Entrepreneurs can generally choose from a number of different entities when incorporating their business. However, due to the fluid nature of businesses, the advantages and disadvantages are not always clear at the time of formation.
Limited liability companies and corporations are the two most typically attractive options for small businesses considering incorporation. Unlike sole proprietorships and general partnerships, members of LLCs and shareholders of corporations have limited liability and greater protection for their personal assets. Members and shareholders can limit their liability and protect their personal assets from creditors.
But if both options offer owners liability protection, why do some business owners choose to form an LLC instead of a corporation, and vice versa? Below are some considerations to help you decide what type of entity might be the best fit for your business.
- Corporate Formalities: Unlike a corporation, an LLC does not have to hold regular meetings and keep corporate minutes, which reduces the paperwork of maintaining your entity.
- Taxation: The tax default for an LLC is treated as a pass-through entity, meaning the profits or losses from the entity pass through directly to the owners. Owners of an LLC can instead elect for it to be taxed as a C or S corporation so they can access certain tax advantages based the company’s income and expenses. The tax default for a corporation is subject to taxation at both the entity and the owner level. A corporation can also elect to be taxed as an S corporation which, like LLCs, allows for pass-through taxation. However, additional restrictions regarding who can be a shareholder of the corporation exist if you elect to be taxed as an S corporation. For example, S corporations can have no more than 100 shareholders and can have only one class of stock.
- Debt Inclusion: Early on, a startup or small business will often operate at a loss. Corporation shareholders may not deduct losses beyond their basis in their stock or debt obligations. In contrast, LLC owners can include their proportionate share of the debt from the LLC, so they can deduct a larger share of the losses.
- Management: An LLC’s members or managers can manage the company. In contrast, a board of directors and its chief executive officer are in charge of managing corporations.
- Distributions: A corporation must allocate its distributions in proportion to each shareholder’s ownership share. An LLC, on the other hand, does not necessarily have to allocate its profits or losses in proportion to each owner’s membership interest. Instead, the LLC’s operating agreement (which is subject to certain IRS restrictions against negative capital accounts) can determine the distributive share of gains, losses, deductions or credits. Additionally, members of an LLC can transfer and withdraw property into the LLC without the recognition of taxable gain by the LLC or the member with whom the property has been distributed. In the case of corporations, property distributions can result in taxable gain.
- Investment: Entrepreneurs hoping to achieve venture seed funding typically choose the Delaware C Corporation. Venture capital firms won’t automatically screen out businesses that are not incorporated in Delaware, but they prefer it due to their friendly corporate governance benefits and predictable corporate laws.
Selecting an entity that is appropriate for your business will depend on how you plan to run the business and where you hope to take it. One size does not fit all. Crafting a strategic entity can mean a world of difference as your business begins to take off.
This article was co-authored by Doug Bend and Alex King.
Disclaimer: This article discusses general legal issues, but it does not constitute legal advice. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.