LLC vs Inc: Which One Is Right For Your Startup?
When forming a new business, one of the first decisions founders are faced with is selecting an entity type for their business, which most often comes down to a decision of whether to form an LLC or corporation. The primary reason founders form an LLC or incorporate the business is to protect themselves from litigation (legal action taken against the company). Without that protection, a founder’s personal assets, like their house, could be taken from them to repay business debts.
While each offers the startup a degree of protection from legal action, LLCs and corporations are owned, organized, regulated, and taxed differently. We’ll take a look at these differences to help you determine which makes the most sense for your startup. But first, let’s define each.
What Does LLC Stand For?
LLC stands for “limited liability company”. As its name suggests, an LLC protects the personal assets of a company’s founder(s) from company-related debt or litigation by limiting the liability of the founders.
What Is a Corporation?
Like an LLC, a corporation is an entity that operates separately from its owners in order to protect them from the liabilities of the business.
Comparing LLCs and Corporations
While LLCs and corporations both offer this kind of legal protection to the founders and owners of the business, there are four key differences you should keep in mind:
1 – Ownership
The owners of a business generally belong to two groups: the business founders (and sometimes early employees) and the business investors, but the actual ownership structure varies between corporations and LLCs.
In a corporation, ownership of the business is given or sold to shareholders in the form of equity. A business can issue, or sell, more equity if it needs to raise capital, and its shareholders can transfer, buy, and sell equity to own more or less of the business. In other words, ownership can change in a corporation, and the corporation exists regardless of that turnover.
In an LLC, ownership is held by members. Instead of equity (shares), members own a percentage of the company that is determined by the LLC’s operating agreement (you can think of this operating agreement as the LLC’s constitution. It is the document that dictates the structure of the business and can vary greatly from LLC to LLC, just like constitutions can vary from country to country).
Rather than ownership percentage being determined by the number of shares held (as in a corporation), an LLC’s articles of organization determine how much of the business each member owns. This means that an LLC has greater flexibility in how its structured. For example, the operating agreement could state that all members are entitled to the same ownership percentage and rights regardless of how much money they’ve put in.
Unlike a corporation, which allows shareholders to buy or sell their shares in a business (assuming there is a market for these shares), members of an LLC can enter and leave the business based on the rules of the LLC’s operating agreement, which outlines the rules the business operates by.
To sum it up, owners of a corporation are called shareholders, and owners of an LLC are called members. Most businesses that we encounter that plan to have a large number of owners and raise capital from outside investors, like growth-focused startups, often choose to form a corporation because the legal structure is well suited for taking on large numbers of investors. This is because corporations have long-standing historical legal precedent and standardized rights, allow for multiple classes of stock and no limit on the number of shareholders and LLCs are responsible for delivering tax forms (called K-1s) to their members, which can become costly in large numbers.
For businesses that do not plan on raising capital from institutional investors or a large number of crowd investors, an LLC can provide structural flexibility and tax advantages (more on that below).
2 – Organization & Management
The type of business entity you choose will also dictate the management structure. LLCs and corporations are managed differently, with LLCs having more flexibility, and corporations being stricter.
Corporations are required to standardize their management with a board of directors and corporate officers. The Board of Directors is responsible for keeping the company on track and helping to deliver profits to shareholders. The corporate officers, like the CEO, CFO, etc., are charged with managing the day-to-day operations. Many institutional and crowd investors prefer this structure because they are familiar with it and know what to expect.
LLCs, on the other hand, are not required to arrange their management structure in any particular way. Members (the LLC’s owners) can decide to run the business however they like when they set up the company, and they are generally not overseen by directors.
In general though, management of an LLC falls into two categories: member-managed and manager-managed LLCs. In member-managed LLCs, every member of the LLC participates in the decision-making process and has a vote. In manager-managed LLCs, control of the LLC is given to a manager (or managers), who may or may not be members of the LLC.
Because of the strict hierarchy of a corporation, corporations may make decisions more slowly because there are more levels of decision making and approval needed before action is taken. LLCs, by comparison, can move much more quickly because of their flexible management structure.
3 – Regulations
When it comes to recordkeeping, once again corporations are held to a higher standard. Corporations are required to hold annual shareholder meetings, keep careful records, and file an operational report every year. They are held to this higher standard to maintain transparency between shareholders and management.
On the other hand, LLCs have fewer recordkeeping requirements and do not have to hold yearly shareholder meetings.
4 – Taxation
Perhaps the most critical difference between LLCs and corporations is how they are taxed. LLC members report the business’s profit and loss on their personal tax returns. This “pass-through” system may appeal to business owners who would like to offset other income with their LLC’s losses, decreasing their overall taxable income, and avoiding double-taxation via corporate income tax.
It’s a bit more complicated for corporations, as the two major types of corporations (known as the S Corp and the C Corp) differ in the way owners are taxed.
S Corp vs. C Corp
Owners of both types of corporation pay personal income tax on dividends or cash distributions they receive. The difference comes in the way the company is taxed.
An S Corp is a corporation with a few notable restrictions. They are not allowed to have more than 100 shareholders, are restricted to one class of stock, and can’t have shareholders outside the US. However, they don’t pay corporate income tax.
A C Corp is perhaps the most well known version of a corporation and doesn’t have the shareholder or stock class restrictions of S corporations. In exchange for that freedom, C corporations incur taxes on both corporate profits and personal income taxes (known as double-taxation).
Any corporation (or LLC, for that matter) can choose to be taxed as a C corporation. Some can also choose S corporation taxation, if they meet the shareholder and stock class restrictions. How a company chooses to be taxed comes down to the balance of pros and cons among the three options:
|No Double-Taxation||No Shareholder Limitations||No Stock Class Restrictions|
*LLCs don’t have shareholder limitations or stock class restrictions, as they don’t have stock; however, by nature, their structure often makes having many owners or different types of ownership much more difficult.
While LLCs are more free to operate as they see fit and enjoy more lax taxation than corporations, it gets more difficult to maintain as the number of owners increases. C-Corps, on the other hand, are more standardized from a legal standpoint and are better structured to accept large numbers of investors through crowdfunding.
If you are debating whether an LLC or a corporation is right for your business and are also interested in raising on StartEngine, fill out our application to talk to our team and start the conversation.