- LLCs limit owner liability and offer more flexible taxation as a pass-through entity.
- Corporations, such as S-corps and C-corps, are entities for larger, profitable businesses or those with shareholders.
- How you incorporate your business entity has a profound effect on the organization of your company, the distribution of profits and losses, and the way your business is taxed.
- This article is for entrepreneurs trying to determine the best type of business entity for their company when preparing to incorporate.
When you first develop your business, a key moment is selecting the legal structure you incorporate under. The most common designations are LLC and Inc. (a corporation). While LLCs are extremely common among small businesses particularly, there are certain circumstances in which an Inc. – S corporation or C corporation – might behoove you.
In choosing an LLC vs. a corporation, it's important to understand how each is organized, the flexibility in that organization, profit and loss distribution, taxation considerations, and reporting requirements. This guide will break down the basics of an LLC vs. Inc. and help you decide which legal structure is right for your business.
What is an LLC?
An LLC is a limited liability corporation. Its function, as the name suggests, is to limit the business owner's personal liability in relation to business operations. For example, if you own a restaurant that is not incorporated and an employee sues you for violation of labor regulations, your personal assets – such as your liquid cash, your car or even your home – could be on the line. Incorporating as an LLC and assigning ownership of certain assets to the restaurant (separate from your personal assets) insulates you from such a scenario.
This means that an LLC is essentially a separate entity from the owners. An LLC has its own Taxpayer Identification Number, and it can open a bank account and operate all under the same name, said Bradley Stevens, founder and CEO of LLC Formations.
"If the owners want to have personal assets separate from the business assets, the LLC business structure is perfect," Stevens told Business News Daily. "If [they] run the business operations as per the LLC structure and requirements, the accusers would not be able to go after the owner's assets. LLC could be the best business structure for entrepreneurs who are looking to run a business without any partner."
What is a pass-through entity?
LLCs are pass-through entities – businesses in which owners are taxed on the payments they receive from the company as personal income, rather than the business being taxed at the corporate income tax rate. In other words, the profit "passes through" to the owners in the form of payments, which is then taxed as personal income.
"A limited liability corporation offers the protection of limiting personal liability, as a corporation does, but functions for tax purposes as a pass-through entity like a sole proprietorship or partnership," said Elizabeth Witko, liquidity and restructuring advisor at Drucker & Scaccetti. "The structure of an LLC limits the owner's liability to the amount of assets they invest."
However, it is possible to have a multi-member LLC as well, which changes the way the IRS treats the entity for taxation purposes.
"If a single person owns the company, then the IRS treats that person as the sole proprietorship for tax purposes," Stevens said. "It means that the company will not pay the taxes, but that person will pay tax and file a return with the IRS. If there is more than one owner of the company, the IRS treats that LLC as a partnership for tax purposes. The LLC does not pay the taxes, but all the owners will, as per their rightful share of the profits on their income tax returns."
Why should you incorporate as an LLC?
So, when should you choose to incorporate as an LLC? According to Witko, LLCs are the ideal entity choice for new businesses just starting out, as well as small businesses that expect to generate small profits or even incur losses.
"If a [small business] anticipates that it is going to have losses and little income, an LLC is the best choice out of the gate, because this structure offers better tax basis for the initial losses," Witko said. "The annual LLC tax return will be done on the individual's personal tax return and will not require a balance sheet. It is also easier to get an asset out of an LLC in the event the business fails."
The lack of a balance sheet requirement makes corporate reporting far easier for an LLC than it is for a corporation. Additionally, the straightforward transfer of assets out of an LLC makes it easier to dissolve the company or pivot your business model without jumping through regulatory hoops. Further, if the LLC reports annual losses, those can be allocated on the owner's personal tax return, reducing their own tax burden through the Tax Cuts and Jobs Act's 199A 20% Qualified Business Income tax deduction as they invest in their business.
"It is much easier to form an LLC, and you can avoid double taxation on corporate profits," said Kevin Lee, CEO of JourneyPure. "It is also much simpler to file tax returns for the profits you earn from your LLC, and there are less annual filing requirements." [Read related article: What Is an LLC?]
Key takeaway: LLCs are extremely flexible legal structures that allow a sole proprietor or multiple owners to structure the business as they see fit. They are also pass-through entities, meaning no tax is owed on LLC income until the owners receive their share of profits, which are then taxed as personal income only.
What is an Inc.?
A company with the "Inc." designation is a corporation, typically either an S-corp or C-corp. Like an LLC, these entities shield the owners and shareholders from personal liability for debts and lawsuits; however, these entities are taxed on their income. When owners and shareholders collect their share of the company's profits, those distributions are taxed again as personal income.
Besides "Inc.," corporate entities might be designated as "Co.," "P.A." or "Company."
How are corporations taxed?
C corporations are taxed on the income they make separately from any distributions to owners and shareholders. Currently, the federal U.S. corporate income tax rate for C-corps is 21%, recently reduced from its previous level of 35%.
"The earnings of a C corporation are taxed at the corporate level, currently at a flat tax rate of 21%," said Michael Price, director at The Hoffman Group. "If profits are distributed out of the corporation to the owners, those profits are then taxed again to the individual as a qualified dividend."
S corporations, on the other hand, are taxed more similarly to an LLC.
"To avoid double taxation, a corporation, as long as it meets the eligibility requirements, can consider electing to become an S corporation, where net income or loss flows through to the owner as if they were a sole proprietor," Witko said. "Distributions to an S-corp shareholder are not subject to self-employment taxes. However, shareholders are typically employees who must pay employment tax on their W-2 compensation."
Why should you incorporate as a corporation?
An LLC makes the most sense for many small businesses, but an Inc. designation makes more sense in certain circumstances, according to Lee.
"A [small business] should choose a corporation if they eventually want to go public or they expect to grow extremely big, to the point where they need formal ownership and management structures," he said. "A corporation is also a good choice if you see a long future for the business where it may be managed by someone else other than the founding partners."
Similarly, if your business has shareholders, incorporating as a corporation is generally the best way to manage the company. Corporations are also typically considered the ideal entity type for small businesses looking to pursue multiple rounds of financing to support rapid growth and scaling, such as a technology startup seeking funding from angel investors and venture capital firms.
Key takeaway: S corporations and C corporations are different types of Inc. entities that tend to be most useful for midsize and large companies, respectively. C-corps in particular are effective for rapidly growing businesses seeking investors.
Can a company be both an LLC and an Inc.?
A business cannot be an LLC and a corporation at the same time. It can, however, change its entity designation through a registration process with the government. Many businesses do this as they grow and change, to better align with their existing structure and tax circumstances.
"A company can't be both an LLC and an Inc. at the same time, but it can change from an LLC to a corporation if it chooses to do so for tax purposes," Price said. "This can be done by either completing Form 8832, Entity Classification Election, to change from an LLC to a corporation, and/or completing Form 2553, Election by a Small Business Corporation, which allows the corporation to become an S corporation, which is taxed similarly to an LLC in that the profits and losses flow through to the individual owners instead of being taxed at the corporate level."
Choosing your preferred entity type is important, but it's important to know you can change it later as your business's circumstances change. For most business owners who plan on starting small and growing gradually, an LLC is the right choice. For others, such as fast-growing startups and companies looking for investors right out of the gates, incorporating as an S-corp or C-corp might be the better option. [Read related article: How to Choose the Best Legal Structure for Your Business]
Key takeaway: A company can't be an LLC and an Inc. at the same time. However, businesses can change their legal structure as they grow and circumstances demand it.