Key Takeaways

  • LLCs and corporations (Inc.) both provide liability protection but differ in ownership, taxation, and management structures.
  • Corporations have shareholders, directors, and officers, while LLCs are owned by members with flexible management options.
  • Tax treatment differs significantly: LLCs typically use pass-through taxation, while corporations may face double taxation unless they elect S corporation status.
  • LLCs offer more flexibility in profit distribution and fewer formal requirements, while corporations offer easier access to venture capital and public funding.
  • Setup and maintenance costs vary: LLCs usually have lower startup costs and fewer compliance obligations than corporations.
  • Investor preference often leans toward corporations due to stock issuance and easier transfer of ownership.

Incorporation vs LLC is a comparison of two of the most common types of legal business structures. An incorporation, or corporation, refers to a business that functions as a distinct entity, separate from its founders or owners. An LLC, or limited liability company, refers to a hybrid entity that combines the advantages of a corporation and a sole proprietorship or partnership. Aspiring business owners should know the pros and cons of these two business types before deciding which one is best for them.

What is a Corporation?

When a business changes its legal structure from a sole proprietorship or partnership to a corporation, it becomes an entity that functions on its own, without holding its owners accountable for its actions. The two most common forms of corporation are C corporation and S corporation. Both types of corporation offer certain benefits, such as protection from personal liability and greater credibility with customers.

What is an LLC?                          

Unlike a corporation, which has a standard management structure, an LLC operates more informally. It allows its owners to avoid being personally liable for its actions. In addition, it practices pass-through taxation, meaning that it reports taxes on its owners' individual tax returns.

Differences Between a Corporation and an LLC

Business Ownership

A corporation's owners are called shareholders, while an LLC's owners are referred to as members. An LLC is allowed to distribute its ownership interests any way it wishes, without consideration for its members' capital contributions. Theoretically, a corporation can do the same thing by establishing a special stock class structure. However, this option is only available to C corporations.

Business Operation

A corporation is required to operate with a board of directors performing management duties and a group of corporate officers managing day-to-day operations. The shareholders usually do not participate in the operations and the decision-making processes of the company, but they may approve or disapprove of important corporate decisions. In general, they are only involved in the election of directors. However, individual shareholders can serve as directors or corporate officers.

Legal Discrepancies

Since the corporation structure was established centuries ago, a corporation has more uniform laws to follow. With knowledge of these laws, it can plan ahead with greater confidence than an LLC. Being a comparatively new, hybrid legal structure, an LLC is treated differently in different states. While some states may have similar laws for LLCs, there may be differences that cause a certain business to opt for LLC status in one state and corporation in another.

Taxes

In a corporation, taxes on profits are reported at the business level. Additionally, shareholders who receive dividends are required to pay individual income taxes on them. As such, a corporation has to pay taxes twice, which is considered one of its biggest disadvantages. However, a corporation can choose to elect S corporation status. With this status, it can pass its profits and losses through to its shareholders, who will be taxed at the individual level. An LLC handles taxes the same way an S corporation does.

Recordkeeping

There are a number of mandatory recordkeeping requirements that a corporation is required to meet, including:

  • holding a shareholders' meeting every year
  • documenting minutes of shareholders' meetings and significant decisions in most states
  • maintaining good shareholder records
  • providing an annual report and paying an annual fee in many states

In most states, the recordkeeping requirements for an LLC are significantly less stringent than those applied to a corporation. Nonetheless, it is beneficial for an LLC to keep good records. An LLC is not required to have an annual meeting and is less likely to have to file an annual report.  

Legal Business Entity vs Tax Entity

Some people may have the misconception that a legal business entity is the same as a tax entity, but they are actually different classifications. A tax entity is a classification that the IRS and the taxing board of the state look at when they deal with a business. A legal entity, on the other hand, is the status that everybody else looks at, including the state government, courts, and contractual partners.

While a corporation is a legal entity, its tax entity classification can be a C corporation or S corporation. An LLC is also a legal entity, but it has the freedom to choose its tax identity, which can be sole proprietorship, partnership, C corporation, or S corporation.

Liability Protection and Credibility

Both LLCs and corporations offer limited liability protection, shielding owners’ personal assets from business debts and liabilities. However, some differences exist:

  • Corporations may be perceived as more credible, especially with investors and financial institutions, due to their formal structure and longevity.
  • LLCs, while providing liability protection, may not carry the same weight of perceived stability as a corporation, particularly in industries where corporations are the standard.
  • The corporate veil can be pierced if legal requirements are not followed; similarly, LLC members risk losing liability protection if the LLC is not properly maintained.

Management Structure and Formality

The management structure between LLCs and corporations reflects a key difference:

  • Corporations are required to have a formal structure with a board of directors overseeing corporate affairs and officers managing daily operations.
  • LLCs allow for flexible management. They can be member-managed (owners handle operations) or manager-managed (appointed managers oversee operations).
  • Corporations must hold regular board meetings, maintain minutes, and comply with strict corporate formalities. LLCs typically have fewer mandatory formalities but are still encouraged to maintain operating agreements and meeting records to protect their liability shield.

Investment and Funding Considerations

When evaluating LLC vs Inc, it’s important to consider how each structure impacts funding opportunities:

  • Corporations can issue stock, making it easier to attract venture capital or public investors.
  • LLCs cannot issue stock, which may deter investors who prefer ownership in the form of shares.
  • Investors in an LLC may become members and may face "phantom income," where they are taxed on profits they have not received.
  • If seeking significant outside investment or planning for an IPO, incorporation is typically preferred.

Startup and Maintenance Costs

The costs associated with forming and maintaining a business entity can influence whether an entrepreneur chooses an LLC or a corporation. Typically, setting up a corporation is more expensive due to higher state filing fees, the need to create bylaws, and requirements to appoint a board of directors. LLC formation fees are generally lower, and the process involves fewer formalities.Ongoing costs also differ:

  • Corporations often face annual report filings and franchise taxes in many states.
  • LLCs may have similar requirements but with fewer reporting obligations and lower fees in some jurisdictions.
  • Legal fees for drafting corporate documents like bylaws can add to corporation startup costs.

Frequently Asked Questions

  1. What is the primary difference between an LLC and a corporation?
    The primary difference lies in the ownership and management structure. LLCs have flexible management and pass-through taxation, while corporations have shareholders, directors, and officers with more formal governance.
  2. Which is easier to form, an LLC or a corporation?
    An LLC is generally easier and less expensive to form due to simpler filing requirements and fewer ongoing formalities compared to a corporation.
  3. Do corporations and LLCs provide the same liability protection?
    Yes, both structures provide limited liability protection, but maintaining this protection requires following state laws and formal business practices.
  4. Why do investors prefer corporations over LLCs?
    Corporations can issue stock, making it easier for investors to gain equity. They also provide more straightforward mechanisms for transferring ownership and raising capital.
  5. Can an LLC be taxed as a corporation?
    Yes, an LLC can elect to be taxed as a C corporation or an S corporation by filing the appropriate forms with the IRS, allowing flexibility in tax treatment.

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