Many start up businesses at pre dawn of their existence are being faced with Corporation vs LLC decision. Which one is a better choice? Which one gives better protection and tax advantage? There is really no one simple and clear answer to that. It depends on business itself, ownership structure, goals, objectives and the state business will be registered in.
Disclaimer: I am not a lawyer and information provided below should not be regarded as legal advice. I strongly recommend that if you are going to start a company, you seek a legal advice from your attorney. how to register a DBA in Texas
Typically there are three kinds of entities that most start up companies will consider:
Limited Liability Company (LLC)
S Corporation (Inc)
C Corporation (Inc)
Each one of those entities has its own benefits. Let’s start with an LLC.
LLC offers flexibility in ownership and ease of operation. There are no restrictions on the ownership of an LLC. An LLC can be managed by its members (operating agreement will define how it is done), meaning that the owners run the company or it can be managed by elected manager, with responsibility delegated to managers who may or may not be owners in the LLC. An LLC is easier to operate since it’s not subject to the formalities by which S Corporations must abide. Also LLC as S Corporation can be “pass – through” entity for the tax purposes. Profits can be distributed and passed through to the owners and reported on the owner’s personal income tax returns, thereby eliminating the double taxation usually incurred by the owners of C Corporation.
LLC owners pay their self employment tax once a year on April 15 when income taxes are normally due. Income tax filings are also relatively easy for the owners of an LLC. A single member LLC files the same 1040 tax return and Schedule C as a sole proprietor. Partners in an LLC file the same 1065 partnership tax return as do owners of traditional partnerships.
LLC can be the perfect structure for many start ups. One of the LLC downsides is that it does not really allow for shareholders so if you plan to attract outside investors such as angel investors or venture capitalists, an LLC is probably not going to work for you. Some venture capital firms have structures that do not allow them to invest in an LLC because it has limitations to the type of stock it can issue.
S Corporation has some restrictions of who can be owners or so called shareholders of an S Corporation. An S Corporation can only have no more than 75 shareholders. None of the shareholders can be non-resident aliens and shareholders cannot be other LLCs or Corporations.
S Corporation requires much more paperwork compare to an LLC. It operates in the same way as a traditional C Corporation so it must follow the same formalities and record keeping procedures. On the flip side S Corporation maintains the tax “pass-through” advantages of an LLC. The directors or officers of S Corporation manage the business. Also S Corporation has no flexibility when it comes to splitting profits amongst its owners. The profits must be distributed according to the ratio of stock ownership even if the owners may feel otherwise.
One of the major differences between S Corporation and LLC is the employment tax that is paid on earnings. The owner of an LLC is considered to be self employed and, as such, must pay a self-employment tax of 15.3% which goes toward Medicare and social security. In LLC the entire income of the company is subject to self-employment tax.
In S Corporation only the salary paid to the owner/employee is subject to employment tax. The remaining income that is paid as a distribution is not subject to employment tax under IRS rules. Therefore S Corporation has the potential to realize employment tax savings. The down side of that is additional paperwork associated with payroll tax. The payroll tax is a pay as you go tax and must be paid to the IRS regularly throughout the year. The tax must be paid on time or business may incur penalties and interest.
C Corporation is your traditional corporation that you can find among most of the Fortune 500 companies. C Corporation is legal tax entity in its own right, so you get maximum protection but not the tax benefits. It is practical for C Corporations to get incorporated in Delaware or Nevada because those two states have great legal framework for corporations, its boards and shareholders. One of the issues with C Corporations is that they have to have a board of directors and adhere very carefully to certain reporting requirements and generally keep operations and finances in order. C Corporation can issue different types of stock (common or preferred) to anyone. C Corporation can have unlimited number of shareholders and this type of entity is recognized and expected structure for most angel investors and venture capitalists. Unfortunately with C Corporation you will have the double taxation issue but if you want investors to invest in your business most likely you will need to be C Corporation.