Registered business entities such as LLCs and corporations are designed to protect business owners against personal liability. This means that you are not financially responsible for your business’s debts and obligations.
While they both serve to protect business owners, there are some differences in ownership, formation, governance, and taxes. LLCs, for example, don’t have as many governance requirements. What’s more, you can choose for your LLC to be taxed as a pass-through entity or C corporation where you are taxed separately (see also S corporation vs LLC post).
As a new business owner, one of the most important decisions you will ever make is how you choose to set up your company. Small business owners often choose LLCs or corporations, but which is the best option for your needs? In this guide, we’ll walk you through the differences so you can make the right decision.
Asking the Right Questions
Choosing between a C corporation and an LLC involves asking yourself some important questions, including:
Do I want the business to operate by regularly sharing profits with the owners, removed from any pressure to sell it for liquidity for investors and stock option holders?
Do I plan on using angel investors or venture funds to raise capital for my business?
Do I want to go the traditional route of trying to build and sell my business?
Do I plan on granting service providers with equity incentive awards?
How do I see my exit from the company?
Choosing Between an LLC and a Corporation
Starting out as a C corporation makes the most sense if you plan on doing the following:
Follow the traditional path of raising business capital.
Issue compensatory equity incentive awards.
Quickly grow the business to reach an exit.
Taking the traditional path is even more beneficial when you consider the $10 million tax exclusion that comes only from C corporations, as this is not an option for LLCs.
That said, if you aren’t planning to build a business to sell it, and you don’t want to be pressured by your investors or option holders to get them liquidity, you may want to consider an LLC. Look for the best LLC formation service in this review, or find a top registered agent here - services like Nolo (click here), Rocket Lawyer (find out more), Zen Business (see the review), or Incfile (check out here), each offer excellent legal assistance when setting up a LLC. With this option, there is only a single layer of tax, making it easier to distribute cash on a regular and ongoing basis. This is far more challenging with a C corporation.
It simply isn’t easy to accomplish when you’re operating under the corporation format. This is because when C corporations pay taxes, their shareholders have to pay taxes again after cash is distributed.
Let’s look at some pros and cons of LLCs and C corporations so you’ll have a better idea of what makes the most sense for your business.
LLC Pros & C Corporation Cons
LLCs are considered pass-through entities, which means their income is subject to a single level of tax (this is at the member level and can be up to 37%, including state income tax when applicable).
The income for a C corporation, on the other hand, is subject to a tax rate of 21%. What’s more, any dividend distributions of earnings, as well as any profits to shareholders (profits that have already been taxed at the C corporation level), will also be taxed to the shareholders (and this is at a rate of up to 23.8%).
In other words, your income can be taxed twice. Therefore, since LLCs are pass-through entities and the business’s income is taxed only once, you would expect them to be more tax-efficient than C corporations.
Sale of Assets
People or businesses that buy other businesses prefer that their acquired assets get a basis step-up (more on that in a moment). You can do this with an LLC, but not with a C corporation unless you want to trigger a second layer of tax. This factor alone is often the single biggest complaint about C corporations. As such, it gives LLC the edge among business owners.
Pass-Through of Losses
For the most part, credits, losses, deductions, and other tax benefits pass through to the members of an LLC. In doing so, it can offset other income on the members’ individual tax returns. When this happens, their income is subject to the following limitation rules:
The losses of a C corporation don’t pass through to its shareholders.
Tax-Free Distributions of Appreciated Property
An LLC is able to distribute its appreciated property to its members. This is essential, as there isn’t any gain recognition to the LLC, including its members. This results in spin-off transactions. Conversely, the distribution of appreciated property to a C corporation’s shareholders is subject to tax. This is at the corporate level and can potentially tax the shareholder level.
Basis Step Up
LLC members get a basis step-up in their interests for any income that is left and not distributed. This is not the case with C corporations, as there is no pass-through of income.
Appreciated property is generally contributed to LLCs tax-free. This is typically under one of the most comprehensive non-recognition provisions (IRC Section 721).
In addition, tax-free capitalizations for C corporations have to comply with the IRS’s restrictive provisions to be tax-free (IRC Section 351). Be that as it may, this isn’t usually an issue.
C Corporation Pros & LLC Cons
C corporation tax rates are typically lower than that of an LLC. The highest corporate tax rate currently sits at 21%, whereas the highest individual federal income tax rate is 37%. It’s important to note that state income tax rates depend on where you live.
To give you some examples of how location affects state income tax rates, California currently ranks the highest with 13.3%. Conversely, North Dakota has the lowest maximum rate at just 2.9%.
LLC tax accounting is far more complicated compared to C corporation tax accounting. With an LLC, everyone’s ownership in the organization is typically determined by their capital accounts, with maintenance being time-consuming and costly. This isn’t something you have to worry about with a C corporation.
Retention of Earnings
The income of a C corporation does not pass through to its shareholders. What’s more, dividends are only taxed whenever cash is distributed to these shareholders, making it easier to retain and grow capital.
Remember, the current corporate tax rate is presently at 21%. The fact that an LLC has pass-through taxation makes it rather difficult to conserve operating capital. Moreover, LLC owners get taxed based on their share of the LLC’s income. This is true whether or not cash is distributed, requiring LLCs to distribute cash to members so that they can pay their taxes on their share of the income.
By forming a C corporation, you pay a 21% federal income tax rate on all of your profits. But if you form an LLC, you could distribute more than 21% of your taxable income. This would then go to your LLC members so that they can pay their taxes on their share of the income.
State Income Tax Return Filing Requirements
Each LLC member could be required to file a tax return in more than one state. Not so with C corporations, as they are not pass-through entities. Moreover, shareholders of C corporations never have to worry about having to suddenly file state tax returns in other states.
This can be especially problematic for angel investors who live in a state that has low-income tax rates. Having to suddenly file in a state with high-income tax rates (i.e., California) would certainly be a financial shock.
In the end, which option you choose boils down to whether you have the patience for lots of paperwork and are accepting of governance requirements. If you are looking for the easiest option, however, choosing an LLC is likely to be your best bet.
There’s no double-taxation, and paperwork is limited comparatively. What’s more, there are far fewer government regulations to abide by. With that said, you are better off starting out as a corporation if you plan on raising venture capital later. It’s pricey, but you can always switch to an LLC when the time is right.
We hope you found this guide helpful in your quest to start a business. In the meantime, we encourage you to check out our blogs page for more information on starting a business, growing it, acquiring a small business loan, and much more. We have a collection of beneficial articles that are sure to lend a hand in your business ventures.
As always, please don’t hesitate to contact us if you need assistance along the way. We specialize in helping small business owners secure the funding they need to succeed. We look forward to serving you and hope to hear from you soon!