A startup’s choice of corporate structure can shape the trajectory of the business for years. The structure of your startup affects your day-to-day operations and long-term prospects, including fundraising, tax implications, operational procedures, and growth potential. Deciding on a business structure is a fundamental part of planning for growth and sustainability.
An analysis from the Small Business and Entrepreneurship Council indicates that as of 2019, there were over 6.1 million employer firms in the United States, of which 89% had fewer than 20 employees. But only a fraction of these small businesses grow to the stage in which they can secure institutional investment, largely because of decisions made early in their life cycles. One such decision—whether to form an LLC or a corporation—can directly affect a startup’s ability to secure funding, hire talent, and manage tax liability.
Whether you’re building the next innovative tech startup or an enterprise to disrupt your local market, you should understand the differences between an LLC and a corporation. Below, we’ll cover the key distinctions between these business structures, explain how they might affect your startup, and provide guidance on how to make this important decision.
What’s in this article?
- What is an LLC?
- What is a corporation?
- LLC vs. corporation: Similarities and differences
- LLC vs. corporation: How startups should choose
What is an LLC?
An LLC, or limited liability company, is a specific type of business structure that combines elements of corporations and partnerships. It’s a popular choice among small business owners because of its flexibility and protection benefits.
Here are a few key characteristics of an LLC:
Limited liability: An LLC provides its owners (known as members) with limited liability. This means the personal assets of the members are protected if the business incurs debt or is sued. Corporations offer similar protections.
Pass-through taxation: Unlike corporations, an LLC typically does not pay corporate taxes. Instead, the profits and losses of the business “pass through” to the personal income of the members, who then report this information on their personal tax returns. This avoids the “double taxation” that can occur with corporations, where profits are taxed first at the corporate level and then taxed again when distributed as dividends.
Operational flexibility: An LLC is more flexible than a corporation in terms of operations and governance. For example, there are fewer requirements for annual meetings and recordkeeping.
Ownership flexibility: An LLC can have any number of members, and these members can be individuals, other LLCs, corporations, or even foreign entities. Unless the LLC’s operating agreement states otherwise, members can typically freely transfer their ownership interests in the LLC.
Management structure: Members of an LLC can choose to manage the business themselves (member-managed) or appoint managers to handle the business operations (manager-managed).
What is a corporation?
A corporation is a type of business entity that is legally separate from its owners. It is created under the laws of the state in which it is registered and is considered a separate “person” for legal and tax purposes. This means it can own property, enter contracts, sue and be sued, and engage in business operations, just like a person.
Here are a few key characteristics of a corporation:
Limited liability: Similar to an LLC, a corporation provides its owners (known as shareholders) with limited liability. This means shareholders are not personally responsible for the corporation’s debts and liabilities. Their financial liability is limited to the amount they’ve invested in the corporation.
Transferability of shares: The ownership of a corporation is represented by shares of stock, which are typically easy to transfer. It’s simpler to buy and sell ownership interest in a corporation compared with other business entities.
Perpetual existence: A corporation has a perpetual existence, meaning it continues to exist even if its owners change or die. This is a significant advantage for long-term business planning.
Double taxation: Unlike LLCs, corporations can be subject to double taxation. This occurs when the corporation pays corporate income tax on its earnings, and then shareholders pay personal income tax on those earnings when they are distributed as dividends. However, some small businesses can avoid this by electing to become an S corporation, which is taxed similarly to an LLC.
Management structure: Corporations have a formal structure that includes shareholders, a board of directors, and officers. The shareholders elect the board of directors, who in turn oversee the corporation’s overall direction and strategy. The board appoints officers (such as the CEO, CFO, etc.) to manage day-to-day operations.
Corporation types
Corporations come in several forms, each with its own advantages, disadvantages, and specific applications. Here are the main types of corporations:
C corporation (C corp): This is the standard corporation type. C corps are legally separate from their owners, provide limited liability protection and have a formal management structure, and their ownership is easily transferable through shares. The major drawback of a C corp is the potential for double taxation—once at the corporate level and again at the individual level when profits are distributed as dividends to shareholders.
S corporation (S corp): An S corp is designed to avoid the double taxation issue associated with C corps. Instead of being taxed at the corporate level, the corporation’s profits or losses pass through to shareholders’ personal tax returns, similar to an LLC. However, there are restrictions: S corps can have no more than 100 shareholders, all shareholders must be US citizens or residents, and they can issue only one class of stock.
B corporation (B corp): A B corp is a for-profit corporation committed to creating public benefit in addition to generating profit. This means B corps have societal and shareholder responsibilities. B corps must meet certain standards of social and environmental performance, accountability, and transparency. The certification process is handled by a third party (B Lab), and a business can be both a C corp or S corp and a certified B corp.
Nonprofit corporation: Nonprofit corporations are organized to fulfill a charitable, educational, scientific, religious, or literary purpose. They are tax-exempt under IRS section 501(c)(3), and any profits made must be used to further the organization’s mission, not distributed to members or directors. Donations made to a nonprofit corporation are often tax-deductible for the donors.
