One of the most common questions we receive regarding the formation of a business is: "which entity should I form for my business, an LLC or a corporation?" This question is typically asked after the business owners have already decided that they need an entity that limits the personal liability of all the owners.
To limit liability, there are two popular choices - the limited liability company (LLC) or the corporation. While there is no right answer for every business, there are some general guidelines that may help each business owner decide what is right for them.
Why an LLC may be the right business entity for you
For most small business owners, an LLC is the better choice because of its relative flexibility and simplicity. For example, an LLC does not need to follow some of the cumbersome requirements that a corporation does - such as regular shareholder and board member meetings.
An LLC is also the preferred choice if the LLC will own property, such as real estate, that is likely to increase in value. This is so because an LLC does not pay tax on its income. Instead, an LLC's tax liabilities are passed through to the LLC owners. In contrast, a corporation and its shareholders are subject to double taxation on the increased value of the property (unless the corporation elects to be taxed as an S corporation - more on that later). Generally speaking, the benefits of an LLC outweigh those of a corporation.
Why a corporation may be the right business entity for you
While generally preferred, an LLC is not always the right choice. Sometimes there are specific situations where a corporation is actually preferred. For instance, if you expect to have multiple outside investors then a corporation is usually better because it's easier to issue stock certificates (something an LLC cannot do) then it is to draft a complex LLC ownership agreement. Moreover, stock certificates are usually preferred by investors and can also be used as a reward to incentivize or keep key employees.
Lastly, unlike an LLC, a corporation can hire the owners to serve as executive officers, pay them a tax-deductible salary, pay for their health insurance premiums and provide other employee benefits. An owner of an LLC cannot be treated as an employee and thus does not enjoy this same favorable tax treatment (unless an LLC elects to be taxed as an S corporation - more on that now).
So what is an S corporation?
An S corporation is an IRS tax-filing status that allows tax liabilities to be passed through to the owners, just like an LLC, but unlike an LLC, the owners can also be treated as employees, just like a corporation. Essentially, S corporation tax status avoids double taxation while also providing tax-deductible benefits to the employee-owners. And either an LLC or a corporation may elect S corporation tax status. However, to file for S corporation status, the business must meet some strict requirements, including the need to limit the amount of owners.
Summing it all up
In most instances, an LLC is typically the best choice for most small businesses. Exceptions to this general rule exist when the business is expected to have outside investors or ownership will be offered to key employees an incentive. If either one of these situations apply, then a corporation is preferred.
Either way, whether an LLC or corporation, if the business income is enough to pay a reasonable salary to the employee-owner(s), then the LLC or corporation should also elect S corporation tax status. This provides the most tax benefits in most instances.
While this article hopefully has helped guide you in the right direction, you can always schedule a free consultation with an experienced business attorney at J.Cutler Law to confirm you made the right decision.