Which is Best for Your Startup: An LLC or a Corporation?

Making the decision of which business formation is right for your company is a big one, but it doesn’t have to be too confusing. Limited liability companies (LLCs) or corporations are two of the most common selections. Understanding the differences between them could help you avoid some common mistakes. 

What Is an LLC?

An LLC is a simplistic business entity that allows the company to separate from your personal assets. It enables the business to become a formal legal entity. You need to register it with the state. Once you do, you can get some protection for your personal assets. 

An LLC is owned by and managed by its members, often referred to as a member-managed business formation. The LLC will carry on even if the members pass away in some states, but in others, you may need to dissolve the company and establish a new one whenever someone exits the company.

What Is a Corporation?

A corporation is a bit different because it is a more complex way of structuring your business. It helps designate your business as a formal legal entity as well. It also requires more work to put it into place, including state registration. Corporations create limited liability protection for your personal assets, and they can help your business to be seen as more professional.

As a more formal business formation, corporations require the placement of more complex operating procedures. Corporations are owned by the shareholders in the company. Typically, there is a board of directors that manages the decision making within the corporation. 

When a corporation loses one or more of its shareholders, the business continues to exist. It is not reliant on the presence of specific directors or shareholders. 

Which Is Best for Your Startup?

To get a better understanding of how an LLC or a corporation may impact your decision to establish your startup, consider the benefits and disadvantages for each and then determine how that may impact the way you plan to operate your business.

Benefits of an LLC for Startups 

Choosing an LLC structure for your startup is often a wise first step. There are several reasons for this.

• You gain personal liability : Having limited personal liability means your home or other assets are protected from claims made against your business. In a sole proprietorship, by contrast, you and your business are the same legal entity. That means if you are accused of negligence, someone could take steps to make a claim on your personal assets.

  LLCs remove this risk to some degree. As long as you do not use your personal assets as a component of your business (like using your bank account for both personal and business needs), you maintain that protection. 

• It’s easier to set up: LLCs typically are easy to set up, requiring the completion of some paperwork. It’s relatively easy to start your LLC online, there are barely any state requirements, prior to setting up the LLC or to run it with any ongoing regulations. By comparison, corporations take far more to set up and often must meet specific requirements, such as holding an annual shareholder meeting and providing significant recordkeeping. LLCs do not. You can hold meetings and should keep records, but you do not have to file these as reports.
• There are tax advantages: LLCs come with tax advantages, even though they do not have their own federal tax classification. However, you and your accountant may determine that you should adopt a strategy of a sole proprietorship, an S corporation, a partnership, or a C corporation, depending on the specifics of your business. That gives you some options.

  LLCs will be automatically considered a sole proprietorship or partnership by the IRS. This means an LLC can operate as a pass-through entity, which means your LLC does not pay any specific LLC or corporate taxes. Rather, it all passes to your personal tax return, and you pay personal income taxes on the profits you have.

• Ownership and management flexibility: Yet another benefit of an LLC is the flexibility you get in how your manage and own your company. With some corporations, for example, there are ownership restrictions, but that’s not the case with LLCs. You can include a foreign member if you would like to do so. You benefit from pass-through taxation without any limitation on the number of type of owners your business has.

  The same applies to your management. Unlike corporations, you can choose who runs your business and makes decisions within it. You don’t have to have a very specific, formal structure. Along with this comes the flexibility to make decisions on how profits are shared. There are fewer rules you have to follow in terms of how or when to distribute your profits. 

Disadvantages of LLCs for Startups 

While not establishing an LLC for a startup (or any legal formation) is not a good idea, it is important to know some disadvantages that exist here that could impact which structure you select. 

• You still have to do some paperwork: Unlike just managing a sole proprietorship, your LLC will require some paperwork and a few fees to pay to register it with the state. As noted, these are fewer than corporations require, but there is still some work to do. You can always hire a professional to manage this process, or you if you want a more hands-off approach.
• Your protections from liability claims are somewhat limited: You are not personally liable for the debts and claims made against your business. However, there is some gray area here. If you make a personal guarantee on a loan or contract for your business, you can still be held accountable for it. If you engage in some type of fraud or illegal activity, you can personally be held accountable for that, too.
• You have to pay self-employment tax: Many people who use an LLC for their startup will find that they have to pay self-employment taxes. This includes Social Security and Medicare taxes. Other businesses do not have to do that, such as a corporation. 
• The structure of your LLC can be hard to change: In some states, the loss of a member could mean the dissolving of the LLC for a new one to be formed. This can make it hard in other situations as well, such as when you are trying to sell your company. You may have limitations on who you can sell it to.

Benefits of Forming a Corporation for Your Startup

There are some benefits to establishing a corporation for your startup right out of the gate. Consider the following.

• You gain asset protection: Your corporation will be a separate legal entity, and that means that you gain protection from claims against your personal property. The shareholders are not responsible for any of the company’s debts or other liabilities. There are limits here, such as when there is a neglect of corporate formalities or you commit fraud. If you are mixing personal and business assets, that’s going to be a concern as well.
• Creating an identity that lasts: When you form a corporation, you create a legal entity for your business that goes on long term. Unlike an LLC, it does not end if a member leaves. That perpetual life for the company is valuable, especially when you want to transfer ownership later. 
• Capital, taxes, and credit are easier to manage: It’s easier to build credit as a corporation and to raise capital for your business because it is a formal company. Your business’s financial history is used rather than your personal history.

  Also notable, there are some tax advantages to having a corporation. You do not have to pay self employment tax (usually at a rate of 15%), but you do have to pay half of Social Security taxes from your corporate account.

Disadvantages of Forming a Corporation for Your Startup

There are a few drawbacks to choosing this business structure.

• The process takes time: It can take more time (and often more cost) to establish a business corporation than an LLC. The application process depends on your state’s rules, but it can be long and requires a significant amount of paperwork to establish. It can also cost significantly more to do this, including on initial application feels, but also whenever you need to file changes. You may pay more in taxes, too.
• Protocols and structure rules exist: Unlike an LLC, you have a long list of requirements to meet when you own a corporation. For example, you will need to create annual reports, document annual meetings, keep board minutes, and meet other compliance requirements. While this does not have to be challenging, it does present more of a time demand on many startups.
• There’s double taxation: Another disadvantage for startups is the double taxation that occurs. Corporations must pay taxes on their business income. That means your company has to pay taxes on the profits you have. On top of that, you personally have to pay taxes on your earnings. Though there are options for working around this as an S-corp, there are limitations to that as well. In many situations, having to pay taxes like this can negate many of the benefits of becoming a corporation.

Which Business Entity Structure Fits Your Needs?

Ultimately, putting some type of formal structure in place to protect your business startup is a wise decision. Do not put this off either, as doing so exposes your company to added risks. Instead, work closely with an advisor if you are unsure which step is the best one in your situation. For some, that may mean forming an LLC now and then, over time, establishing your business as a corporation when it grows and needs more of the formal structure that corporations offer.

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