A common experience among entrepreneurs is choosing between forming a limited liability company (LLC) or a corporation (Inc.). Each structure comes with distinct advantages and considerations.

An LLC is a flexible business structure that comes with limited liability protection, which shields the personal assets of the owners (known as members) from business debts and legal issues. LLCs have more operational flexibility and less strict regulatory requirements than corporations. When forming an LLC, you can choose whether it will be taxed as a sole proprietorship, partnership, or corporation. LLCs are a popular choice for small to medium-sized businesses that would benefit from minimal operational overhead and liability protection.

A corporation, or Inc. for “incorporated,” is a more structured form of business and also comes with limited liability protection. Corporations can raise capital more easily than other business structures by issuing stock, but they also face more rigorous governance and compliance standards. Corporations are a popular choice for businesses that plan on substantial growth or going public in the future.

Entrepreneurs deciding between an LLC and a corporation should consider how much liability protection they need, future plans for growth and funding, and the specific needs and goals of their business. This article will cover the key differences between an LLC and Inc., the pros and cons of each, why startups might choose an LLC over an Inc., and how to convert from an LLC to an Inc.

What’s in this article?

• What is an LLC?
  
• What is incorporation, and what does it mean to be an Inc.?
  
• Differences between an LLC and an Inc.
  
• Pros and cons of forming an LLC vs. incorporating
  
• Legal implications and protections: LLC vs. Inc.
  
• Why startups might choose to form an LLC or incorporate
  
• How to convert from an LLC to an Inc.
  

What is an LLC?

An LLC, or limited liability company, is a business structure in the United States that combines the features of a corporation and a partnership or sole proprietorship. It comes with limited liability protections, which means that owners (known as members) are not personally liable for the company’s debts or liabilities. If the business faces financial difficulties or legal issues, the members’ personal assets are protected.

LLCs are not taxed as separate entities unless the owners choose corporate tax status. Instead, profits and losses “pass through” to the members, who report them on their individual tax returns. This avoids the double taxation that C corporations face.

When it comes to management and formalities, LLCs have more flexibility and fewer obligations than corporations. LLC members can set up management structures and profit distribution according to internal preferences, and LLCs have fewer recordkeeping and reporting requirements than corporate structures.

Who can form an LLC?

Virtually any entity or individual can form an LLC, including individuals, corporations, other LLCs, and foreign entities. Banks and insurance companies are generally excluded from forming LLCs.

What is incorporation, and what does it mean to be an Inc.?

Incorporation is the legal process of forming a corporation. This creates a new legal entity that is separate from its owners (known as shareholders). When a company is incorporated, it is typically identified by “Inc.” (short for incorporated) after its name, which indicates it is a corporation.

A corporation is considered a separate legal entity, which means it can own assets, enter into contracts, sue or be sued, and incur debts—all separate from its owners. Shareholders are not personally liable for the corporation’s debts or liabilities, and their financial risk is limited to their investment in the company.

Ownership in a corporation is represented by shares of stock. Shareholders have the right to vote on certain corporate matters and might receive dividends if the corporation makes a profit.

Differences between an LLC and an Inc.

LLCs and corporations each have specific requirements and considerations. Here’s an overview of the main differences between an LLC and an Inc.

LLC

• Ownership structure: LLCs are owned by members who hold varying percentages of ownership interest.

• Management structure: LLCs have flexible management structures. They’re typically managed by the members or by appointed managers. Operating agreements outline management roles and responsibilities.

• Taxation: LLCs are subject to pass-through taxation, in which profits and losses are “passed through” to members and reported on their individual tax returns. LLCs can be taxed as a partnership, sole proprietorship, S corporation, or C corporation.

• Formation and ongoing requirements: To form an LLC, you must file articles of organization with the state. LLCs come with fewer ongoing formalities and less paperwork compared to corporations.

• Raising capital: LLCs can raise capital through member contributions, loans, or by adding new members.

Inc.

• Ownership structure: Incorporated companies are owned by shareholders with stock representing their ownership share.

