One of the most important decisions you’ll make as a small business owner is choosing your legal business structure. As with most business decisions, there is no one-size-fits-all for selecting the best option. Which classification you choose ultimately depends on your business goals, ownership structure, and more.
But how do entrepreneurs determine if a limited liability company (LLC) or a corporation is right for their business? Let’s take a look at the important features of each.
At a glance
First, let’s look at a couple of things LLCs and corporations have in common:
- Both are separate legal business entities that offer liability protection for their owners
- Both have state compliance requirements they must meet
From there, each business classification has its own unique requirements depending on the type of corporation or LLC. The main differences we’ll go over include the ownership restrictions, management structure, and taxation of each type of business.
Ownership and management
LLCs
Ownership structure: LLCs can have one owner, or multiple owners called members. These are classified as single-member or multi-member LLCs. An LLC has a very flexible ownership structure — it can be owned by individuals, trusts, estates, and other LLCs, corporations, and foreign individuals.
LLCs also have more flexibility in distributing income, losses, and credit items. Most multi-member LLCs file an operating agreement detailing the rights and roles of each owner and how the company will deal with departing members. Without an operating agreement, the LLC must abide by state laws.
Management: As you may have guessed, LLCs allow for greater flexibility in their management structures as well. Members can manage the LLC themselves or hire a manager or management team to handle business contracts and day-to-day operations. States often require members to explain their management structure in their Articles of Organization document.
S Corporations (S corps)
Ownership structure: Owners of a corporation are called shareholders. S corps are limited to 100 domestic shareholders — foreign shareholders are generally prohibited. These corporations can only be owned by individuals, estates, and certain trusts (not other corporations, LLCs, or partnerships). Ownership percentage is proportionate to the number of stocks they own. Income, losses, and credit items are distributed proportionally based on the number of shares owned throughout the year.
Management: Unlike LLCs, it is relatively easy for S Corp shareholders to transfer ownership or authorize additional shares to its owners. S Corps can only have one kind of shareholder with one class of stock, and all shares have equal voting rights in the company.
C Corporations (C Corps)
Ownership structure: There are no restrictions on ownership in a C corp — this kind of corporation can have an unlimited number of shareholders, including foreign shareholders.
Management: C corps operate with a strict corporate structure. Shareholders must elect a board of directors, hold official annual shareholder meetings, and keep detailed paperwork on everything. Unlike S corps, shareholders of C corps can give owners different voting rights by issuing different classes of stock. This method means some shareholder votes mean more than others.
How they’re taxed
LLCs
While LLCs are separate legal entities for liability purposes, the IRS doesn’t automatically give them a separate tax classification.
Single-member LLCs: The IRS considers most single-member LLCs as disregarded entities and taxes them as a sole proprietor. This means the owner reports their business income and expenses directly on their own tax return using Schedule C. They are also subject to self-employment tax, reported on the owner’s individual tax return. If you own a single-member LLC, you can instead elect to be treated as an S corporation or corporation for tax purposes.
Multi-member LLCs: Most multi-member LLCs are taxed as partnerships, but owners still have the option of electing to be treated as an S corp if their LLC meets the qualifications. This type of LLC is called a pass-through entity, meaning the company profits “pass through” to the members (owners), who must report it as income on their personal tax returns (using Schedule K-1) and pay taxes on their share. Owners’ income is also subject to self-employment taxes, reported on their individual tax returns.
Corporations
S corps: S corps are also pass-through entities, meaning their income and losses are passed through proportionally to the shareholders (owners) and taxed at their personal income tax levels using Schedule K-1. S corps must also file an income tax return using Form 1120-S.
C corps: C corps must file their own income tax returns using Form 1120. Have you heard the term “double taxation” thrown around when discussing corporations? C corps are subject to double taxation, which means they essentially get taxed twice — once at the flat corporate tax rate of 21 percent when filing Form 1120 and again when dividends are distributed to shareholders who are taxed at their individual levels.
Examples of what these businesses look like
Still unsure about the differences between LLCs and corporations? Let’s look at some hypothetical examples.
LLC: Company A operated as a general partnership for a while, but the partners recently converted their legal business structure into a multi-member LLC to limit their personal liability. They have hired a few employees and even brought another person on board as an additional member. Their profits are slowly growing, but they have no plans to make any dramatic business changes in the next few years.
S corp: Company B has a small group of shareholders (owners) who are all U.S. citizens. It has been a profitable local business for a few years now, but the shareholders are happy with their small business status and have no plans of widespread expansion or going public.
C corp: Company C has grown from a small business to a large company with many locations. It has a board of directors and more than 100 shareholders (owners), some of whom are foreign investors. Company C’s goal is to become a publicly-traded company, and there are plans to file an IPO on a public stock exchange in the coming year.
Pros and cons
LLC pros
- Liability protection for your personal assets
- No double taxation
- Management flexibility
- Easier to create and operate than a corporation
LLC cons
- Harder to transfer ownership
- Profits subject to Social Security and Medicare taxation
- Fewer fringe benefits – these must be treated as taxable income
S corp pros
- Limited liability and perpetual existence (if the shareholder passes away, the corporation continues to exist)
- No self-employment tax to worry about
- Only subject to pass-through taxation – one of the most valuable benefits of being an S corp
- Losses can be written off on your personal tax return
S corp cons
- Limited ownership options and growth potential
- Must pay a reasonable wage to employee-shareholders (the IRS tends to scrutinize this)
- Must pay payroll tax to make up for no self-employment tax
- Compliance costs can be high
- Shareholders cannot deduct losses on their personal returns that are more than their basis (initial amount invested)
C corp pros
- Limited liability and perpetual existence
- No shareholder limits
- Can be owned by other C corps
- Can deduct fringe benefits like disability and health insurance
- Can deduct losses on its corporate return (up to income amount), resulting in a net operating loss
- Easier to grow
C corp cons
- Subject to double taxation
- Expensive to start
- More complexity, formalities, and stricter recordkeeping requirements
- Owners can’t write off losses on their personal return
- Compliance costs can be high
- Growth comes at the cost of higher taxes and more regulation
Which is best for you?
If you run a startup, new business, or small-scale local business, you may want to stick with an LLC or S Corp. Do you value more flexibility and simplicity? If so, an LLC could be a great option. If you are looking for the credibility and tax benefits of a corporation without concern for flexibility or widespread growth, an S corp could be right for you. And if you really plan on growing your business and becoming a well-known company, a C corp may be your best bet.
When deciding how to structure your business, it’s best to ask yourself: “Where do I see my business heading in the future?” Once you’ve established your key business goals, weigh the pros and cons of LLCs and corporations to see which structure can help you best achieve those ambitions.