LLC versus incorporation: Which should I choose?

The decision to form either a limited liability company (LLC) or a corporation depends on the type of business the individual is creating, as well as the possible tax consequences of forming the corporate entity, among other considerations. Both types of corporate entities have the significant legal advantage of helping to protect assets from creditors and provide an extra layer of legal liability.

In general, the creation and management of an LLC is much easier and more flexible than that of a corporation. LLCs are a relatively new type of business entity governed by state statute. Still, there are advantages and disadvantages to both types of business structures.

Creating an LLC generally takes less paperwork than forming a corporation. LLCs are creatures of state law, so the process for forming an LLC depends on the state in which it is being filed. Most LLCs require filing articles of organization with the Secretary of State. This generally costs anywhere from $100 to $800. The LLC must use a name that is not already being used by another corporate entity.

Some states allow for the form to be filled out online, which makes it a very easy process. Very few states require the additional step of filing some sort of public notice. This public notice may be required before or after the articles of organization are filed.

Once the articles of organization are formed, and any applicable notice requirement is met, the LLC is officially formed. Most LLCs use operating agreements to define the role of the LLC's members. If there is no operating agreement, the LLC is governed by the default rules contained in state statutes. The members are the individuals with an ownership interest in the LLC. They are equivalent to the shareholders of a corporation.

It is not a necessity to draft an operating agreement for the LLC to be valid. However, it is a best business practice. The operating agreement sets forth the rights and responsibilities of the members. It can define the business relationship and deal with issues of capital structure, the allocation of profits and losses, provisions for the buyout of a member, provisions in case of the death of a member, and other important business considerations.

There is more flexibility in how an LLC is treated for tax purposes. The IRS does not treat LLCs as a distinct entity for tax purposes by default, which offers greater flexibility. An LLC with a single member can be taxed and treated like a sole proprietorship. Thus, profits and losses are taxed on the individual’s personal federal tax return.

There are two options for an LLC with more than one member. The first option is to treat the members as partners. The members are taxed the same as the partners in a partnership. The other option is to tax the LLC as a corporation.

One potential drawback to using an LLC is that members may have to pay self-employment taxes on their profits and any salaries. For an LLC, the profits flow through to the members who deal with them on their federal tax returns. For a corporation, profits are taxed at the corporate level. The individual members usually have to pay for federal items such as Medicare and Social Security.

There are other drawbacks as well. There can be an automatic termination of an LLC that is treated like a partnership for federal tax purposes. The automatic termination is triggered if there is a sale or exchange of 50% or more of an LLC’s total interest within a 12-month period. This is called a technical termination. When this occurs, the assets are considered to have been contributed tax-free to a new LLC. The membership interests in the new LLC are then treated as having been distributed to the members of the old LLC. Also, there must be at least two members for an LLC to be treated as a partnership for tax purposes. In contrast, there can be a C corporation or S corporation, which only has one shareholder.

Another major disadvantage is the differences among states in the statutes that govern LLCs. This can lead to uncertainty for LLCs that operate in multiple states. The differences in rules and regulations can result in additional paperwork and inconsistent treatment across different jurisdictions.

Despite the ease of administration of an LLC, there are significant advantages to using a corporate legal structure. Two types of corporations can be formed. An S corporation is a pass-through entity for tax purposes. A C corporation is taxed at the corporate level and files a corporate tax return.

Corporations offer more flexibility when it comes to their excess profits. Whereas all income in an LLC flows through to the members, an S corporation can pay its employees a reasonable salary while deducting expenses such as federal taxes. The remaining profits can be distributed as dividends from the corporation. As of 2015, dividends have a lower tax rate when compared to gross income. C corporations have the advantage of allowing profits to remain with the corporation. Thus, the dividends paid from the corporation can be structured to take advantage of the best tax scenario for the shareholders. Also, for businesses that eventually seek to issue stock, the corporation can easily issue shares, while an LLC cannot issue shares.

There are significant disadvantages to creating a corporation. It requires a great deal more paperwork. Corporations must meet many more guidelines. They must elect boards of directors, adopt bylaws, have annual meetings and create formal financial statements. They generally have more burdensome record-keeping requirements than LLCs.

There is also the issue of double taxation for corporations. This refers to taxes being paid twice on the same income for corporations. This is because corporations are considered a separate legal entity from their shareholders. Thus, corporations pay taxes on their earnings, while their shareholders also pay taxes on any dividends they receive from the corporation even though this income was already taxed.