Choosing Between an LLC and a Corporation for Your U.S. Business
Choosing a legal structure is one of the early decisions a business owner must make when starting a business in the United States. Two common options are a limited liability company (LLC) and a corporation.
Both structures can provide liability protection, but they differ in how they are formed, governed, taxed, and operated. The appropriate choice depends on factors such as the nature of the business, ownership structure, plans for raising capital, tax considerations, and the state where the business is formed.
Understanding these differences before forming a business can help owners establish a structure that better fits their current needs and future plans.
What Is an LLC?
A limited liability company is a business entity created under state law. LLCs can have one or multiple owners, referred to as members.
For legal purposes, an LLC generally provides its members with limited liability for the company's debts and obligations, subject to applicable law and the circumstances of the particular case.
LLCs can also offer flexibility in management and federal tax classification. For federal income tax purposes, the IRS may treat an LLC as a disregarded entity, partnership, or corporation depending on the number of owners and any elections made by the business.
This flexibility is one reason an LLC may be suitable for a range of businesses.
What Is a Corporation?
A corporation is a separate legal entity typically formed under state law and owned by shareholders.
Corporations generally have a more formal governance structure than LLCs. Depending on the applicable law and the company's governing documents, this may involve shareholders, a board of directors, and officers.
Corporations can issue shares of stock, which may be useful for businesses that expect to raise capital from investors or have multiple shareholders.
For federal tax purposes, a corporation is generally subject to corporate tax rules unless it qualifies for and makes an applicable election. The IRS also recognizes S corporation status for eligible entities that satisfy specific requirements.
S corporation status is a federal tax election available to eligible entities. It does not by itself determine the entity's legal structure under state law.
Key Differences Between an LLC and a Corporation
Although both structures can provide limited liability, there are several differences that business owners should consider.
Management and Governance
LLCs generally have greater flexibility in how they are managed. The company's operating agreement can establish how members make decisions and how the business is managed, subject to applicable state law.
Corporations typically operate under a more formal governance system involving shareholders, directors, and officers. Corporate records and formal actions may also need to be maintained in accordance with applicable law.
The appropriate governance structure will depend on the type of business and the jurisdiction in which it is formed.
Ownership and Equity
An LLC's ownership is generally represented by membership interests rather than corporate shares.
Corporations issue shares of stock to their shareholders. This structure can be useful where a company expects to bring in multiple investors or use equity as part of its fundraising strategy.
The ability to issue and transfer ownership interests can also affect how a company approaches future investment, ownership changes, and employee compensation.
Federal Tax Treatment
Tax treatment is one of the areas where the difference between an LLC and a corporation can be misunderstood.
An LLC does not have a single federal tax classification. A single-member LLC is generally disregarded as separate from its owner for federal income tax purposes unless it elects otherwise. A domestic LLC with two or more members is generally treated as a partnership unless it elects to be treated as a corporation.
A corporation generally files its own federal income tax return. A qualifying corporation may also elect S corporation status, under which certain income, deductions, losses, and credits generally pass through to shareholders for federal tax purposes. S corporations are subject to specific eligibility requirements.
Because tax treatment can depend on the entity, elections, ownership, and other circumstances, business owners should consider their tax position carefully when selecting a structure.
Raising Investment
A startup's plans for raising capital may influence the choice of entity.
Corporations can issue shares of stock and are commonly used by businesses that intend to raise outside equity investment. Investors may also have preferences regarding corporate structures and the rights associated with different classes of stock.
An LLC can also admit additional members or provide investors with membership interests, but the structure and documentation may differ from a corporation.
Businesses that expect to seek outside investment should consider how their proposed entity structure will work with future financing arrangements.
State Law Matters
An LLC or corporation is formed under the laws of a particular state, and the rules governing these entities can vary by jurisdiction.
State law may affect matters such as:
formation requirements;
ownership and management;
filing obligations;
fees and taxes;
governance requirements; and
dissolution procedures.
For this reason, choosing between an LLC and a corporation is not only a federal tax question. The state in which the business is formed and operates can also affect the legal and administrative consequences of the decision.
Changing Your Business Structure Later
Businesses sometimes change their legal structure as they grow.
A company that begins as an LLC may later consider converting to or reorganizing as a corporation if its ownership, financing, or business plans change. However, changing an existing structure can involve legal, tax, and administrative consequences.
For this reason, business owners should consider their anticipated needs before forming the company rather than selecting a structure based solely on what appears simplest at the beginning.
Questions to Consider Before Choosing
Before forming a U.S. business, owners may wish to consider:
How many owners will the business have?
How will the business be managed?
Does the business expect to raise outside investment?
How will profits and losses be treated for tax purposes?
Will the company issue equity to investors or employees?
In which state will the business be formed?
What governance and reporting requirements will apply?
Could the business structure need to change as the company grows?
There is no single structure that is appropriate for every business. The right choice will depend on the company's objectives, ownership, financing plans, tax considerations, and applicable state and federal law.
An LLC and a corporation can both provide a legal framework for operating a U.S. business, but they are not interchangeable.
LLCs generally offer flexibility in management and federal tax classification, while corporations provide a more formal structure that may be well suited to businesses planning to issue stock and raise outside equity investment. The legal and tax consequences of each structure will depend on the company's circumstances and the laws that apply.
Considering these factors before formation can help business owners choose a structure that supports their current operations while allowing room for future growth.