What Is an LLC? And How Is It Different Than a Corporation?

I know a thing or two about the complexities of launching a new business. As the owner of several businesses in the Los Angeles entertainment industry, I know from experience that you’ll have a quadrillion questions.

And one of the initial questions you’ll certainly need to ask is, “What is an LLC, and how does it compare to a corp?” Then naturally, your next question will be, “So…which one should I set up?”

Most “movers and shakers” need to pick between establishing a corporation (aka Inc.) or a limited liability company (aka LLC). This can be a tough decision, largely because it’s difficult to understand the differences (let alone which might benefit you more)!

DISCLAIMER: I want to quickly stop and say that I am not a CPA or Attorney. I am an entrepreneur that has started multiple companies and other entities for real estate purposes. So what I write here is what I have learned for myself over the years (much of which was from my CPA and attorney). Before you make your final decision on what to do for your company, please consult your own CPA or attorney!

Now, before we look at some of the more important factors that differentiate the two, let me first answer the question of…

What is an LLC?

An LLC, or limited liability company, is a legal business entity you form to protect your personal assets from liability. It will also establish how your business income is treated come tax time.

It’s not the only business entity that does this, though. It’s one of a handful.

What is a corporation?

The other most common option is a corporation (aka a corp or Inc.). Corporations are another business entity that also provides liability protection. But, they are set up a little differently from an LLC.

They are an entirely separate entity from their owners, who hold ownership through shares (or stock) of the company.

What are the differences between an LLC and a Corp?

These two business entity options have some similarities and, of course, differences. Choosing between the two will depend on your business type and needs and your own liability and tax planning goals.

Ownership

An LLC is typically either owned by one person or a small group of co-founders. But technically, an LLC doesn’t have “owners”; it has “members.”

The governing rules of an LLC are spelled out in an “operating agreement.” Additionally, it’s worth noting that all members can manage the LLC (aka “member-managed”), or one designated member can manage it (aka the “managing member”).

Meanwhile, an Inc. effectively belongs to the people who hold shares in it, and the company management is accountable to those shareholders. Because a corporation is very distinct from its shareholders, a shareholder can sell their stock to someone else, and the company can continue doing business fairly seamlessly.

This is why most private investors will want to have the entity be a corp rather than an LLC. And eventually, if the company grows and goes public, that step will be much easier.

Liability Protection

One reason why making your business an LLC is worthwhile is because, as the name “limited liability company” suggests, it creates a barrier between the business activity and the member’s personal assets from a legal standpoint. Any debts it accrues will not fall to you to repay should it encounter legal issues, for example. (Unless, of course, the debts are personally guaranteed.)

That said, an Inc. pretty much offers the same liability protection that an LLC does, especially for an Inc. owned by one person or spouses. This information comes from my long-time attorney, by the way, so you can rest assured it’s accurate.

In the end, they both will protect you similarly if the company gets sued. However, if you personally get sued, an LLC might be better. Why? If you personally get sued (say from a car accident), and you lose, the suit can take ownership of the stock of your Inc. and consequently control over any assets. Yikes.

Now, if you have an LLC, a winning suitor can’t take ownership of your share of the LLC. They can get a charging order to garnish your income from the LLC, but you can remain in control of what income you get. Bonus for the LLC!

Paperwork

One of the common issues discussed when deciding between an Inc. or LLC is the amount of paperwork hassle you have to undertake.

Generally speaking, LLCs indeed have less paperwork, particularly because it doesn’t have to hold “annual meetings” of the directors and take meeting minutes. It also does not have to issue “stock certificates” to its members.

It’s also true that a single-member LLC doesn’t have to do payroll or even file a tax return (because all profit is taken on the individual owner’s “Schedule C”). Now, that would be beneficial; except that, as you will see below, it comes at a relatively high financial cost.

So, if you make your LLC an S corp to save on taxes, you will have to, in fact, do payroll and file a tax return for the entity. But again, that still does leave the LLC/S corp with fewer paperwork hassles overall.

Tax Treatment

Tax savings used to be the most important deciding factor between an Inc. and an LLC. Oddly, since both can be classified as C corps and S corps for tax purposes, they can be pretty much the same. But let’s take a closer look…

Federal Taxes

Just as independent contractor taxes are applied on the basis that this is personal income, the same status is relevant if you generate income from an LLC as a sole owner. In plain English, a single-member LLC does not have to do a tax return. Instead, the net income goes right on your personal return on the “Schedule C.”

Multi-owner LLCs will be taxed as partnerships, which means the entity does have to file a tax return. However, the net income still passes through directly to the members’ personal return; only it’s in the form of a K1.

In both of these cases, being the profit of the LLC is passed directly onto the members, the entity itself pays no taxes. Thus, this is a so-called “pass-through entity.”

Furthermore, in both cases (specifically of LLCs), those profits that are passed through are subject to “self-employment tax” (of an extra 15%) on the personal return. It’s the same for 1099 income as well. This is very important to note! (More on this below.)

NOTE: K1s are the tax document a company owner will get at the end of the year to represent the income they received from the company. It’s similar to the W2 that an “employee” receives or 1099 that a freelancer would get.

On the other hand, corporations are taxed as if they were an entity in their own right. Revenues gained through sales are considered the equivalent of income earned by individuals.

A C corp earns money, has expenses it deducts, pays federal (and often state tax) on the net income. It does not “pass through” to the shareholders. That said, you can make an Inc. a pass-through entity by giving it an S corp election (see below).

A tax on profits and dividends will also apply. If you are a shareholder, the dividends, in particular, will be taxed twice since they are not deductible (which is why people often avoid C corps).

