Should I use an LLC or a corporation for my small business?

A limited liability company (LLC) is a formal entity structure that protects small business owners from being personally liable for business debts. Regulations for LLCs fall under each state's jurisdiction, so the process to form one will vary depending on the state. In most states, the owners of the LLC will need to file a document called “articles of organization” with the Secretary of State's Office.

The owners of an LLC are called “members.” Once established, it's recommended to outline the roles and responsibilities of each member in a document called an “operating agreement.” Although not required by every state, maintaining an operating agreement is good business sense. If no operating agreement exists, the LLC must abide by the default state statutes, which may not always result in the best outcomes for its members. Operating agreements typically include basic information about your business and provisions for member contributions, voting rights, dissolution measures, new member entrants and exits and other rights and responsibilities of the members.

The LLC structure is a popular choice for many small business owners due to its ease of formation, liability protection and tax flexibility. An LLC will protect its members' personal assets from being taken to satisfy its debts, financial losses or lawsuits against the business. The LLC is also a common choice for estate planning purposes because it offers similar benefits as a corporation, without all of the hassles of maintaining a corporation.

A corporation is another type of formal entity structure. A corporation is owned by its shareholders. The shareholders are not legally or financially liable for the company's debts. A corporation has the power to act like an individual with the ability to enter into contracts, loan and borrow money, and own assets independent of its owners.

While the corporation provides its owners with stronger protections from personal liability, it is also more expensive to form. Additionally, corporations involve more extensive operational processes, financial reporting and record-keeping requirements. There are more steps involved, with more paperwork to complete. The corporation's founders will need to file a document called the “articles of incorporation” with the state. Additionally, corporations must develop “bylaws” that outline all of the rights and responsibilities of the shareholders. It's important to conduct annual meetings with the board of directors and shareholders. Many corporations have these meetings quarterly. It's also essential to keep a record of these meetings in a document called “meeting minutes.” All of these practices are necessary to keep the corporation in good standing.

An LLC is generally easier to set up and maintain than a corporation. There is less paperwork involved in both the formation and the ongoing operation of the company. For this reason, it is often the preferred choice for many small businesses. Additionally, LLCs offer greater flexibility in taxation than corporations and greater flexibility in financial distributions.

The members of an LLC can choose to split profits in any way they wish as long as the distribution strategy is defined in the operating agreement. Profits may be divided equally among all members. Or, profits may be split according to the amount each member invests in the company. Profits may alternatively be divvied up according to some other factor agreed upon by its members.

Corporations have more flexibility in what to do with their excess profits. For LLCs, all company income flows through to the members. Corporations may retain profits at the corporate level and pay them out as dividends to shareholders. Additionally, corporations can issue stock to raise capital for the company.

LLCs allow much greater flexibility than corporations regarding how members may structure the business. The owners of an LLC can manage the business themselves or designate others to do it for them. These managers can be other members, non-members or a combination of both. Suppose the company assigns all non-member managers to run the day-to-day business operations.

In that case, this arrangement is called a “manager-managed” LLC instead of a “member-managed” LLC. In this scenario, the non-managing members have no say in the company's activities and have no responsibilities to meet either. Frequently, these non-managing members are family members who have invested financially in the business but prefer to take a hands-off approach and simply collect their share of the profits.

Corporations are owned by shareholders who have been issued stock in exchange for a percentage of ownership in the company. Shareholders have the power to purchase more shares for a higher percentage of ownership in the business and sell shares to own a smaller portion of the company. For this reason, small business owners looking for outside investors may want to register the business as a corporation.

A corporation's management structure requirements are more rigid than an LLC. Although shareholders own a corporation, these shareholders usually do not participate in the business' day-to-day operations. Instead, a corporation must have a formal board of directors to oversee the company's management and ensure profits are distributed to shareholders. Additionally, corporate officers (e.g., chief executive officer, chief operating officer and chief financial officer) manage the day-to-day business activities.

While the shareholders of a corporation do not usually participate in the day-to-day decision-making or management of the company, they do have the power to elect directors of the board. Individual shareholders may also be selected as a board director or as a company's corporate officer. In this case, the shareholder would have management responsibilities and participate in the company's day-to-day operations.

Corporations have the advantage of remaining intact in the event of an owner's death or departure from the company. If a shareholder dies or otherwise leaves the company, the corporation can continue with minimum disturbance. In contrast, an LLC does not automatically have this perpetual existence apart from its owners.

The lifespan of an LLC varies greatly depending on the state in which it is registered. Some states require an LLC to be dissolved and re-formed any time a change in membership occurs - whether a new member is joining or an existing member has departed. The best way to avoid this formality for an LLC is to detail the members' succession plans and process for the transfer of ownership in the operating agreement. These measures will save a lot of time and headache when the event occurs.

