Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with a CPA and/or lawyer.
As an entrepreneur, you’re in charge of making a wide variety of decisions for the benefit of your company and yourself. One of the biggest questions you’ll encounter at the beginning of your entrepreneurial journey is determining what kind of business structure to use.
The answer you choose will affect everything from your tax liability to your legal responsibilities in case of a lawsuit. It’s completely normal to feel overwhelmed with the choice.
This article will break down the key differences between a limited liability company (LLC) and a corporation. It will help you understand which makes the most sense for your business and individual situation. It will also highlight the differences between both organizations that you can expect through the lifecycle of your business.
As indicated by the title, an LLC is designed to limit your liability in case of an adverse legal event. It can help protect your assets in case of a judgment against your company.
First, the basics. An LLC is defined as the U.S. version of a private-limited company. Per the New York Department of State, an LLC is “an unincorporated business organization of one or more persons who have limited liability for the contractual obligations and other liabilities of the business.”1 LLCs appeal to entrepreneurs because they provide the limited liability you can expect from a corporation, plus the flexibility you can expect from a partnership.
An LLC is comprised of members. A member doesn’t have to be a person -- it can also be a corporation, a partnership another LLC or any other legal entity. There is no residence or age requirement, and LLC members are not required to be listed in the LLC’s Articles of Organization. (More info on the steps to form an LLC appears below.)
Besides the legal protections, LLCs are popular due to their relative simplicity and their taxation benefits. To put it very simply: LLCs protect your assets if you get sued, and they prevent you from being double taxed. LLCs offer one of the most straightforward ways of choosing the S-Corp (“pass-through” entity) tax designation -- which appeals to many entrepreneurs. More on that below.
The first step toward forming an LLC in New York state is to confirm through the Department of State’s Division of Corporations that your desired business name is available. Once you have determined that it is, you must file your LLC’s Articles of Organization with the Division of Corporations. At the time of filing, you must also pay the $200 filing fee.
One of the most attractive features of the LLC is the fact that it is a “pass-through entity.” What does this mean?
In contrast to a corporation -- where profits are taxed before being distributed as well as being taxed as income on members’ individual tax returns -- profits in an LLC go directly to the members. The profits must be recorded and reported on the members’ individual tax returns. Due to the fact that the profits “pass through” the LLC, they are taxed only one time: on the individual level, but not on the corporate level.
When an LLC experiences losses, those are deducted from the member’s or members’ incomes and reported on the individual return.
In the eyes of the IRS, the way your LLC is regarded depends on how many members you have.
In single-owner LLCs, the LLC behaves like a sole proprietorship for tax purposes. The sole owner of the LLC reports all profits and losses to the IRS at tax time on their tax return. This is true even if the owner leaves some money in the LLC’s account for business purposes -- that money must be reported as well, and income tax will be charged on it.
In contrast, LLCs that have more than one owner are handled like partnerships by the IRS. The pass-through structure remains the same -- business income is not taxed. Each owner is responsible for paying personal income taxes on her share of the LLC’s profits. The portion that each owner claims of the LLC’s profits and losses is known as a distributive share, and it’s set forth in the LLC’s operating agreement. (Typically, distributive shares are directly proportional to ownership percentages.) Just as in the case of sole ownership LLCs, the taxes due from each owner in a co-owned LLC will include not only the money paid out, but also the owner’s proportion of all profits and losses, even if some money remains with the company for business purposes.
By filing IRS Form 8832, LLC owners can elect to be taxed as a corporation. This is appropriate in cases where owners choose to keep a large proportion of the profits in the LLC on a regular basis. Such monies are known as retained earnings.
Corporations have access to a variety of fringe benefits not available to LLCs. These include deductions, incentives and expense categories that can help defray the cost of running a large organization. For instance, a corporation can deduct the costs associated with administering staff health benefits from its corporate taxes, and it can offer stock options and purchase plans to employees. The owners of a corporation are its shareholders.
To form a corporation in New York state, you must file Articles of Incorporation. Persons who form a corporation, or incorporators, must be “natural persons who are 18 or older.”2
Foreign entities may form C Corporations, but they are not able to form S Corporations.
Entrepreneurs that sell physical products, operate a storefront and have employees often choose the C Corporation business structure. The major drawback is that it isn’t a pass-through entity, so profits are taxed twice: Corporations must pay corporate taxes on profits, and shareholders must pay taxes on the distributions received (dividends). S Corporations avoid the double taxation problem, as their profits aren’t taxed at the corporate level.
One key difference between LLCs and corporations is the ability of corporations to issue shares of stock and to sell business ownership percentages to shareholders. The shareholders may transact the stock as they see fit -- selling shares, purchasing more, etc. -- in order to adjust their desired ownership stake.
Corporations can make their stock shares available to outside investors, which is another attractive feature of this business type. Corporations are set up to remain in existence even if an owner leaves or divests.
Whether you choose to operate as an LLC or a corporation depends on a variety of factors. Your profits and losses, your startup costs, the amount of income you would like to draw and the type of product or service you provide are all important factors in your decision. You should think very carefully about your tax situation, and don’t forget to consider how it might change through the life cycle of your business. Your geography -- including relevant federal, state or foreign tax rates -- is important as well. Finally, your future plans for the business, as well as your plans to attract outside investors or expand operations, should be carefully considered.
While this article is intended to provide a helpful summary of the distinctions between different business types, it is not intended to provide legal or financial advice. Consult a professional before executing a decision.