LLC vs. Inc. - Which Initials Best Suit Your Business?

LLC vs. Inc. - Which Initials Best Suit Your Business?

“LLC or Inc?” What is the correct structure for your business? Is it an LLC (limited liability company) or is it a corporation (Inc.)? There is no single, one-size-fits-all answer. To solve the choice of entity puzzle, you must fit together these four different pieces:

  • limited liability protection
  • management and control
  • funding options and opportunities
  • tax consequences for the owners and the business

These four factors differ significantly between a limited liability company (LLC) and a corporation (Inc.).

Limited Liability Protection

Actually, both corporations and LLCs provide limited liability protection. Corporations and LLCs have their own legal existence. They own the business, and they are liable for the business’ debts and liabilities. The shareholders of a corporation and members of an LLC are not liable for the business’ debts. Their liability is limited to their investment. But, keep in mind, whether the business operates as an LLC or a corporation, all the entity’s assets are at risk for the entity’s debts. 

However, sometimes the entity may also need protection from the debts and liabilities of its owners. While both an LLC and a corporation offer some protection, there are differences in the way that protection operates. 

  • Corporation: While incorporating may protect a shareholder's assets from the company’s creditors, the company itself may be at risk from the shareholder’s creditors. How? Judgment creditors of a shareholder can attach the shareholder’s stock and assume all the shareholder’s rights. These rights may include voting for directors which will shape the direction of the company. If the shareholder has a controlling interest, the creditors may even be able to vote to dissolve the corporation.

  • LLC: Limited liability companies also protect the owner’s assets from business creditors. And, in some circumstances, may offer better protection for the entity. Why? Because many state LLC laws limit what a member’s judgment creditor can get from the member to what is called a “charging order”. That’s a court order requiring the LLC to pay any distributions due the member to the creditor instead. But a member’s creditor cannot touch the member’s ownership in the LLC or become a member with management rights.

Management and Control

The second factor to consider in the "LLC vs. Inc." question is who will be calling the shots—both tactically (day-to-day) and strategically (long-term). Who has the right to decide which issues can tip the balance in favor the LLC or the corporation.

  • Corporation: In a corporation, the ownership is separated from control. Shareholders own the corporation, but they only have limited governance rights. These include the right to elect the board of directors, to remove directors under certain circumstances, and to vote on fundamental transactions that affect their economic, ownership rights such as mergers, asset sales, and dissolution. It is the directors that establish the strategic direction of the company, who set the policies and who appoint the officers that run the corporation’s day-to-day affairs.

  • Statutory Close Corporation: While the limitations on shareholders management rights hold true for most corporations (including those that have made an S corporation election for tax purposes), there is a special type of corporation—the statutory close corporation—that vests control directly in the members. Not many states allow this type of corporation. In those that do, there are strict limits on the number of shareholders and the transferability of stock. Other states allow shareholders to enter into shareholder agreements that give them management rights. There are strict limitations here too, including that all shareholders must consent.

  • LLC: In an LLC, the members themselves decide how the LLC will be managed. In fact, management by all the members is the default method of management in most states. However, the LLC’s operating agreement can override the state default by specifying that it be manager-managed. In this case, the management can be much like that of a corporation, but with much less formality regarding meeting and notice requirements. But an LLC is flexible enough that it can be set up with all the corporation-like formalities too if the members so desire.

Funding Options And Opportunities

Businesses need to make money to survive. So, every business owner must consider: “How will this company get the money it needs to get started and to grow?”

  • Corporation: Because of the split between ownership (economic rights) and management (control), corporations have a much easier time attracting passive investors. In fact, many venture capitalists not only prefer to invest in a corporation, but their governing documents don’t let them invest in LLCs. It is also far easier for a corporation to offer stock options—a key way to attract talent to the business. It is also generally easier for a corporation to obtain bank financing. This factor can be especially important in capital intensive businesses.

  • LLC: In order to get obtain equity investment, an LLC must make the investor a member which generally carries with it far more rights to control the organization than shareholders have in a corporation. Although an LLC can have passive members too, people who chose to invest in an LLC instead of a corporation may want to have a say in how the business is run. Also, because of the disinclination of banks and venture capitalists to provide money to an LLC, the owners may find themselves having to personally guarantee debts. This effectively destroys limited liability.

Investing in a business is also about making money. So, every business investor asks: “What are my financial rights to share in distributions during the entity's lifetime and upon its termination?”

  • Corporation: Distributions during corporation's existence are based strictly on the number (or percentage) of shares owned. A shareholder who holds 10% of the corporation share will get $100 if the corporation declares a $1,000 dividend. Allocation of profits and losses depend on the type of corporation. In a regular corporation (a C corporation for federal income tax purposes) there is no allocation to the shareholders—the corporation is its own taxpayer. In an S corporation, income and losses are allocated to the shareholder in according to their percentage ownership. Also, directors decide whether dividends will be paid. The shareholders do not have a say.

  • LLC: Distributions are based on the operating agreement. There doesn't need to be any correlation between the percentage of ownership and percentage share of the distribution. The operating agreement also determines how annual profits and losses are allocated to the members. As with distributions, this allocation doesn't need to correlate with the ownership interest. What's more, profits and losses can be allocated differently if that is what the operating agreement provides. Also, the members may have the right to decide whether dividends are paid.

Tax Consequences for the Owners and the Business

The first difference that most people think of when considering an LLC versus a corporation is taxation. Conventional wisdom touts the LLC as the tax-preferred entity type. However, for many businesses, this might not be the case.

  • Corporation: A regular (or C) corporation is a separate tax-paying entity. This means that it pays corporate income tax on its income, after offsetting income with losses, deductions, and credits. A corporation pays its shareholders dividends from its after-tax income. This is the often mentioned “double taxation.” However, there are ways to reduce or eliminate double taxation, which your tax adviser can advise you on.
  • S Corporation: S corporations are corporations that have made an election with the IRS to be taxed as a pass-through entity. All the company’s income, deductions, and losses are passed through to the owners who report these items on their individual income tax form.
  • LLC: In an LLC the members can decide whether they want to be a pass-through entity or be taxed as a C corporation. By default, an LLC with one member is disregarded (like a sole proprietorship) while an LLC with more than one member is taxed under the pass-through rules applicable to partnerships. However, an LLC can elect to be taxed as a C corporation and also as an S Corporation. 

LLC vs. Inc?

When it comes to the difference between an LLC and a corporation (Inc.), there is no one perfect entity choice. However, considering the four factors listed above will help the small business owner determine the best for his or her particular business, along with the advice of trusted legal and tax advisors.

Information in this article was updated March 2018. The original publication date was April 14, 2014.

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