CORPORATION. VS. LLC

This is the big decision clients face right at the start. Here are the differences between a Corporation and a Limited Liability Company to help you decide.

Q. What is a corporation?
A. A corporation is an entity, usually a business, that has the legal authority to act as though it were one individual rather than a large organization. A corporation is considered a person through the United State Constitution, and as such, it has free speech rights, and is guaranteed to receive both equal protection and due process under the law. A corporation can procure and hold property, sue others and be sued in return, and the shareholders will be protected because they have limited liability resulting from the corporation being its own legal entity, distinct from the shareholders. In addition, a corporation pays its own taxes, unless it is an S-corporation in which case the taxes are passed through to the shareholders.

Q. What is an S-Corporation?
A. An S Corporation is no different than any other corporation in regards to corporate legal requirements, limited liability of shareholders, and all other aspects of a corporation. Just like all other corporations, it is formed under state law. The only difference is the method of taxation. The IRS will allow a corporation to be taxed like a partnership, thus the shareholders will pay the taxes on their individual tax returns.

Q. How is a corporation different from a limited liability company?
A. In short a limited liability company (“LLC”) is a company that has limited liability for its owners but it is taxed as though it were a partnership. It is not available in all states, and like a corporation the company is considered a separate legal entity. In most states it is taxed like a partnership in that the owners will pay the taxes on their personal tax returns. As you can tell, LLC’s are similar to corporations in that they will limit personal liability for the debts and claims of the business and they will likely cost more to form. They will also have more administrative duties than a partnership, although they are taxed like a partnership.

Q. So when should a business become a corporation or an LLC?
A. It pretty much depends on the type of business you will operate and the risk of liability that you will have. You may want to think about forming either a corporation or an LLC if your business will have a potential likelihood of being sued by your clients and/or customers. If you will accumulate a high amount of business debt an LLC or a corporation may be a good option for you. Finally a corporation or an LLC can be a viable option if you want to avoid the potentiality of having your personal assets being used to pay for business debts.

To avoid double taxation, corporations can make a special tax election, known as a “subchapter S election”, to be taxed as a flow-through entity like a partnership and LLC. Corporations which make the subchapter S election are known as “S-corporations”, and corporations which do not are known as “C-corporations.” However, there are still important differences between S-corporations and LLCs.

LLC Advantages:

Fewer corporate formalities. Corporations must hold regular meetings of the board of directors and shareholders, keep written corporate minutes and file annual reports with the state. On the other hand, the members and managers of an LLC need not hold regular meetings, which reduces complications and paperwork.

No ownership restrictions. S-corporations cannot have more than 75 stockholders, and each stockholder must be a natural person who is a resident or citizen of the United States. There are no such restrictions placed on an LLC.

Ability to use the cash method of accounting. Unlike a C-corporation, which often must use the accrual method of accounting, most limited liability companies can use the cash method of accounting. This means that income is not earned until it is received.

Ability to place membership interests in a living trust. Members of an LLC are free to place their membership interests in a living trust. It is difficult to place shares of an S-corporation into a living trust.

Ability to deduct losses. Members who are active participants in the business of an LLC are able to deduct its operating losses against the member’s regular income to the extent permitted by law. Shareholders of an S-corporation are also able to deduct operating losses, but shareholders of a C-corporation are not.

Unemployment tax. A member-employee of an LLC is not required to pay unemployment insurance taxes on his or her salary. Shareholder-employees of corporations must pay this tax. Currently, the federal unemployment tax is 6.2% of the first $7,000 of wages paid, to a maximum of $434 per employee.

LLC Disadvantages:

Profits subject to social security and medicare taxes. In some circumstances, owner-employees of an LLC may end up paying more taxes than owner-employees of a corporation. Salaries and profits of an LLC are subject to self-employment taxes, currently equal to a combined 15.3%. With a corporation, only salaries (and not profits) are subject to such taxes. This disadvantage is most significant for member-employees who take a salary of less than $72,600.

For example, if a member earns $40,000 in salary and is distributed $20,000 of the LLC’s profits, a 15.3% tax would have to be paid on $60,000. For an S-corporation, social security and medicare taxes would only have to be paid on the $40,000 salary. Please note, however, that the IRS frowns upon employee-owners of an S- corporation not paying themselves a reasonable salary and simply distributing the profits. In situations where the IRS feels that shareholders are taking too little in salary, the IRS will re-characterize all or part of the profits as salary.

Owners must immediately recognize profits. A C-corporation does not have to immediately distribute its profits to its shareholders as a dividend. This means that shareholders in a C-corporation are not always taxed on the corporation’s profits. Because an LLC is not subject to double-taxation, the profits of the LLC are automatically included in a member’s income.

Fewer fringe benefits. Member-employees of an LLC who receive fringe benefits, such as group insurance, medical reimbursement plans, medical insurance and parking, must treat these benefits as taxable income. The same is true for stockholder-employees who own more than 2% of an S-corporation. However, stockholder-employees of a C-corporation who receive fringe benefits do not have to report these benefits as taxable income.

Capital Contributions and Ownership

Ownership in an LLC can be expressed in two ways: (1) by percentage; and (2) by membership units, which are similar to shares of stock in a corporation. In either case, ownership confers the right to vote and the right to share in the profits of the LLC.

Unlike a corporation, an LLC can distribute its ownership interests as it pleases, without regard to how much money or property a member contributes to the company. For example, if Sam contributes $10,000 to the company and is a silent partner, and Rick contributes no money but runs the company on a daily basis, they could still decide to split the membership interests 50%-50%.

A limited liability company can also be organized with different classes of ownership interests, which provides flexibility for special allocations of profits and voting power. For example, you can create a special class of “super-voting” units that provide 10 votes per unit or pay a certain level of profit before the “regular” units.

The sale of membership interests is subject to securities laws. Generally though, if you are not advertising the sale and are dealing only with a small number (less than 35) of knowledgeable and sophisticated investors, then you will be exempt from the regulations. If, however, you are seeking to raise a significant amount of money from a large number of investors, it will be necessary to consult an attorney.

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