This rule encourages owners to inject cash back into the business rather than extracting it as it grows (to avoid this double taxation). In addition, this means that the C corp does not have to pass on the profits if it doesn’t want to. Instead, it can just keep them and reinvest them back into the company.

State Taxes

Now don’t think you are out of the tax woods yet! Your state will want to get its hands on some tax as well, most likely.

There are actually two types of state tax you may run into. First, you have tax on “net profits,” which you would commonly refer to as “income tax.” But again, income tax will only be paid by a C corp (or a non-pass-through entity).

That said, some states also have a “privilege tax” (which can also often be called a “franchise tax” or “minimum business tax”).

The privilege tax is just that. A tax for the privilege of doing business in that state. This tax is often based on the gross revenue of the company, with a minimum amount imposed.

NOTE: The privilege tax percentage may be the same for both LLCs and Inc.’s, but often it’s different…yah! I have found that the privilege taxes imposed on LLCs are often higher than that of INCs. But it varies state by state.

To confuse matters a bit more, most states also require you to file an “annual report” where you update them on any changes (or lack of) that have happened with your entity. Unfortunately, with this report, you usually pay a fee.

In some states, the annual report fee is one-in-the-same as the privilege tax. In others, you may have no privilege tax, but you have an annual fee. To confuse matters more, in some, you have just a privilege tax and no annual fee! Aye, Yai Yai!

Suffice it to say, you should do some investigation on this. You can check out my post about Annual S Corporation Filing Requirements for All 50 States, where I lay much of this out!

S Corp (Tax) Status

At some point, it became possible to give your corporation (which by default is a “C” corp) an “S” corp designation. This basically makes the corp a pass-through entity. But an S corp exists only as a taxation option rather than as a specific type of entity.

Now it’s true that this means all profits are no longer taxed at the corporate level but passed through to the shareholders. HOWEVER, being that in a corporation, the (active) owners are also considered employees, you have to do some amount of payroll for the owners.

The common practice (for single-owner entities) is to give yourself a percentage of your profits in the form of “W2 Salary” and the rest as profits. What that percentage is, you have to figure out with your CPA, of course. But this is also a crucial tax distinction (more on this below).

This practice can also be useful in preventing the full profits of a business from being taxed if you are only taking a small proportion of this as income.

Interestingly, it’s possible for LLCs also to request to be classified as an S corp by the IRS. In the case of an LLC classified as an S corp, the owner is considered an employee (just like in an Inc./S corp).

So rather than simply equating the income and expenses of the organization to personal income on their tax returns (i.e., on their “Schedule C”), they must take part of their profits in the form of a W2 salary.

Effectively, both LLCs and corporations can be classified as S corps if they wish, although there are some restrictions. For example, an S corp cannot have over 75 shareholders, and everyone needs to be a resident within the US.

The CRITICAL Self-Employment Tax Distinction (for an S corp) **VERY IMPORTANT**

Ok, this is one of the MOST IMPORTANT things to know in all of this bologna! A little ways back, I wrote that…

1) An LLC passes through all the profits to the members and then has a 15% “self-employment tax” imposed.

Well, the reason this is the case is that the fed and state want to get some money for social security, medicare, and UI. But being you don’t receive W2 payroll, they don’t collect it through your paycheck. Instead, they collect in the form of a self-employment tax.

2) I also said that an S corp considers the owners “employees,” which requires you to pay yourself via a W2 paycheck…and is therefore taxed via employment taxes.

HERE’S THE THING. With an S corp, you only have to pay yourself “reasonable” compensation in the form of W2. Commonly this is considered to be somewhere between 40-60% of your profits, but it could be more, and it definitely depends on what your CPA advises.

The remainder of your profits come to you from that K1 that I mentioned earlier. BUT, for whatever reason, that K1 income is NOT SUBJECT TO SELF-EMPLOYMENT TAX. Thereby saving you money in taxes!

Here is a tax calculator I made illustrating how the tax savings can potentially work. But again, you do have to check with your CPA to see if you and your business can capture these potential tax savings.

Now, if you are interested in getting your hands on this calculator, you can do so by checking out my free course on Incorporating Your Business. Or, you can check my article, “How to Incorporate Yourself to Save Money.“

Some other semi-important random points about the entities

• LLCs can have INC/C corps, INC/S corps, LLC/S corps, LLCs, and people as members.
• S corps can only have individuals (or a living trust) as a shareholder.
• S corp can change back to C corp, but you have to wait 10 years to switch again once you do that.
• Per my CPA: Except for medical write-offs, S corps are usually more tax-favorable.
• Per my CPA: Statistically, S corps get audited the least of all entities.
• If you have losses on a C corp, no one benefits, as it does not pass through. However, losses are passed through to the owners for S corps and straight LLCs.
• Customers are required to send Single-Member LLCs and Partnership LLCs a 1099. But, they don’t have to send a 1099 to an INC/C corp, INC/S corp, or an LLC/S corp. You are on the honor system for those entities in terms of reporting your income to the IRS.

Which is right for you?

For small businesses, becoming an LLC (with an S corp election) could be the best option, particularly if the organization is small and is aiming to minimize the complexity of its tax affairs while still protecting the owners from unwanted legal ramifications.

But again, you should double-check the state-based taxes for LLCs before going that route. I personally feel that the INC/S corp is the best way to go for individual owners or spouses. That’s what I do, but I can’t tell you what to do. You have to decide for yourself.

Growing firms with several owners who are looking at the option of becoming a corporation, but do not want to commit to being a fully-fledged C corp, should consider the advantages of S corp status. You can even go back to being a C corp if you need to.

This post originally appeared on Wealth of Geeks.