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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

Put simply, limited liability creates a wall between a business owner’s personal assets and the assets of the business, protecting the owner’s personal assets from the entity’s debts liabilities and obligations. Limited liability can also protect the entity from the owner’s personal debts, liabilities, and obligations. 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. 

While both an LLC and a corporation offer limited liability 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? The creditors of a shareholder can attach the shareholder’s stock and assume all the shareholders 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 a member’s creditor cannot touch the member’s ownership in the LLC. While the creditor might be entitled to the member's economic right to distributions from the LLC, the creditor cannot 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 the right to elect the board of directions and to vote on fundamental transactions that affect their economic, ownership rights. 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.
  • 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 close corporation—that vests control directly in the members. Not every state allows this type of corporation. In those that do, there are strict limits on the number of shareholders and the transferability of stock.
  • 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 is much like that of a corporation, but with much less formality regarding meeting and notice requirements.

Funding Options And Opportunities

Business is about making money. 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 prefer to invest in a corporation. 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. 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.
  • 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.

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 many ways to reduce or eliminate double taxation, such as paying a salary, making contribution to deferred compensation plans, or retaining earnings within the corporation. A C corporation can also accumulate income, which an S corporation or LLC cannot do.
  • S Corporation: S corporations are regular corporations, LLCs, or partnerships that have made an election with the IRS to be taxed as a pass-through entity. This election enables the corporation to pay both salary and dividends, thus reducing the employee-owners self-employment tax liability. However, an S corp cannot retain earnings within the corporation, so all income is taxed as if it was distributed to the individual owners, even if the owners save it to reinvest in the corporation.
  • LLC: As a general rule, an LLC is not a separate tax-paying entity. (An LLC can elect to be taxed as a corporation and also as an S Corporation.)  All the company’s income, deductions, and losses are passed through to the owners who report these items on their individual income tax form.  In addition, the members must pay self-employment tax on their share of income from the LLC, which can add a significant amount to the member’s overall tax liability.

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 well help the small business owner determine the best for his or her particular business.

Information in this article has been updated for 2016 on February 19, 2016. The original publication date was April 14, 2014.

 

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