Both LLCs and corporations provide personal protection from legal and financial liability obligations incurred by the company. The members of an LLC benefit from limited liability. Each member will not be held personally responsible for debts or lawsuits incurred by the company. Creditors are not able to collect personal assets for company debts. The only type of assets creditors may take are those that belong to the company.

In some cases, individual members of an LLC can be held liable for company debts and legal obligations. It's important to follow some best practices to ensure this does not occur. Maintain a clear separation between individual assets and those of the company. This separation is even more essential if you are the sole member of your LLC.

If there is no clear separation, a court can decide you and your company are the same entity. In this case, your personal assets would be up for the taking. Get a federal employer identification number (EIN), keep a detailed operating agreement, maintain accurate records, and keep business and personal bank accounts separate.

A member may be liable if they have personally guaranteed a company loan, injured someone, committed tax fraud, or participated in other illegal activity. Additionally, LLC members may be held personally liable for business debts and liabilities if they have treated the company as an extension of themselves. This is why it is crucial to ensure a clear separation between self and the entity.

As long as all LLC members maintain a high level of personal integrity and operate in the realm of fair and legal actions, the company should not run into this kind of trouble. Ensure no business information is misrepresented or concealed from anyone, especially creditors and vendors dealing with the company.

Additionally, it's a good policy to keep enough cash invested in the LLC to ensure the company will always be able to cover costs and liabilities that may come up.

Most of the time, the owners of a corporation are protected from any personal liability for company debts or legal obligations. Creditors can only collect assets belonging to the corporation to satisfy any corporate debts. However, there are some cases where the corporation's owners may find themselves personally liable. For instance, if a shareholder has personally guaranteed the corporation's debts or pierced the corporate veil in any way, that shareholder would be personally liable.

The IRS classifies corporations and LLCs differently, so it's important to understand the tax implications of each entity structure. Many small businesses prefer to form an LLC over a corporation for tax purposes. As an LLC, the business owners enjoy more flexibility regarding how they may be taxed.

The LLC may choose from three different options for taxation. The IRS classifies an LLC as a “disregarded entity” by default. This classification means the company is taxed as a sole proprietorship or a partnership. In this case, the company's profits are passed through to the LLC members to report on their personal tax returns. Many small business owners choose this type of classification because this "pass-through" taxation is much simpler than the taxation process for a C corporation.

Suppose the LLC prefers to be taxed as a corporation. In that case, it has the power to choose either an S corporation or a C corporation classification. To be taxed as an S corporation, the company must meet some minimum requirements and file Form 2553 with the IRS. The disregarded entity and the S corporation classification are "pass-through" entities. All company income is passed on to the members, and the company does not file a separate corporate tax return.

An LLC may want to be taxed as a C corporation under certain circumstances. For instance, when taxed as an LLC or an S Corporation, the company is limited in the amount it can deduct for child care, education, retirement plans and life insurance. If taxed as a C corporation, the company doesn't have these limitations. If an LLC chooses to be taxed as a C corporation, the company must file Form 8832 with the IRS.

Corporations can either be classified as C corporations or S corporations for tax purposes. The default classification for any corporation is the C corporation. C corporations must file a corporate tax return and pay income tax on the company profits.

Additionally, shareholders must pay personal income tax on any company profits allocated to them. This means shareholder distributions are taxed twice (once at the corporate level and again at the individual level). For this reason, C corporations often pay more in taxes than LLCs.

Many C corporations opt to be classified as an S corporation through the IRS to avoid double taxation. When classified as an S corporation, the company does not file a corporate tax return. Instead, all corporate taxes are passed on to the shareholders to be reported on their personal tax returns just as they would in an LLC.

If the company wants to be taxed as an S corporation, a form will need to be submitted to the IRS before taxes are due. Not every corporation can file as an S corporation, however. Some requirements must be met in order to do so. The company must have no more than one hundred shareholders, no more than one class of stock, and its shareholders must be individuals instead of partnerships or corporations. Shareholders must also be U.S. citizens and current U.S. residents.

Both the LLC and the corporation structures have advantages for small business owners. In general, the LLC is a good choice for small business owners who value flexibility in the management and taxation of the company and want a structure that is simple to manage. However, small business owners who plan to issue stock to raise funds for the company will need to register as a corporation.

A corporation is also a good choice for small business owners who intend to take the company public or sell it eventually. Taking the time to determine the proper entity structure for your business requires careful planning and consideration but will be rewarding in the long run.