There is a lot of planning and thought that goes into starting a business. And before you open up for operations, one of the most important decisions you will have to make is which type of entity you want to create. Many business owners narrow the decision down to two options; a corporation or a limited liability company (LLC). Both entities provide advantages for businesses, but there are some drawbacks to be aware of as well.
Before discussing the differences, it is important to note is that there is one major similarity between corporations and LLCs; they both provide owners with limited liability protection for their personal assets. Without limited liability protection, your personal assets would be at risk, and these assets could be used to repay debts that may be incurred from your business being sued or going into bankruptcy. Sole proprietorships and standard partnerships do not enjoy this type of protection.
Here is a detailed look at some of the primary differences between a corporation and an LLC:
Corporations and LLCs have different ownership structures. A corporation is owned by shareholders (also referred to as stockholders), and ownership is in direct proportion to how many shares of stock an individual owns. An LLC is owned by one or more individuals, referred to as “members”. The main difference is that an LLC has more flexibility on how it can distribute its ownership stake. For example, an LLC could distribute profits to all members equally, even if they did not all invest the same amount of capital into the company. LLCs can also be owned by other corporations, foreign individuals, or any type of trust.
Corporations are often a good choice for startups that are looking to raise capital from outside investors. This can be done more smoothly through stock offerings. Corporations are also separate legal entities, which means they do not die when one or more of their owners dies. A corporation exists in perpetuity unless/until its owners decide to dissolve it.
The management structure of an LLC is less formal and more flexible than that of a corporation. An LLC can be run by a member/owner or a manager who has no stake in the company. It is entirely up to the owners/members how the company will be managed. Corporations have a much stricter and more formal management structure. There must be a Board of Directors that are elected by the shareholders to oversee the management of the corporation, and corporate officers are appointed to handle day-to-day business operations. Although shareholders own the corporation, they are not involved in its decision-making, except to elect directors. Shareholders are, however, allowed to serve as directors or officers of the corporation.
Another area where corporations and LLCs differ significantly is with taxes. Once again, LLCs have far greater flexibility in this area. By default, an LLC is taxed as a “pass through” entity, meaning that profits and losses are reported on the individual tax returns of the owners/members, not at the business level. In California, LLCs are required to pay an $800 annual tax to the California Franchise Tax Board (CFTB). If annual gross revenues exceed $250,000, an additional fee is added based on the LLC’s income from California sources.
An LLC can also choose a different tax treatment. If it is a single member LLC, the owner can be taxed as a sole proprietorship, which would mean filing a Schedule C form with their personal tax return. An LLC could also be taxed as a C corporation or S corporation. This could allow members to take advantage of the tax benefits of either of these options while retaining the flexibility of the LLC entity structure.
As mentioned earlier, corporations are separate legal entities, and therefore they are taxed separately from their shareholders. Corporate profits are currently subject to a 21% federal tax rate, along with an 8.84% California state tax rate. After these taxes are paid, the remaining profits are distributed as dividends to shareholders, where they are taxed again. This is commonly referred to as “double taxation”, and it is one of the most unpopular aspects of the corporate tax structure.
In smaller corporations, owners/shareholders can get around the double taxation issue by paying themselves a salary with all the profits, thus leaving nothing left over to be taxed at the corporate level. This becomes much more difficult, however, when profits go beyond the point where you can justify using all of them to pay an owner’s salary.
Another option for a corporation to avoid double taxation is to become an S corporation. S corps are “pass through” entities like LLCs, and profits flow through to shareholders as dividends without being taxed at the corporate level. To qualify as an S corporation, however, an entity must have fewer than 100 shareholders and meet some other strict requirements.
Not Sure which Entity to Form for your Business? Contact Garmo and Garmo, LLP for Assistance
Choosing the right entity structure is crucial for the success of any business, and it is important to get this right from the outset. Although you can change an entity structure later on, it could be much more complicated to do this once you are already in business, and it could result in some unintended consequences.
To know for sure whether your business should be a corporation or an LLC, it is best to consult with an experienced business lawyer. If you are starting a business in San Diego or anywhere in Southern California, contact Garmo and Garmo, LLP for legal guidance. We will meet with you to discuss the type of business you are starting, your goals and objectives, and explain the differences between an LLC and a corporation.
Call our office today at 619-441-2500 or message us online to schedule a consultation with one of our attorneys.