on corporations. By choosing to be taxed as a corporation, the entity remains an LLC entity type for legal purposes but is taxed as if it were a corporation (either C or S), thereby avoiding the additional fees or taxes imposed on an LLC.
Another reason is that the profits distributed to an LLC member who is actively involved in the business are subject to self-employment (SE) taxes, essentially Social Security and Medicare taxes, totaling 12.4% of the member’s share of profits. By choosing to be taxed as an S Corporation, an LLC is still a pass-through tax entity but the members now become employees of the LLC and have some flexibility to establish salaries that may be less than their profit distributions. SE taxes must be paid on the salaries received but do not have to be paid on profit distributions to the member. There is an opportunity for SE tax savings, but the salary must be supportable as a reasonable amount under the circumstances.
Non-Factors (but commonly misconceived as important factors)
You’ll read articles that list one or more of the following factors as important considerations or distinctions between a corporation and an LLC to be considered in choosing between the two entity types. For the reasons discussed below, they’re really not.
Limited Liability Protection
The fact that “limited liability” is part of the LLC name has led some people to believe that an LLC offers its owners better protection for their personal assets than a corporation. That’s not the case. In fact, many state statutes simply describe the limited liability protection for members of an LLC as being the same as shareholders in a corporation. Importantly, it probably also means that LLC members may also be held personally liable if they use the LLC to perpetuate a fraud or other circumstances exist that a court finds would make it unfair for the LLC members to be shielded from personal liability, just as courts do in the corporation context.
Transferability of Ownership Interests
You may have read that it is easier to transfer ownership in a corporation than in an LLC. It’s true that state corporate statutes generally don’t contain restrictions prohibiting a shareholder from transferring an ownership interest to another person or requiring approval of the other shareholders (the requirements of any securities laws aside).
It’s also true that state LLC statutes often require consent from members before a membership interest can be transferred to an outsider. This distinction has much less significance, however, in a small business setting. There is rarely a market for selling an ownership interest in a small business corporation unless it’s for a controlling interest where the minority shareholders will not have much influence in the corporation. The same is true with an LLC. No outsider would be particularly interested in purchasing a minority interest in an LLC and if a majority LLC member wanted to sell, the required approval of the majority would automatically exist.
Continuity of Business Operations
There used to be a significant difference in the continuity of a business between a corporation and an LLC primarily because in earlier days an LLC could not have a perpetual existence–it was required to exist only for a specified number of years or terminate by a stated date. This is no longer required. The IRS regulations imposing this requirement were changed to allow an LLC to have the same perpetual existence as a corporation and state statutes have followed by removing requirements for a finite existence as well.
Unless the Articles of Organization or operating agreement of an LLC require otherwise, an LLC may have a perpetual existence.
LLCs have been described as simpler to form and therefore less expensive than a corporation. This is commonly the case with a single member LLC where a written operating agreement is generally not required. When there are multiple members in the LLC and a written operating agreement is required, the cost of forming an LLC can easily exceed the cost of a corporation, particularly if the operating agreement is properly prepared and customized for the members and their specific business relationship.
Maintaining Corporate Formalities
No doubt the most misconceived characteristic of a small business corporation is that it is more time–consuming to maintain than an LLC because of the requirement to conduct shareholder and director meetings in order to authorize or approve actions and document activities in written corporate minutes.
The first misconception is that a small business corporation is required to hold meetings to authorize or approve actions. Every state permits shareholder and directors to forego meetings and simply document approvals for corporate action in what are called “written consent” minutes. Stated simply, these are written minutes signed by all or a majority of shareholders or directors and indicating their consent to specified actions by the corporation. They are prepared without any meeting being required.
The second part of this misconception is that an LLC is excused from preparing any written minutes to authorize or approve activities of its members or managers. Most state laws exempt an LLC from having to hold any “annual meetings” (or written consent actions) as are required for corporations. This exemption for an LLC exists because of the difference in structure from a corporation: an LLC doesn’t have shareholders who must annually elect directors.
That fact notwithstanding, minutes may also serve an important function in documenting financial transactions of the business for tax purposes in the event of an audit and would be just as beneficial for an LLC as for a corporation.