Professional corporation (PC): PCs are corporations for professionals such as doctors, lawyers, accountants, and engineers. In many states, these professionals are not allowed to form a standard corporation or LLC, so they form a PC instead. Though PCs typically offer the same limited liability protection as a standard corporation, in some cases, professionals may still be personally liable for malpractice claims.
Close corporation: Close corporations are more common in smaller business operations, with a more limited number of shareholders and a less rigid management structure. They often operate more like a partnership. The shares of close corporations are not sold to the general public and often come with transferability restrictions to prevent the business from becoming publicly traded.
The appropriate choice of corporation type depends on numerous factors, including the number of shareholders, the need for capital, tax considerations, and the overall business goals.
LLC vs. corporation: Similarities and differences
The biggest similarity between LLCs and corporations is that both business entities provide owners with limited liability protection. However, they have substantial differences in terms of structure, management, taxation, and ownership rules.
Let’s discuss the similarities and differences:
Similarities
Limited liability: Both entities provide owners with limited liability protection. This means the owners are not typically personally responsible for business debts and liabilities.
Separate legal entities: LLCs and corporations are separate legal entities created by a state filing.
State regulation: Both are regulated under state law and must be formed by filing the necessary documents with a state agency, usually the secretary of state’s office.
Differences
Ownership: Corporations determine ownership through the issuance of stock. Stock can be transferred easily, making it simple to sell ownership interests. Corporations can also have an unlimited number of shareholders. In contrast, LLC ownership is often harder to transfer and may require approval from other members. Some states restrict the number of members an LLC can have.
Management: Corporations have a fixed structure consisting of officers, shareholders, and a board of directors. The board oversees the corporation’s business and affairs, while the officers manage day-to-day operations. Shareholders elect the board and vote on major corporate issues. LLCs are more flexible; they can be managed by the members (owners) or by managers, depending on the terms of the LLC’s operating agreement.
Taxation: A key difference between LLCs and corporations is how they are taxed. Corporations are treated as separate tax entities and are subject to corporate income tax rates. After the corporation pays income tax, any dividend distributions to shareholders are taxed again at each shareholder’s personal tax rate (double taxation). In contrast, LLCs typically have pass-through taxation in which the profits and losses pass through to the owners’ personal tax returns. However, an LLC can choose to be taxed as a corporation, and a corporation can avoid double taxation by electing S corporation status, if it meets certain requirements.
Formality and paperwork: Corporations must adhere to more formalities and regulatory compliance, such as holding annual meetings, maintaining corporate minutes, and having a board of directors. LLCs are not usually required to observe such formalities.
Profit distribution: Corporations have set rules for profit distribution based on the number and type of shares owned. In contrast, LLCs have more flexibility and can distribute profits in different ways as decided by the members.
LLC vs. corporation: How startups should choose
Choosing the right business structure can influence legal liability, funding options, tax implications, operational flexibility, and even the success of the business in the long run. Let’s examine how a startup might decide between an LLC and a corporation:
Founding team’s future vision: Consider the type of business you’re planning and your long-term goals. If you envision a smaller operation or one that will primarily involve a few key owners, an LLC might be a good fit because of its flexibility and simplicity. However, if your vision is to grow big, get publicly listed, or attract venture capital, a corporation—particularly a C corp—may be the better choice. Many investors prefer the structure of a corporation because of the clearly defined roles and familiarity.
Investment and funding needs: Corporations, specifically C corporations, are often a better fit for startups that plan to seek funding from venture capitalists or through an initial public offering (IPO). This is because the stock of a corporation is easily transferable and can be divided into different classes with different rights, which is attractive to investors.
Operational flexibility: LLCs have fewer regulatory requirements and greater operational flexibility than corporations. They have fewer formal meeting requirements, fewer document filings, and greater flexibility in distributing profits. If maintaining a less formal, more flexible management structure is important for your startup, an LLC may be a good choice.
Tax considerations: An LLC is a pass-through entity, meaning profits are passed through to the owners’ personal income without incurring corporate taxes. In a C corporation, profits are taxed at the corporate level and potentially again at the personal level when distributed as dividends. However, a corporation can mitigate this double taxation if it retains and reinvests its profits or if it chooses to be an S corporation.
Employee compensation: A corporation might be the best choice of structure if you plan to offer stock options as a part of employee compensation, a common practice in many startups. While LLCs can distribute membership interests, it can be a more complex process than issuing stock options in a corporation.
Liability and legal protection: LLCs and corporations offer limited liability protection, but the laws and regulations can vary by state. Depending on the specifics of your business, one may offer more advantages than the other.
Selecting the appropriate business entity is a decision that can significantly affect your business legally and financially. But every startup is unique, and there’s no one-size-fits-all answer. If you expect to reinvest significant profits back into the business, a corporate structure may be more beneficial. If flexibility and simplicity are a priority, an LLC could be a better choice. Fully understanding your business’s unique attributes can help you choose the best business structure, increasing stability, growth, and success.
Approach the process of choosing a business structure with thorough research, thoughtful deliberation, and professional counsel. Changing your business structure after you’ve established your business can be complicated and costly, so it’s worth taking the time to make the right decision from the start.