• Management structure: A board of directors elected by shareholders manages incorporated companies and appoints officers who handle day-to-day operations. Incorporated companies have a more formal management structure with stricter rules and regulations.

• Taxation: Incorporated companies are subject to double taxation, in which the corporation pays taxes on its profits, and shareholders pay taxes on dividends received. S corporations can avoid double taxation if they meet certain requirements.

• Formation and ongoing requirements: Incorporated companies are formed by filing articles of incorporation with the state and creating company bylaws. This structure comes with more ongoing formalities, including annual meetings, recordkeeping, and reporting requirements.

• Raising capital: Incorporated companies can raise capital by selling shares of stock to investors. They have more options for raising capital than LLCs, including public stock offerings.

Pros and cons of forming an LLC vs. incorporating

When deciding whether to form an LLC or to incorporate (usually as a corporation, often designated as Inc.), you should consider several factors that influence legal liability, tax implications, administrative requirements, and growth potential. Here’s a detailed comparison.

Forming an LLC

Pros

• LLCs enjoy pass-through taxation by default, meaning profits and losses pass through to the owners’ personal tax returns, avoiding corporate tax. LLCs can also opt to be taxed as a corporation.

• Owners (members) have protection from personal liability for business debts and claims, similar to corporations.

• LLCs are not required to hold annual meetings or record minutes, which simplifies operations compared to corporations.

• LLCs can be managed by members (owners) or managers—unlike corporations, which require a formal board of directors and officers.

• There are fewer restrictions on who can own an LLC and how many owners it can have compared to S corporations.

Cons

• In some states, LLCs might have a limited lifespan or need to dissolve upon the death or withdrawal of a member, unless stated otherwise in the operating agreement.

• Members of an LLC are often considered self-employed and must pay self-employment taxes on their share of the profits.

• Some investors might prefer corporations over LLCs due to their familiar structure and the potential for growth through the issuance of shares.

Incorporating

Pros

• Shareholders of a corporation are typically not personally liable for business debts and liabilities.

• Corporations continue to exist even if ownership or management changes, which can be advantageous for long-term operations.

• Corporations can raise funds through the sale of stock, which can be more attractive to investors, especially venture capitalists.

• Incorporating can provide a perception of more credibility and professionalism.

• While double taxation (corporate and then personal tax on dividends) is a downside, benefits such as the ability to retain profits and potential tax deductions are advantages.

Cons

• C corporations are subject to double taxation, where income is taxed at the corporate level and again as dividends to shareholders.

• Corporations face stringent regulatory requirements, including mandatory annual meetings, detailed recordkeeping, and reporting obligations.

• Corporations require a formal structure of directors, officers, and shareholders—each with defined roles and responsibilities.

• S corporations, a subset of corporations, have restrictions on the number and type of shareholders they can have, and how profits are distributed.

Legal implications and protections: LLC vs. Inc.

Both LLCs and corporations come with liability protection, but they differ in their legal frameworks, compliance requirements, and implications for business owners. The choice between the two structures depends on factors such as the size and complexity of the business, desired tax treatment, and the level of formality desired in management and operations.

• Liability protection
  Both LLCs and incorporated companies come with limited liability protection, but there’s a slightly greater risk of courts “piercing the corporate veil” with corporations, which is a rare occurrence when owners might be held personally liable for business debts. This usually happens when owners have commingled personal and business finances, failed to maintain proper corporate formalities, or engaged in fraudulent activities. Both LLCs and incorporated companies are subject to this risk, but it’s less likely for LLCs due to their more relaxed operating requirements.

• Legal formalities
  Incorporated companies have more stringent legal formalities than LLCs. They must adhere to specific corporate governance rules, hold regular shareholder meetings, maintain detailed records, and file annual reports.

• Tax implications
  LLCs can choose to be taxed as a sole proprietorship, partnership, S corporation, or C corporation. Incorporated companies are typically taxed as C corporations, which leads to double taxation, but they can elect to be treated as S corporations if they meet specific IRS requirements.

