When starting a new business, one of the first choices is deciding whether to form a limited liability company (LLC) or a corporation.
LLCs and corporations both give you protection from personal responsibility for liabilities and debts incurred by the company. LLCs are easier to set up and maintain than corporations, making them an attractive option for new businesses. However, corporations can be a better choice in some circumstances.
What are some of the factors to consider in making this choice?
Considering the nature of your business, taxation, liability, goals and the level of privacy desired can help you decide on an entity structure.
Type of business
Are you looking to start a consulting business, retail, property management or a passive investment? The type of business you want to create will factor into which entity structure to choose.
Real estate, rentals and royalties are some of the most common passive investments. File as an LLC for your passive investment if you want the personal asset protection similar to a corporation but with more tax flexibility.
As a property management business owner, you can potentially be sued for property damage and injuries that occur onsite. For this reason, it's vital to maintain separation between you and the business to shield you from personal liability. Both LLCs and corporations provide this protection, while some other entity options such as sole proprietorships and partnerships don't. Smaller property management companies often choose the LLC structure, while a corporation may be better if you plan to grow a larger operation with many properties and employees.
As the owner of a consulting business, you may be liable for advice that leads clients to lose money or face other adverse outcomes. Both LLC and corporations protect owners from personal liability for business failures as long as no illegal activity or willful negligence is involved. However, tax laws for service-based C corporations may make the taxes too high to handle for your small consulting business. However, if you want to grow your business into a more extensive operation with multiple offices, consultants and employees, you may want to consider this option.
For small retail enterprises, the LLC has the most benefits. You don't have to worry about double taxation, shareholders' dividends or the corporation's extra paperwork and compliance requirements. Registering as a corporation will provide liability protection and credibility for larger businesses with multiple storefronts.
Think about what you want to accomplish with your business now and down the road. Your current objectives and future goals will help you decide which type of business structure to choose.
If you're just starting out and you've never owned a business before, you may want to set up an LLC. The LLC is simpler to set up and maintain. Tax treatment is flexible and straightforward. However, if you're looking for startup funding from outside investors right away, you may want to file as a corporation now.
Suppose your future plans include outside investors, taking your company public or growing your business into a more expansive operation. In that case, you may want to consider establishing a corporation. Corporations can issue multiple classes of stock, dividends and have an unlimited number of shareholders. All of these things make a company attractive to investors. However, if your future goals are to keep your small business small, an LLC will suit your needs just fine.
The level of liability protection can vary by entity type. Single-member LLCs are viewed very differently than multi-member LLCs and corporations.
If you're the sole owner, the single-member LLC provides personal liability protection that informal structures such as the sole proprietorship do not. However, single-member LLCs can get into trouble if the separation from owner and entity is unclear. The key to keeping yourself protected is to put together a detailed operating agreement and keep accurate records for every action taken by the company. If you skip these steps, you may become personally liable because a court can decide you and your business are not separate, but in fact, one and the same. There are a few states (Delaware, Nevada and Wyoming) that give single-member LLCs the same level of protection as multi-member LLCs. If you file in another state, you may want to consider enlisting at least one other owner and file as a multi-member LLC for better protection.
To ensure the personal asset protection of all business owners involved, think about setting up a multi-member LLC. There are a few times an owner's personal assets may still be at risk, including situations in which an owner has personally cosigned a business loan, guaranteed personal property to secure a loan, committed some fraud, or “pierced the corporate veil,” which means they didn't fulfill legal business compliance obligations. To ensure no members' personal assets become at risk, outline all responsibilities and requirements of each member in your LLC's operating agreement.
If you file as a corporation, you'll have to hold an annual shareholders' meeting and an annual board of directors' meeting, both of which must be documented with meeting minutes. If you're the sole member, you can prepare annual meeting minutes yourself that state that you, as the shareholder, have elected yourself as the director and officer of the company. It's crucial to perform all corporate requirements each year whether you're the sole owner or one of many.
Even with the corporation structure, owners are not necessarily 100% protected. If an owner engages in fraud or illegal activity, fails to report taxes or treats the business as an extension of themselves they may be held personally responsible for consequences of these actions.
Privacy of ownership
If you're hesitant to start a new business because of privacy concerns, you can keep your ownership status anonymous in some states. States that allow anonymous LLCs let you list the organizer(s) of the company instead of the owner(s). An organizer can be an attorney, accountant, registered agent or anyone else you authorize to file for you. Check with your secretary of state's office to see if your state allows anonymous LLC registration.
