Should I Incorporate or LLC: Everything You Need to Know
Small business owners typically start their companies as sole proprietorships, which means they and their business are essentially the same thing. 3 min read
Should I incorporate or LLC? This is a common question asked by entrepreneurs. Small business owners typically start their companies as sole proprietorships, which means they and their business are essentially the same thing. However, many entrepreneurs overlook the advantages of changing the format of their company to a corporation or limited liability company (LLC). One of the biggest advantages of these structures is that they protect the entrepreneur's personal assets from debt or legal action taken against the business.
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Small business owners are likely to hear differing opinions about the pros and cons of setting up an LLC or corporation, but they really need to consider what is best for their individual company and situation.
Most entrepreneurs consider three kinds of entities for their startups:
Small business owners should take lots of things into consideration when deciding what kind of entity to start, including if they will soon be looking for outside investors and if the company is expected to generate a profit in the near future. Each type of entity has its own pros and cons.
It is easy and inexpensive to set up an LLC. In an LLC, the owner chooses the members and decides what percentage of the company each member owns. An LLC offers the same amount of personal liability protection as a C-corp.
One of the best advantages of an LLC is that there is limited regulation, so you don't have to follow the same strict rules and disclosures you would have to maintain with a C-corp. LLCs aren't taxed as entities. Instead, members are taxed according to their ownership percentage.
This is helpful because when starting a company, you will initially lose money. Your personal portion of that loss can be used on your personal tax return. If you don't have any personal income, the IRS allows you to either roll the loss forward and offset future income or apply the loss retroactively to the past three years of tax returns. Following either of these paths will lower your adjusted gross income, which often means you'll get a refund.
A C-corp is required to pay tax on all income, which means that money coming into the company is actually getting taxed twice: once when the company pays you and again when you pay your personal income taxes. Considering these circumstances, an LLC is a strong option for a start-up structure.
One disadvantage to an LLC is that it doesn't support shareholders, which means it likely isn't the best option if you have outside investors. In fact, some investors, especially those working with VCs (venture capitalist firms), aren't allowed to invest in LLCs.
A C-corp is a full corporation. It offers absolute protection for your personal assets because it is its own tax entity. Many C-corps are based in Delaware because the state offers a strong legal framework for corporations, shareholders, and boards. If you choose to create a C-corp, you must have a board of directors and follow strict requirements like reporting revenue and keeping your operations running in an organized manner.
C-corps also have shareholders and can issue stock, which makes them a more enticing structure for investors. If you want to accept money from investors, your company will have to be formed as a C-corp. The only exception to this is if you meet the requirements to be an S-corp.
An S-corp is essentially the same as a C-corp, expect that it is allowed to behave differently in certain situations. “S” refers to a section of the IRS code. To create an S-corp, you must first create a C-corp and then choose the S-election if you qualify. An S-corp provides the regulatory benefits of a C-corp and the tax advantages of an LLC.
One of the biggest downsides to being an S-corp is that the types of investors you can have are extremely restricted. Investors are not allowed to be corporations, such as VCs, or people who aren't residents of America. S-corps also face restrictions on the number of shareholders they can have.
If you need help with knowing if you should incorporate or create an LLC, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.