As an entrepreneur, you need to understand the differences between corporations and LLCs. You also need to understand why there are differences and what impact this may have on your business structure.
In this article, you will learn what LLCs and corporations are and their differences.
What is an LLC?
An LLC, by definition, is a limited liability company that gives the benefits of an incorporated entity to the owners. An LLC functions as a hybrid between a partnership and corporation, giving business owners many of the benefits of incorporating while still maintaining the legal protection of having an LLC versus being completely incorporated.
Main Characteristics That Define an LLC
- An LLC is owned by one or more owners, called members. These members are not liable for debts beyond their investment amount, which means that if your business accumulates debt, the creditors cannot come after you personally to collect on the business's obligations.
- LLCs have a lot of flexibility when it comes to rules, regulations, and structure. Unlike corporations, LLCs do not have many bylaws that govern operations.
- An LLC has limited liability like a corporation. However, unlike incorporating, an LLC member only needs to pay for one share of stock, whereas incorporated entities must purchase at least two or more shares of stock.
- LLC's are easy to create; you only need to file with your state and register your business name.
- An LLC is not required to hold annual meetings or record minutes of the meeting.
The hybrid nature of an LLC offers businesses a tax structure similar to a partnership. This means that an LLC is taxed as a pass-through entity, which does not have taxes imposed at the business level. Rather, members of an LLC report and pay taxes on their personal returns.
What Is a Corporation?
A corporation is a separate legal entity from its owners. In other words, corporations are self-owned entities that can do business. You establish corporations by filing articles of incorporation with the state department of business along with the initial filing fee. To run a corporation, you must have a board of directors and shareholders.
Main Characteristics That Define a Corporation
- All corporations are required to hold annual business meetings (typically in the month of the company's incorporation) to elect officers and conduct other corporate matters.
- All corporations must record the minutes of all meetings.
- All corporations must purchase at least two shares of stock to be issued. The corporation owns one share while the second share remains with the corporation to name officers.
- Corporations have a separate legal identity. This means that the owners of a corporation are not liable for the company's debts or obligations.
- Corporations are subject to double taxation. The business is taxed at the corporate level, and then income from the corporation is taxed again when it's distributed to shareholders in the form of dividends.
- Corporations are required to have bylaws that govern their operations.
What Is the Difference Between an LLC and a Corporation?
The primary differences between corporations and LLCs are as follows:
An LLC provides limited personal liability, while corporations provide none.
Business profits and losses are only recognized by the corporation. There is no difference between business income/losses and individual income/losses (i.e., pass-through taxation) for an LLC.
The Number of Members Allowed in a Corporation
Depending on the state in which you operate a corporation, there may be a limit to how many memberships or shareholders it can have. Most states do not have this limit for LLCs.
The Number of Directors Allowed
States may also have a limit on the number of directors that can be in a corporation. For example, California does not allow for more than five board members. Five or fewer LLCs are governed by this law as well, but other states do not have such restrictions.
Tax Filing Requirements
Corporations must file a special tax form with the IRS to report business profits, called the 1120S. For LLCs, all owners must submit a personal income tax return (Form 1040) and include their share of the profits/losses from the LLC.
Corporations can be owned by shareholders or other corporations. An LLC can be owned by business owners and other LLCs.
The Structure of a Corporation
The IRS has very strict rules about how corporations can be structured. This means that you must divide your corporation into departments and positions that match the IRS requirements for all corporations (called "headings"). Most LLCs do not have such restrictions, so it is easier to customize the structure of an LLC.
To have a corporation, you must issue stock to owners (called shareholders). This enables them to participate in earning profits and voting on business matters. An LLC can be member-managed or manager-managed, so there is no need to issue shares of ownership.
LLCs are not required to pay income taxes at the business level, but members may have to pay self-employment tax on their share of business profits (depending on the state). Corporations must pay income tax and may also be subject to certain levels of double taxation (paying the corporate tax and individual shareholder/owner's personal income tax).
Foreigners in most states can own up to 20% of an LLC; it is much more difficult for foreigners to own stock in a corporation (foreign ownership limits vary by country).
By understanding the differences between corporations and LLCs, you will better understand what type of structure is best for your business. You can then make an informed decision that is right for your business needs.