Incorporation vs LLC: Everything You Need to Know
Incorporation vs LLC is a comparison of two of the most common types of legal business structures. 3 min read
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
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.
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.
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.
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.
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.
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