If I had a penny for every time I have been asked, “Should I form an LLC or a Corporation”? I would be a millionaire several times over. Well the good news is that deciding to elect a legal business entity for your business is always a good idea and as a business owner you have the right idea that making your business a legal entity can protect you in more ways than sole proprietorship. So read on.
WHAT IS A LIMITED LIABILITY COMPANY?
A limited liability company, also known as an “LLC or L.L.C”, unlike sole proprietorship offers you limited liability protection of your personal assets should a dispute arise relating to your business asset. It offers you protection against a claim on your personal asset if a credit or an opponent of your business goes after it. HOWEVER, if you co-mingle your personal and business funds, that is the quickest way to pierce the corporate veil of protection you get. So you MUST separate your business funds and bank accounts from your personal account at all times. (This is actually good practice, even if you chose to be a sole proprietor).
Also, if you do register your business as an LLC, you have the option to be taxed as a disregarded entity or general partnership, which is the default taxation depending on how many members of the LLC there are or you can elect with the IRS to be taxed as an S-Corporation, instead of as a disregarded entity or general partnership. This gives you a slight tax advantage of being taxed only on your salary and not your dividend/profit. However, you must pay yourself a reasonable salary and not try to circumvent the system. The form 2553 on www.irs.gov is usually the form used to make this designation, however consult your accountant or a tax attorney to assist you in deciding what tax designation is best for your business.
WHAT IS A CORPORATION?
A corporation also known as “INC or CORP” generally has a much more stringent requirement than an LLC because of the level of corporate formalities that must be strictly observed (bylaws, maintenance of separate books, issuance of stocks, records, accounts, periodic and annual meetings and written consent of directors and shareholders).
A corporation can either be designated a C-Corporation or an S-Corporation. The main difference between the two is the C-Corporation is double taxed. In essence, the corporation is taxed and the shareholders are taxed on dividends they earn, as well as earnings received when and if they sell their stock. An S-corporation passes through to the owner/shareholder’s personal tax just like it would in an LLC and is not double taxed. To break this down further, here is an example of how to differentiate between an LLC versus an S- Corporation as it relates to being taxed.
Your first year of business takes off really well and your business nets a total of $100,000 that year. Of this amount, you pay yourself a salary of $70,000 per year. If this is a pure LLC, your FICA (Social Security and Medicare taxes), your FICA taxes would apply to 100% of your net earnings of $100,000 and if you are an S-Corporation, or elect that your LLC be taxed as an S-Corporation, your FICA taxes will only apply to the salary amount you paid yourself of $70,000 but not for the remaining $30,000 in net dividend/profit you made that year, saving you several thousand dollars. But note that you must pay yourself a reasonable salary to avoid audit if you want to be taxed as an S-Corporation, don’t attempt to game the system.
HOW DO I QUALIFY AS AN S-CORP
To qualify as an S-Corporation, you must hold an annual meeting, you cannot have more than 100 shareholders, and the corporation may not have more than one class of stock and all shareholders must be US citizens.
Just like an LLC, both types of corporation offer limited liability protection of your personal assets from your business assets in most instances unless you cause your corporate veil to be pierced.
WHICH ENTITY TYPE IS BETTER?
The answer is that it depends on you and what you want out of your business, the level of growth you want for your company, diversity in shareholders and if you want it to remain in perpetual existence.
With an LLC, it is more likely that if there are only two members, the company can be dissolved easily in the case of conflict and that might not be the original desires of the members of the business. An LLC and an S-Corp will also allow an owner to report business profits and losses on their personal tax return while a C-Corporation will not. An LLC is not required to hold an annual meeting or have cumbersome corporate record keeping requirements. On the other hand, a corporation shareholder can walk away from a business and it can continue in perpetual existence as long as there are several shareholders. You might also issue stocks to attract investors in a way, you can’t do with an LLC.
WHAT ARE THE ADVANTAGES OF A C-CORP OVER an S-CORP
You might elect a C-Corporation over an S-Corporation even though you are subject to double taxation because a C-Corp will allow you to have an unlimited number of shareholders and diverse shareholders without regard to citizenship status or how many classes and types of shareholders it has. A C-Corp as a result offers the most unlimited growth potential from a venture or investors perspective, the ability to become a publicly traded company, which allows the company trade on the stock exchange.
So as you can see, it really depends. The process of deciding the right entity for your business can be complex and confusing since it is generally not a one size fits all as several things need to be taken into consideration before an entity type is selected. It is always recommended to consult with an attorney and an accountant to explain the legal and tax ramifications as it relates to your business entity selection and which entity might be best in the long run for you.
Ayesha Chidolue is the Managing Attorney at The Chidolue Law Firm. We are a boutique law firm that act as trusted legal advisors to business owners. Ayesha Chidolue is licensed to practice law in the states of Florida and New York. At The Chidolue Law Firm, we can guide you through organizational design, business planning, entity selection and set up as well as with a proper operating agreement and/or bylaws for your business from the onset of entity formation. If you need legal assistance with your business, we will be happy to assist you. Please contact us at firstname.lastname@example.org or call us at 407-995-6567.