What's the Difference Between an LLC and Incorporation?

Friday, January 17th

What's the Difference Between an LLC and Incorporation?

As a business owner, it is important that you take steps to create a barrier between yourself and your company. Otherwise, you may be at risk of being held personally liable for any damages a customer, vendor or employee may incur because of your firm's reckless actions. To do this, you may want to consider structuring your business as a limited liability company (LLC) or a corporation. Let's take a closer look at the differences between these two entities.

An Overview of the LLC Structure

The LLC structure is often referred to as a hybrid between a sole proprietorship and a corporation. If your business has more than one member, it is considered to be a hybrid between a corporation and a partnership. Like a corporation, your LLC is an entity that is separate from yourself for legal purposes.

This means that only your company's assets are vulnerable to being liquidated or seized if a judgment is rendered against your company. The same is generally true if your business defaults on a loan or otherwise runs afoul of its creditors. It's worth noting that you are still liable for any loans that you personally guarantee regardless of what your company is structured as.

By default, an LLC is taxed as a sole proprietorship or a partnership depending on how many members your company has. However, your business can elect to be taxed as a corporation by submitting IRS Form 8832.

An Overview of the Corporate Structure

Like an LLC, a corporation is a legal entity that is separate from its owners. There are two types of corporate structures that you can choose from. The C corporation is the traditional entity that places no restrictions on the number of shareholders that it can have.

Unlike an LLC, excess earnings are taxed at the corporate level before they are distributed to shareholders or others affiliated with the company. Any dividends, bonuses or other types of compensation that is distributed to shareholders, executives or employees are then taxed at the individual level.

The S corporation is designed for small business owners who operate companies that have fewer than 100 shareholders. Unlike the traditional corporation, the profits and losses that this type of entity generates flow through to each shareholder's personal tax return.

You Can't Raise Capital With an LLC

One of the key differences between a corporation and an LLC is that you can't raise capital with an LLC structure. It's important to note that this doesn't mean that your company can't get a loan, ask for capital from its members or otherwise have stores of cash available for use to operate and grow the company. What it means is that you can't sell shares of stock to the public as a means of raising money for your business. Therefore, if you are planning to take your company public in the future, it may be necessary to eventually adopt a corporate structure.

LLC Ownership Can Be Allocated However You Would Like

A corporation must allocate ownership proportionally based on how many shares a person owns. However, an LLC can allocate ownership in any way that it wants. This means that you could retain 75% ownership of your company even if your partner contributes most of the money to the business.

You could also decide to retain a majority stake in your company even if your partner develops products, recruits customers or performs other key tasks. It is important to remember that profits or losses that an LLC generates flow to a member's personal income return based on that person's ownership stake in the company.

For instance, if you owned half of the company, you would be entitled to half of the company's profits. However, if you owned 20% of the company, you would only be entitled to 20% of the profits regardless of what your actual role is within the organization.

You may be wondering why a person would want to claim any losses that a company generates on his or her tax return. The answer is that a capital loss can be used to offset any other income that an individual earns over the course of a year. Any losses that can't be claimed in a given tax year can be rolled over and used to offset income in future years.

An LLC Is Generally Easier to Operate

As an LLC does not have any shareholders, there is no need to have a shareholder meeting each year. Furthermore, there are fewer rules than LLCs must abide by as it relates to recordkeeping and management structure. Essentially, you can create any type of management structure that meets your company's needs, and there is generally no need to create a board that oversees the business.

You Can Create an LLC Within Minutes Online

In many cases, you can form an LLC online while on your lunch break, while the kids are sleeping or whenever you have 10 to 15 minutes of free time during the day. All you need to do is choose the state where you want your company to be domiciled, provide a few pieces of information and submit your organization documents to the relevant authorities.

Typically, you'll need to provide the name of your company, its address and who will act as the company's agent. You will also likely need to list the names and addresses of other members of your LLC. In a few states, you'll need to publish a formation notice in a newspaper that has a sufficiently large readership.

It's important to understand that you'll need to base your company in a state where it has a nexus. A nexus is another way of saying an important connection to the area where you do business. For instance, if your company is headquartered in New York, you'll likely need to form your company in New York.

LLCs Can Be Terminated Immediately After You Die

An LLC's operating agreement may stipulate that the company shall be dissolved after you pass on. Alternatively, it may state that the company be dissolved after both you and your partner pass on. Although corporations can be dissolved after the death of a key owner, this generally cannot happen without shareholder approval.

If shareholders don't agree to dissolve the business, it will continue under the leadership of another individual. Of course, if you were a corporation's only shareholder, it's possible that the business would be shuttered by the state where it's incorporated after your passing.

In the event that an LLC is terminated, any remaining profits will be distributed among the surviving owners. Your share of the company's profits will likely be claimed by your estate and distributed per your will or per state intestacy laws.

LLCs Can Be Classified as Disregarded Entities

If you don't change the tax status of your LLC, it will be classified as a disregarded entity by the IRS. This means that it follows the same tax rules that any other sole proprietorship or partnership must abide by. However, a corporation cannot be a disregarded entity because it is inherently designed to be an entity that is separate from its owners. As a general rule, it is not possible to change the tax or legal status of a corporation.

Minimize Your Risk

Running a business as a sole proprietor may leave you exposed to personal liability for anything that happens to those who interact with it. The same may be true if your company is structured as a partnership. Forming an LLC generally allows you to operate under one of these structures while minimizing the risk that you could lose your home, car or bank account because a customer got hurt or a vendor wasn't paid on time.