Starting a Small Business: What is the Difference Between an LLC and a Corporation?

A common first question for small owners is whether to incorporate as an LLC or a corporation.  While the two entities are similar in many ways, they also have several differences.  LLCs, as opposed to corporations, combine the personal liability protection of a corporation with the tax benefits and simplicity of a partnership.  Also, corporations can elect to be taxed as an S corporation.  S corporation status provides many of the benefits of partnership taxation, but there are certain restrictions.  There are benefits to both entity structures, but personal liability protection is basically the same for both, so your decision to form a corporation or an LLC should not hinge on the asset protection issue.  Consequently, which entity is best for you will depend on your businesses’ individual needs and circumstance.

Advantages of a Corporation

Here are four principal advantages to forming a corporation rather than an LLC:

Corporation profits are not subject to self-employment taxes.  Salaries and profits of an LLC are subject to Medicare, Social Security, and certain other taxes.  In the case of a corporation, though, only salaries (not profits) are subject to such taxes.

Corporations are able to offer a greater variety of fringe benefits.  In fact, various retirement, stock option and employee stock purchase plans are available only for corporations.

Judicial treatment of corporations is more predictable.  Unlike corporations that have been around for a long time, LLCs are a relatively new legal creature and still being tested by courts.  Furthermore, some states place restrictions on the type of business conducted by an LLC.  For Ohio LLC restrictions and rules, see the Ohio Revised Code, Chapter 1705.

Transfer of ownership is easy for corporation.  Corporation stock is freely transferable, as long as IRS ownership restrictions are met.  LLC membership interest (ownership) typically is not freely transferable – approval from other members is often required.

Advantages of an LLC

Here are four main advantages to forming an LLC rather than a corporation:

There are fewer corporate formalities with LLCs.  Corporations have a relatively detailed list of things that need to be done in order to insure the courts will “respect” the corporate structure and liability shield.  For example, corporations must hold regular meetings of the board of directors and shareholders and they must keep written corporate minutes.  Conversely, members and managers of an LLC are not required to hold such meetings.

LLCs have no ownership restrictions.  S corporations, for example, cannot have more than 100 stockholders.  Also, each stockholder in an S corporation must be a U.S. resident or citizen. S corporations cannot be owned by C corporations, other S corporations, LLCs, partnerships or many trusts.  These restrictions do not apply to LLCs (or C corporations).  And LLCs are allowed to have subsidiaries without restriction.

LLCs have greater tax flexibility.  LLCs are treated as a “pass-through” entity for tax purposes.  In fact, LLCs can elect to be taxed as either a C corporation or an S corporation.

LLCs have the ability to deduct certain losses.  Members who are active participants in an LLC’s business can deduct operating losses against their regular income to the extent permitted by law.  But taxes issues are usually not a legal question.  They are an accounting question, so please consult your tax planner also.

Starting a Small Business – Why Incorporate?

There are many reasons business owners choose to form a legal entity – whether a limited liability company, corporation, S-corporation or otherwise.  The most important reason is that forming a legal entity reduces personal liability.  Forming a legal entity also adds credibility and permits the business to grow.  Plus, a legal entity permits the business to build its own credit.  And ownership in the entity can be more easily transferred.

Limit Personal Liability.  First, and foremost, forming a legal entity shields the owner(s) from personal liability for debts of the business and lawsuits against the company.  So the existence of a legal entity protects the your personal assets such as your home, car, possessions, and savings.  It does not, however, shield you against personal torts (injuries) that the owner commits on behalf of the entity.  This limited liability is often referred to as the “corporate veil” because the owners of the company are protected behind it.  It is very important, though, for business owners to understand that there are some limited situations where the corporate veil can be pierced to reach the personal assets of the business owners, such as where the owner co-mingles assets or does not abide by corporate formalities.

Grow Your Business, Now and Later.  Second, forming a legal entity adds credibility to the business.  Forming a legal entity communicates not only credibility but also permanence and prestige.  The credibility that comes with forming a legal entity can also help your new business with potential customers, employees, vendors and partners.  At the same time, it informs those same people that they are dealing with an entity and not you personally.

Build Buiness Credit.  Third, because a legal entity – whether corporation or an LLC – is a separate entity, you are able to establish both a new and separate credit profile completely distinct from your own personal credit profile.  Being able to establish business credit is especially advantageous for those who may have poor personal credit because it enables you to build a clear credit profile for the business.  As a result, you may be able to receive loans, credit cards and credit lines that you might not be able to obtain as an individual, and eventually at better interest rates.

Transfer of Ownership.  Corporation ownership can be easily transferable (with some restrictions on S corporations).  Capital can be raised more easily through the sale of stock.  Another advantage is that many banks prefer handling loans with incorporated borrowers.  And while you can’t live forever—your corporation can.  Even if an owner dies or sells interest, the corporation still exists.