Many businesses – small ones in particular – make the decision to seek some type of legal and liability protections, as well as special tax treatment. This is typically done through adopting a business organization form that will effectively separate the business owner(s) from the business itself. In doing so, the obligations and liabilities of the business become the responsibility of the business entity, and not its owners.
Two prominent forms of ownership are corporations and limited liability companies (LLC’s). Each will provide the needed liability protection as well as certain income tax advantages. Corporation status is generally more formal in its structure and can be better suited to large, established businesses. LLC’s, being less rigid, tend to work better for newer and smaller businesses.
(NOTE: This discussion will limit consideration of Sub-chapter S corporations (“S corporations”) in order to minimize an already complex comparison.)
S Corporations are distinct legal entities created under state law. They enable business owners to separate themselves, legally and financially, from the business itself. This provides a strong level of protection for owners from creditors and lawsuits seeking financial compensation from the company.
S Corporations require a substantial level of compliance – sometimes referred to as corporate formalities (see the chart below) – that are necessary to establish a dividing line between the corporation and its shareholders. For this reason, small business owners often choose simpler business organization forms, such as LLCs.
One of the primary advantages of corporations is that ownership of the company can change hands without disturbing the operation of the business. This also allows for the continuation of the company in the event of the death of one of its shareholders, and makes it easier to hire non-shareholders to manage the company’s operations.
Limited Liability Company – LLC
A Limited Liability Company offers a business owner considerable flexibility. The owner can have many of the same legal and liability protections available to corporations, but corporate formalities are greatly relaxed. The major exception are loans and obligations (such as leases) personally guaranteed by an owner – they will remain a potential liability of the owner despite the LLC status of the business.
LLC regulations vary from state to state, so you will need to be familiar with the rules in your state before making the decision to create an LLC status for your business. This is partially due to the fact that LLCs are a relatively recent phenomenon compared to corporations, which have been around for centuries. In many states, regulations and practices regarding LLCs is still being worked out.
Income Tax Treatment
Both corporations and LLCs offer various tax advantages to the owner(s). A corporation is taxed as a separate taxpaying entity by the IRS. It will file its own income tax return (IRS Form 1120), and pay taxes on its profits. If the corporation pays dividends to its shareholders out of those profits, the dividends will be subject to income tax at the shareholders rate of taxation. This is often referred to as “double taxation” – the same profits are subject to corporate income tax, and then again at the personal level on the distributed dividends.
Shareholders can get around the double taxation dilemma that corporations pose by compensating themselves through salary, benefits and bonuses. Since the compensation is deductible to the corporation for income tax purposes, it will only be taxed once – at the personal level of the shareholder.
Shareholders can also avoid double taxation by converting the corporation to a Sub-chapter S corporation. This allows the corporation to pass its profits on to the shareholders, where it will be taxed as individual income only, similar to treatment under a partnership. No income tax will be owed by the corporation itself.
LLCs offer greater flexibility when it comes to income taxes. The owner or member of an LLC can have their income taxed in three ways:
- A single owner LLC is treated as a Schedule C (sole proprietor) for tax purposes
- Two or more owners are taxed as a partnership, filing IRS Form 1065 on the LLC, then reporting partnership income shares on their personal income tax returns
- LLCs also have an option to be taxed as a corporation and file an annual Form 1120 corporation income tax return; this can be done by filing IRS Form 8832 (Election to be Treated as a Corporation for Purposes of Taxation) in order to obtain corporate tax treatment
A Summary of the Difference Between a Corporation and an LLC
LLC, or Limited Liability Company
|Created Under||State law||Same|
|Owners are Called||Shareholders||Members|
|Purpose||To create a distinct legal entity for the purpose of income taxes, liabilities and legal challenges||Similar protection to corporation but without the heavy requirements for corporate formalities (See below)|
|Tax Consideration||Corporation files income tax returns (IRS Form 1120) based on it’s own profits; unless dividends are paid shareholders can avoid double taxation by being compensated through salary, benefits and bonuses, which while taxable to the shareholder, are also tax deductible to the corporation||Three options: Can be taxed as a sole proprietor (Form 1040, Schedule C), as a partnership with more than one owner, or as a corporation with a special election|
|Liability Protection||Shareholders are generally not responsible for debts and other obligations of the corporation, including taxes and legal claims (See Corporate formalities below for exceptions)||Similar to corporations (except for income tax liability for non-corporate LLC’s), except that personal guarantees on loans and obligations of the business will remain a liability of the member/owner as well|
|Business Management||Shareholders can manage the business operations of the corporation, or they can hire non-owners to manage it for them||Ownership and management are usually the same, but LLC can hire non-owners to manage the business|
|Corporate Formalities||In order to determine and maintain separate legal status of the corporation, the company must issue stock, maintain adequate capital in the company, keep asset accounts separate from those of shareholders, appoint officers, hold annual meetings, and record minutes of those meetings – shareholder liability protection can be lost if these procedures are not maintained||Varies from state to state, but generally much less involved than for corporations; general requirements are 1) Articles of Organization, and 2) Operating Agreement|
|Life of Business Entity||Since a corporation is a separate legal entity, it can continue in existence forever; the death of one or more officers of the company will not necessarily result in it’s termination||Can be a perpetual entity if it is provided for in it’s Articles of Organization, otherwise dissolves upon the death, resignation, termination or bankruptcy of a member|