• Contracts and legal agreements
  Both LLCs and incorporated companies can enter into contracts and legal agreements in their own name. Contracts should always be signed in the name of the LLC or incorporated company, not the individual owners, to ensure that the limited liability protection applies.

Why startups might choose to form an LLC or incorporate

For startups, the decision between an LLC and a corporation is an important one. Corporations can help businesses raise more external capital, conduct a public offering, and accomplish major growth. LLCs come with less personal financial risk and a simpler management structure. Each structure also has its own tax implications. Here’s a closer look at why startups might choose each structure.

Reasons startups might choose to form an LLC

From management flexibility to taxation, there are many reasons startup owners might prefer to form an LLC over incorporation.

• Less paperwork: LLCs generally require less paperwork and formal procedural requirements compared to corporations. There are no mandatory shareholder meetings, board meetings, or minute-keeping, making the administrative process simpler and more flexible.

• Simpler management structure: LLCs are easier to manage—either by members or managers—and offer more flexibility.

• Pass-through taxation: The default tax treatment for LLCs is pass-through taxation, which avoids the double taxation that C corporations face.

• Flexible ownership: There are no restrictions on the number or type of owners in an LLC. This can be advantageous, particularly if the startup wants to include foreign nationals or other entities as members, which are more restricted in S corporations.

Reasons startups might choose to incorporate

Startup owners might choose to incorporate over forming an LLC for the following reasons:

• Raising capital: Becoming a corporation can help startups raise external capital. Corporations can issue various types of stock, which can be attractive to venture capitalists and investors who prefer equity shares that reflect varying levels of risk and potential returns.

• Credibility and perception: Incorporating can boost a startup’s credibility with potential customers, suppliers, and investors, who may perceive the corporate form as more stable and better managed than an LLC.

• Perpetual existence: Corporations have the advantage of perpetual existence, unlike LLCs, which might have a limited life or dissolve upon the exit or death of a member. Corporations continue to exist regardless of changes in ownership or management.

• Tax flexibility for future needs: Corporations allow owners to retain profits within the company (at a potentially lower corporate tax rate), which they can reinvest in the business without immediate tax implications for shareholders. Corporations can also offer stock options or purchase plans, which are attractive recruitment and retention tools.

How to convert from an LLC to an Inc.

Converting an LLC to a corporation is a legal process that business owners might do for several reasons, including seeking more investment or planning for a public offering. Here’s an overview of the process.

Determine the type of corporation

Decide whether you want to form a C corporation or an S corporation. C corporations are the default option and are subject to double taxation. S corporations come with pass-through taxation, but they have stricter eligibility requirements.

Choose a conversion method

There are two main methods to convert an LLC to a corporation:

• Statutory conversion: This is a simplified process available in many states. The LLC files articles of conversion with the state along with any required supporting documents. The LLC’s assets and liabilities automatically transfer to the new corporation.

• Statutory merger: This is used in states that don’t allow statutory conversion. The LLC’s owners create a new corporation and merge the existing LLC into it. This can be more complex and might require additional filings and approvals.

If you choose to form an S corporation, you’ll also need to file Form 2553 with the IRS to elect S corporation tax status.

Prepare and file the necessary documents

The exact documents required vary by state and the chosen conversion method chosen, but articles of conversion and articles of incorporation are typically part of the process.

• Articles of conversion: These documents outline the conversion process, including the names of the LLC and new corporation, the effective date of conversion, and details about the transfer of assets and liabilities.

• Articles of incorporation: This document establishes the new corporation and includes information such as its name, purpose, registered agent, and share structure.

Obtain necessary approvals

Some states require approval from LLC members or managers before the conversion can proceed. This might involve holding a meeting and obtaining written consent.

Update internal documents

Update the company’s operating agreement, bylaws, and any other internal documents to reflect the change in structure and ownership.

Notify relevant parties

Notify the IRS, state tax agencies, banks, creditors, customers, and any other relevant parties about the conversion.