You will not be able to register a corporation anonymously in any state, however. Corporations must disclose the names of all directors and officers in the company.
The flexibility of financial distributions
If you want flexibility in splitting profits among owners, the LLC has this advantage. As long as you define how you and your fellow LLC members will divvy up the profits in your operating agreement, you can split them in any way you choose.
An LLC's profits are allocated according to ownership interest (often the fairest split) if no alternative method is specified in the operating agreement. However, in some cases, such as if one member has put a significant amount of money into the business, you may want to define an alternative allocation plan.
You may have heard both allocation and distribution as terms for profit splitting. These two terms do not mean the same thing in an LLC. Profit allocation is how profits are divided among members. Distribution is how profits are actually handed out.
Your business may need to retain profits to ensure enough funds for operations instead of distributing them to members. As long as profits are still allocated to members, those profits have to be accounted for on their personal tax returns regardless of whether they have actually been received. Make sure to include details of how profits will be allocated and distributed in your operating agreement.
Corporation profits are distributed in three standard ways. The first portion pays corporate taxes. The company retains the second portion to finance capital investments. The third portion is paid out as dividends to shareholders. The largest amount usually goes to taxes. Next comes dividends. Finally, the smallest portion is the retained earnings. Corporations have some flexibility in how much gets retained versus how much goes to shareholders as dividends.
The formality of structure and operations
LLC - business related
It's relatively easy to set up an LLC through your state secretary of state's office. You'll need to submit the articles of organization form along with a registration fee. That's it for the legal requirements to set up an LLC. Although not required by every state, it's a good idea to create an operating agreement to protect all members if any issues arise down the road. Your operating agreement should contain any managerial and financial responsibilities for each member.
Corporation - by statute
Corporations have more extensive requirements for setting up and operating the business than LLCs. You'll need to complete the articles of incorporation form, pay the registration fee and create bylaws that define the rights and responsibilities of your company's directors, members and shareholders. Don't forget to conduct your annual board of directors' and shareholders' meetings, both of which must be completed every year and documented with meeting minutes.
LLCs and corporations are classified and taxed very differently. Knowing the ins and outs of taxation for both entity structures will help you determine which one is right for your company.
The LLC structure allows you to choose corporation tax treatment. In some cases, you may prefer the tax treatment of a corporation. Just make sure you file the appropriate forms with the IRS in time. If not, you will automatically be treated as a pass-through entity.
By default, a corporation is classified as a “C corporation” for tax purposes. The “C” is a reference to Subchapter C of the federal tax code. C corporations submit a tax return at the company level and pay taxes on profits. Double taxation occurs after the corporation pays taxes on profits, then distributes dividends that will need to be accounted for on the owners' personal tax returns (resulting in owners technically being taxed twice on the same income). Corporations can also file an election to be treated as an “S corporation,” which has pass-through taxation. You should speak with your tax advisor as to whether such an election is right for your business.
Most small businesses will need financing at some point. There are several routes you can take to secure funds for your business.
Financing for new businesses can either be in the form of equity (funding from investors in exchange for a percentage of ownership in your business) or debt (loans). The equity route will mean you give up a certain amount of control over your business to investors. The debt route will require you to pay back any loans taken out along with interest. Think about all of the obligations that come with each type of financing before jumping into a capital raise.
Banks are often one of the first places LLC owners will go for funding. Lenders usually require personal guarantees since members are not personally liable for the debts of the company. Make sure you fully understand the terms of the loan, the payment rate and the interest rate. Is it reasonable? Is it something you will be able to pay back? Bank loans can help small businesses, but they also create higher liability and risk for LLC members. Make sure to weigh your options before going this route.
Investors such as venture capitalists typically favor C corporations over LLCs because C corporations can provide preferred stock. If you'll have a small number of investors, an LLC may be the best option. However, if you want to pursue multiple rounds of financing, issue various classes of stock, or convertible debt, you're going to need to be a C corporation.
The answer for everyone is likely to be different. Still, the advantages of an LLC in terms of flexibility and informality usually make it the best choice for a small business.
Whichever entity structure you choose today does not have to be permanent. If ease of getting started and tax flexibility are important to you, the LLC may be the way to go. You can always convert to a corporation later if your business objectives change. Remember, though, that converting from an LLC to a corporation can be a bit of a costly headache. If you know your business will need to be a corporation at some point, you may want to register it as such from the get-go to save yourself the trouble in the future.