Not all incorporation options are created equal. In choosing between an incorporation vs LLC, you have to consider both the advantages and the disadvantages that each option can provide to your company. The right decision does not only help you to start on the right foot, but also greatly helps the company’s ongoing growth and success. You should also weigh in your short-term and long-term goals when considering between an incorporation and an LLC. Continue reading below to understand better about the benefits and disadvantages that each option possesses.
What is an Incorporation?
Actually, the term “incorporation” refers to the legal process for forming a corporate entity. However, corporations are indicated by the terms “Inc.” or “Limited” in their names. Corporations can be formed in almost every country in the world. There are two types of corporation, C corporation (no ownership restriction, taxable entity) and S corporation (restricted ownership, pass-through tax entity).
As a corporation, a company becomes a separate legal entity from its owners. It also has its own rights and obligations. A corporation offers liability protection, but an incorporation vs LLC differs in terms of the ownership structure and rules, management, regulation, and tax treatment.
Benefits of a Corporation
A corporation has more flexibility in handling its excess profits. For a business that will eventually seek to issue stock, a corporation makes a great choice. A corporation can issue shares easily, whereas an LLC cannot. A corporation can have only one shareholder.
As mentioned above, there are two types of corporation. The C corporation can give great flexibility when you are just about to start a business if you are planning to expand the ownership or sell the corporation later. It does not have any restriction over the ownership, and it can have multiple stock classes. However, note that it is required to pay taxes at the corporate level, and it may face double taxation if the corporate income is distributed to the owners as dividends.
On the other hand, the S corporation is great if you are not planning to expand the ownership. An S corporation can pay its employees a reasonable amount of salary while deducting some expenses such as the federal taxes. As a pass-through tax entity, there is no income tax at the corporate level. The profits/losses are passed through to the owners’ personal tax returns. Note that an S corporation is restricted to no more than 100 shareholders who have to be US citizens or residents, and cannot be owned by other corporations, LLCs, or partnerships.
Disadvantages of a Corporation
With the financial flexibility as a big advantage, a corporation also comes with several disadvantages. Perhaps the very first thing to be mentioned is that forming a corporation requires a great deal of paperwork. In addition, a corporation is required to meet many guidelines. For example, a corporation should elect boards of directors, conduct annual meetings, create formal financial statements, and adopt bylaws. There is more burdensome record-keeping.
A corporation may also face the issue of double taxation if it distributes its profits as dividends. A corporation is a separate legal entity, and a dividend is considered as a personal income. Hence, some taxes may be applied twice for the same income, once at the corporate level and once again to the shareholders receiving dividends.
What is an LLC?
A limited liability company (LLC) is a company structure in which the members of the company cannot be considered personally liable for the company’s debts and liabilities. An LLC is essentially a hybrid entity which combines the characteristics of a corporation and a partnership/sole proprietorship. Why is that so? The limited liability feature of an LLC is similar to a corporation, whereas the flow-through taxation is similar to a partnership/sole proprietorship.
Benefits of an LLC
The very first benefit of an LLC is that it is much easier to form. Creating an LLC typically takes less paperwork than creating a corporation. An LLC is a creature of state law, which means that the process depends on the state where it is being filed. Some states have allowed the form to be filled online, thus making the process s much easier. Once the articles of organization are formed and all the applicable notice requirements are met, an LLC is officially formed.
Although it is not a necessity to create an operating agreement for an LLC, this is a good business practice. An operating agreement will set forth the rights and responsibilities of each member, deal with the issues of capital structure, profit/loss allocation, and provisions. The members of an LLC are equivalent to shareholders.
The next benefit of an LLC that you need to know when considering between an incorporation vs LLC is that an LLC is not a distinct entity by default. If the LLC is owned by just a single person, it can be taxed out and treated like a sole proprietorship. In such case, the profits and losses are taxed on the personal federal tax return.
An LLC with more than one member has two options regarding the taxing. The first is to treat the members as partners. The second is to tax the LLC like a corporation.
Disadvantages of an LLC
Of course, in choosing between an incorporation vs LLC, you should know that the LLC also has several disadvantages. First, the members may have to pay self-employment taxes on the profits and salaries. Second, there is an automatic technical termination for an LLC that is triggered when there is a sale or exchange of at least 50% of the LLC’s total interest within a period of twelve months. If it happens, the assets are contributed tax-free to a new LLC, and the membership interests of the new LLC are distributed to the members of the old LLC.
An LLC requires two shareholders in order to be treated like a partnership for taxing purposes. The next disadvantage of an LLC is that it is a creature of state law; an LLC that operates in multiple states may face uncertainty from different rules and regulations.
|- A separate legal entity with its own rights and obligations||- A hybrid between a corporate and a partnership/sole proprietorship|
|- May be an independent taxable entity (C corp) or pass-through tax entity (S corp)||- Not a distinct tax entity by default|
|- Can have only one shareholder||- Requires at least two shareholders in order to be treated as a partnership for taxing purposes|
|- Can be formed in almost every country in the world||- Depends on state laws and regulations|
|- Much more paperwork||- Significantly less paperwork|
You should choose an incorporation if your business will eventually issue stock. You may also want to choose an incorporation if your business operates in multiple states in order to avoid the uncertainty of different rules and regulations. However, you can choose an LLC if you don’t plan to issue stock and if your business only operates in one state, as the amount of paperwork required for an LLC is significantly lower.